Don't Get Screwed By Your Company's Stock Options: What To Ask Your Employer About Your Equity
In this episode of the Money Rehab podcast, Nicole Lapin and her guest Tracy DiNunzio provide an informative overview of equity compensation offered by companies. They demystify the key concepts around stock options and grants, including the difference between the two, their potential risks and rewards, and important factors to consider when evaluating equity offers.
The discussion covers essential aspects such as company valuation, exercise prices, liquidation preferences, and their impact on potential payouts for employees. DiNunzio offers insights from her own experience, highlighting the importance of understanding the mechanics behind equity compensation and aligning expectations with the realities of owning company stock.
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1-Page Summary
Understanding the Basics of Equity Compensation
Equity compensation can come in the form of stock options or stock grants, as Nicole Lapin explains. Stock options grant employees the right to buy company shares at a set price in the future, while stock grants directly provide ownership of shares, Tracy DiNunzio states.
Stock Options for Early-Stage Startup Employees
Stock options are more common for employees at early-stage startups. DiNunzio received 10,000 options allowing her to potentially buy shares. However, she cautions that options carry risk, as their value depends on the company's future performance and ability to exercise them before expiration.
Assessing the Value and Risks of Stock Options
To evaluate stock options, DiNunzio advises understanding the company's valuation and the percentage of ownership the options represent. Options can become worthless if the company fails. Exercising options is costly, so DiNunzio recommends only taking options over salary if financially secure.
Understanding the Mechanics of Stock Options
The 409A valuation, based on assets and revenue, determines the lower internal exercise price for employee options, DiNunzio explains. The exercise price impacts the potential upside.
Employees can convert options to shares at the exercise price, binding the 409A valuation to their potential gains.
Understanding Liquidation Preferences and Their Impact
DiNunzio states that liquidation preferences dictate the order shareholders are paid out in a company sale, with preferred shareholders like investors paid first. This limits potential payouts for common stockholders like employees.
Knowing if the founder holds common or preferred stock signals how well employee interests are aligned. DiNunzio recommends inquiring about these factors to understand risks.
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Additional Materials
Counterarguments
- Equity compensation, while including stock options and grants, can also involve other instruments like restricted stock units (RSUs) or performance shares that are not mentioned.
- Stock options do not always depend solely on the company's future performance; market conditions and investor sentiment can also significantly impact their value.
- Stock options might not become entirely worthless even if a company underperforms; they can still hold speculative value or be subject to a turnaround strategy.
- Exercising stock options can be costly, but there are strategies like cashless exercises that can mitigate upfront costs for employees.
- While understanding the company's valuation is crucial, it's also important to consider the broader market context and industry trends when evaluating stock options.
- The percentage of ownership is important, but the quality of the equity, in terms of voting rights and other privileges, can also be a critical factor.
- Taking options over salary might be advisable even if not financially secure if the potential upside is significant and aligns with one's risk tolerance and career strategy.
- The 409A valuation is an important factor, but it's also a snapshot in time and may not fully capture the company's potential or future growth trajectory.
- The potential upside of stock options is impacted by the exercise price, but also by other factors such as dilution from future financing rounds or changes in the company's equity structure.
- Liquidation preferences are important, but they are just one part of a complex term sheet that can include other provisions affecting employee payouts, such as participation rights or anti-dilution protections.
- Preferred shareholders are typically paid first, but in some cases, common shareholders may have negotiated terms that provide them with a minimum return or other protections in a sale.
- Knowing the type of stock the founder holds is useful, but it's also important to understand the overall cap table and the rights attached to different classes of stock to fully grasp how interests are aligned.
Actionables
- Create a personal financial safety net before opting for stock options over salary by setting aside an emergency fund that covers at least six months of living expenses. This ensures you can afford to take the risk associated with stock options, which may not pay off if the company doesn't perform well. For example, if your monthly expenses are $3,000, aim to save at least $18,000 in a high-yield savings account before accepting a compensation package heavy on stock options.
- Use online valuation calculators to estimate the potential future value of stock options you're offered. Input variables like the current 409A valuation, your exercise price, and the percentage of ownership your options represent to get a rough idea of what your options could be worth. This can help you make an informed decision about whether the stock options are a worthwhile part of your compensation. For instance, if you're offered options representing 1% of a company valued at $10 million, you can use a calculator to see what that 1% could be worth if the company's value grows to $50 million.
- Before accepting stock options, request the company's capitalization table to understand the distribution of common and preferred shares. This will show you where you stand in the hierarchy of payouts in the event of a company sale and how your interests align with those of the founders. If the table shows that founders have a significant amount of preferred stock, you might infer that they have a different risk profile and payout potential compared to employees with common stock.
