What you should know about your startup stock options

Congratulations! You got your dream job at a startup. You’re reviewing your offer letter and you see your salary, which is about what you were expecting. You also see a grant for stock options. The letter says you’ve been awarded 400 stock options. Amazing! Or is it amazing? Is 400 stock options high? Is it low?

You call your recruiter to get more insight. They confidently tell you that your 400 stock options are worth $1M. That sounds pretty good, right?

Unfortunately, they have no idea what your stock options will be worth, and you don’t either.

Why talk about startup stock options?

Over the last several years, I’ve been part of hundreds of conversations about stock options. One thing has become clear: Some people are much more informed than others.

Before we started Textio, I had only worked at large companies that were publicly traded, not at startups. Stock was a regular and sizable part of my compensation; at least once a year, I received a large number of shares, which I could turn into cash at any time. I knew next to nothing about stock options and how they differed from stock. In my experience, this is true of most people joining a startup for the first time, and even of some people who have worked at several.

I’ve noticed other patterns too. The people who are least represented within startups tend to be the least informed and the least likely to ask questions about it. Over the last few years, I’ve spent a lot of time offering Q&A on stock options at Textio so that people can better understand their compensation. Consistently, more than 90% of the questions I get come from white men. Their questions are often precise and in the details. They ask about early exercise, exercise windows, the timing of our annual 409a valuation, potential acceleration of their vest during a change of control, and more.

If these terms are unfamiliar to you, you’re not alone. But very few people in our employee forums ask me what they are, and very few people other than white men ask me any questions at all. Almost no one asks the fundamental question that is probably on their minds if they’re brand new to stock option compensation: What are stock options? How do they work?

Inequitable access to information leads to inequitable outcomes. This blog doesn’t cover every question you might have on the topic, but my hope is that it begins to level the playing field. At the end of this piece, I share the five questions I’d make sure to ask as part of understanding your stock options grant.

What are startup stock options?

A stock option is literally an option: It’s a contract that offers the holder of the option to buy a specific number of shares of stock in the company at a fixed, pre-set price.

How is that price set? At least once a year (more if the company is fundraising), your company has an independent auditor perform what’s called a 409a valuation. The independent auditor looks at company performance and the overall market, and determines the price for any of the company’s employee stock options that are issued that year.

Let’s say you get a stock option grant of 400 options when you start your new job. The current issue price is $5 a share. This doesn’t mean that you have $2,000 worth of stock; you do not. It means that, at a later date when you’re eligible to sell your stock and there is a market for doing so, you have the right to buy your 400 shares from the company for $2,000. At that point (or any point after) you can sell your shares for whatever the market will allow at that time.

A stock option gives you the right to buy stock from your company at a fixed price at a later date. This is advantageous if you believe the value of the company will continue to increase, because your buy-in price would be lower than the price at which you could sell your options.

So if that recruiter tells you that you have $1M worth of stock options when you get your job offer? They’re lying to you. What you likely have is the right to pay $1M later on to buy some stock, and hopefully sell it for a higher price. That’s pretty different.

What’s the difference between stock and stock options?

In publicly traded companies, compensation often includes stock. These are shares in the company that can be traded for cash, at a price determined by the public market. When you receive stock awards, you can choose to sell your stock right away or hang on to it to sell later. If you believe the company is doing great work and the share price will continue to increase, you might hang on to your stock for a long period of time. When you own stock in a company, you have an immediate share of ownership in the company.

In contrast, stock option grants do not give you direct shares in the company. They give you the right to buy shares later on.

How does vesting work?

Vesting is the process of earning all the stock options that have been committed to you in your grant. In most companies, vesting happens automatically by working at the organization for a specified period of time.

If you receive 400 stock options at an issue price of $5/share, the next thing you want to know is when you have the right to buy your 400 options (also called exercising). Your employment contract specifies these terms. Let’s say your contract specifies that you have a 4-year vest with a 1-year cliff. This means that you earn your 400 options by working at the organization for 4 years, at the rate of 100 shares a year. If you leave the organization after 2 years, you have earned half your options, and you forfeit the remaining 200 shares.

A cliff is the minimum amount of time you need to work to earn any of your options. If you have a 1-year cliff, it means that you need to work at the organization for at least one year to earn your first 100 options. After the cliff, at most organizations, options continue to vest monthly.

What does it mean to exercise your stock options?

