Employee stock options form a core part of a growing startup’s compensation package. Yet, this is a widely misunderstood topic by employees (sometimes, even founders themselves aren’t clear on how that works). It took us a while to figure out what was going on, and make sense of the information. Everyone had something to say about employee stock options, how to structure, how it works, etc. Here’s how we explain it simply, so that you, as an employee, are aware of what it means when you are awarded employee stock options:
Fact #1: Employee stock options suggest you own a piece of the company
Here’s the most straightforward (and widely understood) purpose of employee stock options — to enjoy ownership of the company you are working at. How you own part of the company is through shares. Shares are what you own (assets, as the financial people would love to classify it under). Just as how you can buy/sell shares of publicly traded companies such as Singapore Airlines, Apple, Google, etc., having shares in a company means you can buy/sell them. The key difference, however, would be the conditions where you can buy / sell. More on this later.
How much of the company do you own? The math is simple:
(Number of shares you own) / (Total number of shares the company has) x 100% = Your % ownership
However, it is surprisingly easy to forget that when more shares are issued, the total number of shares the company has also increases, hence diluted ownership. Say Company A has 1000 shares in total on 30 Jan 2016. Company A issues 100 shares to Employee X on 1 Feb 2016. Employee X thinks he has 10% of the company. That’s wrong. Because Company A now has 1100 shares in total, Employee X has 100 / 1100 = 9.09% of the company.
This is important because as an employee, the number of shares you own never changes, but the total number of shares the company has does (and it tends to increase). For example, Employee X owns 100 shares and Company A has 1100 shares. Company A decides to raise funding and investors in Company A decide that in exchange for their investment, they want 20% of the company.
Company A cannot “reduce” the total number of shares, so they have to increase. In order for investors to own 20% of Company A, Company A has to issue 275 more shares. That means, Company A now has a total of 1375 shares and 275 shares are given to the investors.
Now, remember that Employee X owns 100 shares? Initially, he had 100 / 1100 = 9.09%. Now, after the investors came in, he has 100 / 1375 = 7.2%. That’s 1.89% reduction in percentage ownership.
Fact #2: Employee stock options suggest you own a piece of the company — not just yet
Buying/selling/owning employee stocks is not as simple as trading on the public market (in term of liquidity). Here’s where the differences start — cliff & vest.
Cliff is the time period where if you leave the company, you don’t get any of the stock options. Zero. Zilch. At Glints, we practisee a 12-month cliff period, similar to that of other tech companies. That means if we award you 100 shares on 1 January 2016 and you leave the company before 1 January 2017, you do not get the right to own/buy any shares. You have no equity.
Vest is the time period where if you leave the company, you get pro-rated stock options. At Glints, we practise a 48-month vest period (including the 12-month cliff period), similar to that of other tech companies. That means if we award you 100 shares on 1 January 2016 and you leave on 1 January 2018, you would have the right to own/buy only 50 shares. This is because you have only worked for 24 months (out of the 48-month vest period), hence you are eligible for 24/48 x 100 shares = 50 shares.
Here’s the math:
(Time you spent working with the company since award of stock options) / (Vest Period) x Your % maximum ownership = Shares you can own
Your % maximum ownership is what is stated on your employment contract.
Say Company A tells Employee X at the point of hiring — you are receiving $3000 in monthly salary and 1% stock options with a 1 year cliff and 4 year vesting period. Employee X cannot just leave right away with the 1% in stock. Employee X has to work for the full 4 yeas in order to enjoy the 1% in stock. If Employee X leaves in Month 11, he is not entitled any stock. If Employee X leaves in Month 36, he is entitled to (36/48) * 1% = 0.75% of the stock.
Fact #3: Employee stock options suggest you own a piece of the company — you have to buy
This is the most commonly overlooked fact where employees gloss over, only to realise later and feel that they have been “conned” by the company. Shares in the company aren’t given upfront to employees. They have to be bought by the employee.
At this point, the common reaction would be — What? I’m already contributing to the company and I actually have to spend my own money to get what I am entitled to?
Yes. Here’s how it works.
When the company issues you stock options, they will indicate the current price of the stocks (either as a price per share or as a whole lump sum of how much your stock options are worth). Say Company A is currently valued at S$1,000 and owns 1000 shares. The price per share is $1 / share.
As Employee X, you own 10 shares, amounting to 1% of Company A. These 10 shares aren’t given to you. You will have to buy them, at 10 shares x $1/share = $10.
The assumption then would be that Company A becomes more valuable (because of Employee X’s contributions). Say Company A grows and is valued at $10,000 a year later. With 1000 shares, the new price per share is $10 / share. As Employee X, you own 10 shares. Your 10 shares are now worth 10 shares x $10/share = $100.
Your investment has just increased by 10x, from $10 to $100, because your net gain is $100 – $10 = $90. You do not make $100 because you paid $10 to own the 10 shares earlier on, remember?
Now here’s where the tricky part comes:
Hard Truth #1 — These are numbers on paper, not cash in your wallet.