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Understanding the Basics of Equity Compensation
Equity compensation is a way for employers, especially startups and early-stage companies, to offer a slice of the company's potential to their employees. This article breaks down the basics of equity compensation, covering its main forms: stock options and stock grants.
Equity compensation can take the form of stock options or stock grants, with significant differences between the two
Nicole Lapin emphasizes that stock options and stock grants are quite distinct types of equity.
Stock options grant the right to purchase company shares at a predetermined price in the future, while stock grants directly provide ownership of company shares
Tracy DiNunzio, the head of product and options knowledge at Nicoleisamazing.com, received an offer of 10,000 options as part of her compensation. She explains that stock options are essentially a future right: they allow an employee to buy a specific amount of stock at a certain price within a set timeframe. In contrast, stock grants, or Restricted Stock Units (RSUs), directly provide ownership of company shares to the employee.
Stock options are a more common form of equity compensation for employees at early-stage startups
Stock options carry risk, as their value ...
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Understanding the Basics of Equity Compensation
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Clarifications
- Restricted Stock Units (RSUs) are a form of equity compensation where employees receive company shares after a specific vesting period. Unlike stock options, RSUs do not require the employee to purchase the shares; they are granted outright. The value of RSUs is tied to the company's stock price and is typically subject to certain conditions like continued employment. Once RSUs vest, employees receive the shares or their cash equivalent.
- An initial public offering (IPO) is when a private company offers its shares to the public for the first time, transitioning from a privately held entity to a publicly traded one. This process allows the company to raise capital from investors and provides liquidity for existing shareholders. Shares are then traded on stock exchanges, enabling investors to buy and sell them freely in the open market. IPOs are typically underwritten by investment banks, who help determine the share price and facilitate the listing of shares on stock exchanges.
- Employee stock options allow employees to buy company shares at a set price in the future. When employees exercise stock options, they purchase the shares at the agreed-upon price. This process can happen after a vesting period or when certain conditions are met. The difference between the stock's market price and the opti ...
Counterarguments
- Equity compensation may not always align with the interests of employees if the company's potential does not materialize.
- Stock options and stock grants are not the only forms of equity compensation; there are also other instruments like stock appreciation rights and phantom stock.
- Stock options can sometimes be disadvantageous for employees due to their complexity and potential tax implications upon exercise.
- Stock grants, while providing immediate ownership, may not be as motivating as stock options since they don't require the company's valuation to increase to become valuable.
- The assertion that stock options are more common at early-stage startups could be challenged by the increasing popularity of other equity forms, such as SAFE (Simple Agreement for Future Equity) notes.
- The value of stock options is not only dependent on the company's future performance but also on market conditions and investor sentiment, which can be unpredictable.
- Describing stock options as risky might be overly simplistic, as the risk level can vary widely based on the company's stage, industry, and the specific terms of the options.
- The illiquidit ...
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Assessing the Value and Risks of Stock Options
Understanding the intricacies of stock options is key to evaluating their worth and assessing the risks involved in accepting them as part of an employment compensation package.
When evaluating a stock option offer, it's crucial to understand the company's current valuation and the percentage of ownership the options represent
Nicole Lapin and Tracy DiNunzio discuss the critical nature of comprehending the slice of the company pie that stock options might represent. DiNunzio suggests that behaving like an investor is paramount when accepting stock options in lieu of higher cash compensation. She points out the importance of inquiring about the current share price and the total number of fully diluted shares available. This information can reveal the percentage of the company the options represent and their potential value. For instance, if one is offered 10,000 shares at $1 per share and the company is valued at a million dollars with a million shares outstanding, then the offered shares would constitute 1% of the company, equating to a value of $10,000.
Startup equity often comes with significant risks, as options may become worthless if the company does not achieve a successful exit
DiNunzio emphasizes that the options might become worthless if the company fails to thrive, reiterating that equity in a startup should never be solely relied upon as a financial strategy. She shares her experience of having much of her net worth invested in a high-risk startup and warns that there is always a chance of the stock plummeting to zero. With most stock option plans, should an employee leave the company, they typically have a mere 90 days to ...
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Assessing the Value and Risks of Stock Options
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Counterarguments
- While understanding the company's valuation is important, it's also crucial to consider the growth potential and market trends that could affect future valuations.
- The percentage of ownership is significant, but the type of stock options (e.g., ISOs vs. NSOs) and the vesting schedule can also greatly impact their value.
- Viewing stock options as an investment is wise, but one should also consider them as part of a broader compensation package that includes salary, benefits, and work-life balance.
- The current share price and total number of shares are important, but so is understanding the terms of the stock option agreement, including any clauses that could affect the ability to exercise the options.
- While startup equity does come with risks, diversification within an investment portfolio can mitigate some of this risk.
- Options may not become entirely worthless even if the company doesn't succeed; they can sometimes be used as a tax write-off.