Exercising your options means that you’re paying your company cash in exchange for ownership of the options that you have vested. If you continue to work at the company, you don’t need to exercise your options until you are ready to sell them. If you leave the company, you generally need to exercise your options within a certain time period or forfeit the right to exercise them later. Any stock options you do not exercise get returned to the company.

Why do startups use stock options?

Stock options give employees a share in the potential upside of the company’s success. They are high-risk, high-reward compensation. You don’t know how much they will be worth when they’re first issued. But if the company does well, employees with large option grants stand to gain significantly.

Startups are looking for employees who want to create this kind of liquidity for themselves; the theory is that, if they believe in the company, they will care deeply about its success and work towards it. For a startup to succeed, it needs a full team of people who buy in. When a big part of the compensation package is in stock options, people have incentive to buy in; when the company succeeds financially, they do too.

How do startups negotiate stock options? How much should I expect to get?

Most startups determine stock option grants using the same principles they use for determining salary. If it’s the kind of organization that looks at fair market data to determine standard salary ranges, they’re likely doing so for stock option grants as well. If they negotiate salary, they probably also negotiate stock options. If they don’t negotiate salary, they probably don’t negotiate stock options.

Just as different roles have different salary norms, they have different stock option norms as well. Roles with high incentive pay like sales tend to receive smaller stock option grants, and salaried roles like product or engineering tend to receive bigger ones.

What are refresh grants?

Most organizations offer employees the chance to earn additional ownership the longer they stay at the organization. Refresh grants award the employee additional stock options, often on a regular cadence and sometimes as bonus compensation for a job well done. They are usually smaller than the initial hiring grant.

How do I turn my stock options into cash?

To turn your startup stock options into cash, you need three things to be true: You need to have vested your options and turned them into stock, you need to have exercised your options so that you own them, and you need a buyer.

In cases where a startup is growing over time or heading to a successful exit, employees can sell their stock for more than they paid to exercise their options, and they make a profit. The bigger the difference is between the initial issue price and the eventual selling price, the more money the employee makes.

This is why stock options received earlier in the life of a company tend to be more valuable. They are usually issued at a lower price, and they are finished vesting sooner. Especially if your company ends up getting acquired, there’s an advantage to finishing your vest sooner; there’s no guarantee that the employee retains their unvested options after the acquisition.

What questions should I ask when I get a job offer from a startup?

You probably want to ask several things about vision, values, customers, culture, and compensation. These are five questions I would ask about stock option grants specifically.

1. How many fully diluted shares does the company have? What percent ownership does this award represent?

It’s impossible to assess whether “400 options” is a high number or a low number, without knowing how many shares there are overall. 400 out of 1,000 is very different than 400 out of 1,000,000.

However, contrary to popular perception, knowing your percent ownership is less important than knowing the issue price of your grant. The main reason to ask about the number of fully diluted shares is that you should be wary of any organization that is unwilling to share this with you.

2. What is the issue price for this grant?

The issue price of your grant tells you how much money you’d need to buy your stock when you exercise your options after they vest. This in turn limits the potential upside you might see in a potential exit. You want your issue price to be as low as possible. (The company can’t control this value, as it is determined by the independent auditor.)

No one can tell you how much your startup stock options are worth. Anyone making statements like, “This is $1M worth of stock options” is making a promise they can’t keep (as many startup employees have learned painfully in the current market). But you should ask about the issue price anyway. Knowing the issue price is critical because it tells you how expensive it will be to buy your options, and because it sets a bound on the upside you can see in a liquidity event.

3. When is the next 409a valuation?

The 409a valuation process determines the current issue price for options grants. Companies are required to run this process at least annually to issue new options grants.

If you’re receiving your offer close to the date for a new 409a valuation, you should ask whether your options will be received at the current issue price or the new one. You want your grant to be issued at the lowest price possible. In most cases where a startup is growing, this means you want your grant at the current issue price rather than the new one. It’s important to ask this question because it may alter your thinking about the start date for your new job!

4. Do you offer refresh grants? When do you offer them?

It’s important to know whether your initial grant will be your only grant, or whether you can earn more options in the future. You also want to ask when and why refresh grants are given: as performance incentives, as part of annual compensation, or something else.

This is an important question because it shows whether the company has an ongoing commitment to increasing ownership and significant financial upside for employees.

5. What have other people recently hired in my level/role received in their stock option grants? What is the range for my level and role? How are options grants determined?

You may wish to ask this about salary too. This helps you understand how the company thinks about equity in its internal compensation and shows you how much room you may have to negotiate.

More than any other question, this one can help you understand the company’s commitment to pay equity over time.