In tech companies, the valuations are frequently determined by the latest round of investment by external investors. In the context of the example above, Company A was valued at $1,000 at the start by their first round of investors (seed). Later on, new investors decided that Company A should be valued at $10,000 given the traction. Employee X just enjoyed a 10x increase in investment. Amazing right? Except it’s only on paper. The net gain of $90 does not end up in Employee X’s bank account. It is simply paper wealth.
Lesson #1: Don’t hope to get rich through your equity. Treat your equity as worthless, and if it happens to materialise, it’s a bonus.
But can’t I sell it? Sell it to people who are willing to buy it at $10/share?
Hard Truth #2 — If you want to sell your shares, you have to offer it back to the company at the original price which you bought.
In the event that you want to “cash out”, most of the time, there is a legal clause indicating that you will have to offer your shares to the company at the exact price which you bought it first, before you can sell it to someone else. This is called first right of refusal. This is also to ensure that the company’s shares do not end up in the wrong hands (such as you selling the shares to a competitor, who can then demand to see your company’s sensitive information).
In that respect, you can’t choose to sell your shares to anyone, even if you have found a willing buyer. You can’t even sell the shares to existing shareholders (e.g. Employee X can’t sell his shares to Founder 1). You have to “return” the shares to the company as a “refund”.
Lesson #2: Don’t hope to get rich through your equity. Treat your equity as worthless, and if it happens to materialise, it’s a bonus.
Then isn’t all this equity a scam? When do I actually ‘cash out’ on my equity?
Hard Truth #3 — You will only get to cash out where there is a liquidation event for the company — trade sale / Merger & Acquisition / IPO
Only when there is an “exit” will you be able to cash out on your equity and enjoy the net gains. Say Conglomerate Z decides to buy Company A at $10,000 (as compared to Company A at $1,000 when Employee X joined), only then can Employee X “cash out” the stock ownership and enjoy the net gain of $90.
Lesson #3: Do not start planning your retirement just yet. There are many factors that determine whether an exit event happens, and remember — companies are bought, not sold. Very few successful companies were designed to be sold / exited from the onset.
Alright, after my cliff ends, I want to move on from the company I am at, since I will own shares in Company A after all.
Hard Truth #4 — If you leave early, you have a limited time to “exercise” your stock options. That means you need to get the money to buy the shares, else you lose the shares.
Returning back to the example above, imagine Employee X was awarded 10 shares at a price of $1 / share across a 4 year vest period, and Employee X leaves after the 2nd year of joining the company. Employee X is then entitled to 50% of his shares — 5 shares. Employee X then has to buy the 5 shares within a specific time period, commonly known as the exercise period. The standard exercise period is 90 days.
This means that within 90 days, Employee X has to cough up 5 shares x $1 / share = $5 in order to own those 5 shares.
Now we have significantly reduced the numbers to make the math simple. Any respectable company at an early stage would be worth much, much more. Let’s say the company is valued at S$1,000,000 (1 million), the typical valuation of a seed stage technology company.
If you are Employee X who is awarded 1% equity across 4 years but you leave in Year 2, you will have 90 days to pay the company 50% (vest) x 1% (original equity) x $1,000,000 (company valuation when you joined) = $10,000 within 90 days. That’s no small sum, and this is for an early-stage company.
Now imagine you are an employee at a Series A company, where valuations tend to range from $5,000,000 upwards. If you are Employee X, you have 90 days to pay 50% (vest) x 1% (original equity) x $5,000,000 (company valuation) = $50,000 within 90 days.
If you aren’t able to pay, you don’t own the shares. It’s simple (and brutal).
Lesson #4: Be extremely selective of the startup you join. If you want to reap the fruits of your labor, be prepared to work until there’s an exit. Early departures in the company will be costly for you, especially if you still want to retain the up-side.
A Message to Glints Team Members Reading This
I wrote this article to explain the realities of employee stock options. By now, you would have realised that employee stock options aren’t that straightforward, and there are a lot of uncontrollable circumstances that affect this arrangement. Still, we believe in awarding employee equity because it creates ownership and allows you to enjoy the up-side.
With the employee stock options you own, I encourage you to avoid using an “expected value” calculation to decide whether you want to join / stay on with us. The probability distribution is unknown — the least your stock is worth is $0, and that’s the default value. The best companies return 10x. As we work towards being the best, the upper bound of your stock is most likely 10x of your purchase price. Finally, to “realise” (or liquidate) your equity will take years, and there is no specific timeframe in mind.
Decide to join us / stay on because you believe in what we do, you believe that we can succeed in what we do and you believe that you have a role to play when we succeed in what we do.
And we know that if our equity is ever worth something in future, it would be the sweetest icing on the cake we ever tasted.
Image Sources: http://cubeit.io/blog/wp-content/uploads/2016/01/StckOptions.jpeg
Article inspired from: https://medium.com/@henrysward/a-better-offer-letter-4e9bf61a7365#.3pldidf39