- Equity in a startup shouldn't be the sole financial strategy, but it can be a valuable component of a diversified investment strategy.
- The 90-day exercise window is standard, but some companies are offering longer exercise periods, which can reduce the pressure on employees to make quick decisions.
- The cost of exercising options can be high, but there are financial strategies and instruments that can help manage these costs, such as secondary markets for private ...
Actionables
- Create a personal stock options ledger to track the specifics of your equity, including valuation, ownership percentage, and share price. Use a simple spreadsheet to record details such as the date you received the options, the strike price, the number of options granted, and any vesting schedules. Update this ledger whenever there's a change in the company's valuation or when you receive new information about the total number of shares.
- Develop a financial contingency plan that outlines what you would do if your stock options did not pan out. This plan should include a budget that accounts for your current salary without relying on the potential value of your stock options. Consider consulting with a financial advisor to explore alternative investment strategies and savings plans that can provide financial security independent of your stock options.
- Simulate the cost of exercising stock options after leaving a company using a "what-if" financial model. Create ...
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Understanding the Mechanics of Stock Options
Tracy DiNunzio sheds light on the complex systems behind stock options for employees, clarifying the often misunderstood distinction between the 409A valuation used internally and the more publicized valuations aimed at outside investors.
The 409A valuation is the internal valuation used to determine the exercise price of stock options, which is typically lower than the valuation used for outside investors
The 409A valuation significantly impacts stock options' exercise price and ultimately the potential profit for employees. DiNunzio explains that employees' stock options are valued using a 409A valuation, which typically delivers a lower figure than the valuations seen making headlines that investors pay attention to.
The 409A valuation is based on the company's assets and revenue, rather than future potential, resulting in a more conservative valuation for employees
The 409A valuation, DiNunzio states, is grounded in tangible factors such as the company's assets and revenues. This leads to a more conservative figure because it discounts speculative future potential—often the basis of investor-driven valuations.
The strike price, or exercise price, is the predetermined price at which employees can purchase shares through their stock options
Upon issuance, the exercise price of an option matches the value of the stocks at that time, which is derived from the 409A valuation.
This strike price is set based on the 409A valuation and is an important factor in determining the potential upside of the stock options
DiNunzio notes that the exercise price set by 409A valuation—not further detailed in the transcript—becomes a critical variable in calculating the possible financial advantages of stock options for employees.
Emplo ...
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Understanding the Mechanics of Stock Options
Additional Materials
Clarifications
- The 409A valuation is a company's internal assessment of the fair market value of its common stock. It is crucial for setting the exercise price of stock options for employees. This valuation is based on tangible factors like the company's assets and revenue, providing a conservative estimate compared to external investor valuations. The 409A valuation impacts employees' potential profits from stock options by influencing the price at which they can purchase shares.
- The 409A valuation is an internal assessment used by companies to set the exercise price of stock options for employees. This valuation is based on the company's current assets and revenue, providing a conservative estimate. In contrast, valuations for outside investors often focus on the company's future potential and growth prospects, resulting in higher figures. The distinction lies in the purpose of the valuation: internal valuations for employee stock options prioritize current company value, while external valuations cater to investor expectations and future growth potential.
- The strike price in stock options is crucial as it determines the price at which employees can buy shares in the future. It is set based on the 409A valuation, reflecting the company's current worth. A lower strike price can offer employees more potential profit when the stock price rises. Understanding the strike price helps employees assess the financial benefits of their stock options.
- A cashless exercise option for employees allows them to use some of their existing stock options to cover the cost of exercising their options to purchase shares, rather than paying cash upfront. This method enables em ...
Counterarguments
- The 409A valuation, while typically lower than investor valuations, may not always be the best indicator of a company's true value, as it can be influenced by conservative accounting practices that do not fully account for future growth prospects.
- Relying solely on assets and revenue to determine the 409A valuation may not capture the full potential of companies, particularly in industries where intangible assets like intellectual property or market position play a critical role.
- The strike price, though based on the 409A valuation, might not always be advantageous for employees if the company's value does not increase as expected, or if the stock market as a whole declines.
- The potential upside of stock options is not only determined by the strike price but also by the volatility of the stock, the overall performance of the company, and market conditions, which are not addressed in the text.
- Cashless exercise options, while beneficial, may not be available to all employees, and the terms can vary significantly between companies, potentially affecting the realizable value of stoc ...
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Understanding Liquidation Preferences and Their Impact
Liquidation preferences play a crucial role in determining the financial outcome for shareholders in the event of a company sale or liquidation event. They can significantly impact both preferred and common stockholders, often shifting the financial landscape during a company's exit.
Liquidation preferences determine the order in which shareholders are paid out in the event of a company sale or other liquidity event
Liquidation preferences specify situations when stock and options holders can convert their stakes into cash. Tracy DiNunzio explains that preferred stockholders, who are often investors, negotiate liquidation preferences as part of their investment terms. This preference means that they get paid before common stockholders in the event of a company sale or liquidation event. For example, investors might have a "2X liquidation preference," meaning they would receive twice the amount of their initial investment before anyone else, including common stockholders and even previous investors who may have less favorable terms.
Preferred shareholders typically have priority over common shareholders, which can limit the potential payout for employees holding common stock options
A stark example DiNunzio provides is a scenario where a company sells for a hundred million dollars and investors have put in fifty million dollars. If these investors have a 2X liquidation preference, they could end up receiving the entirety of the hundred million dollars, potentially leaving nothing for others, such as employees holding common stock options. This situation demonstrates the power of liquidation preferences and the importance of understanding their implications.
Employees should inquire about the founder's equity structure and any liquidation preferences held by investors to understand the potential risks
When employees join a startup, they should not only ask about liquidation preference but also look at the equity structure of the company. Specifically, it helps to know whether the founder holds common or preferred stock. If the founder holds only common stock, it might be a positive signal that the founder' ...
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Understanding Liquidation Preferences and Their Impact
Additional Materials
Clarifications
- Liquidation preferences determine the order in which shareholders are paid out in a company sale or liquidation event. Preferred stockholders, often investors, negotiate these preferences to ensure they get paid before common stockholders. This can significantly impact the financial outcomes for different types of shareholders, potentially leaving common stockholders with limited payouts. Understanding these preferences is crucial for shareholders to assess their potential risks and rewards in various exit scenarios.
- Preferred stockholders have priority over common stockholders in terms of receiving payouts during a company's liquidation or sale. This means that if a company is sold or liquidated, preferred stockholders are entitled to receive their investment back before any distributions are made to common stockholders. Preferred stockholders typically have negotiated rights that give them this priority, providing them with a level of protection and ensuring they are paid out first in such scenarios.
- Preferred stockholders, often investors in a company, negotiate liquidation preferences as part of their investment terms. These preferences determine the order in which shareholders are paid out in the event of a company sale or liquidation event. Negotiating these preferences allows preferred stockholders to secure a specific payout priority, ensuring they receive their investment back before common stockholders in such scenarios. This negotiation process is a crucial aspect of investment agreements and can significantly impact the financial outcomes for different classes of shareholders.
- A 2X liquidation preference means that investors must receive an amount equal to twice their initial investment before other shareholders receive any proceeds from a company sale or liquidation event. This preference can result in investors taking a larger share of the proceeds, potentially leaving less or nothing for common stockholders. It is a protective measure for investors to ensure they recoup their investment before others benefit from the company's exit. Understanding this preference is crucial for assessing the potential financial outcomes for different classes of shareholders.
- In a scenario where investors with liquidation preferences are entitled to receive a multiple of their initial investment before others, such as common stockholders, they can potentially claim all the proceeds from a company sale, leaving nothing for common stockholders. This situation highlights how liquidation preferences can prioritize certain shareholders over others, impacting the distribution of funds during a company exit event. Understanding these preferences is crucial for stakeholders to grasp how they can influence the financial outcomes for different classes of shareholders.
- Understanding the founder's equity structure and investor preferences is crucial for employees to assess potential risks and rewards associated with their stock options in a startup. By inquiring about these aspects, employees can gauge how their financial outcomes may be affected in the event of a company sale or liquidation. This information helps employees make informed decisions about joining a startup and aligning their interests with those of the company's stakeholders. It also sheds light on the distribution of proceeds during an exit event, highlighting the impact of liquidation preferences on different classes of shareholders.
- Understanding whether a founder holds common or preferred stock is crucial because it can indicate how aligned their interests are with employees and investors. If a founder holds common stock, it may suggest a shared fate with other common stockholders, including employees. On the other hand, if a founder holds preferred stock, they may have different priorities and rights during a company's exit or liquidation event. This distinction can impact how payouts are distributed ...
Counterarguments
- While liquidation preferences do prioritize payments to preferred shareholders, they are not inherently unfair; they compensate for the higher risk that investors take on by providing capital to the company.
- The presence of liquidation preferences does not always mean common shareholders will get nothing; the outcome depends on the sale price of the company relative to the preferences and the amount invested.
- Investors may argue that a 2X liquidation preference is a reasonable protection for their investment, especially in high-risk ventures where the likelihood of failure is significant.
- Employees with stock options should be aware that these options can still be valuable, even with investor liquidation preferences, if the company performs well.
- The alignment of interests between employees and founders is complex and holding common stock is not the only indicator of a founder's commitment to their employees' welfare.
- High-integrity founders are important, but structural safeguards like equitable stock option plans can also protect employees' interests.
- Companies may have legitimate reasons for being cautious about disclosing financial details, such as competitive concerns or privacy obligations to o ...
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