Stock Option Basics

Here’s what I wish I’d known when I started working at 10gen. Disclaimer: don’t take this as financial advice, consult someone who actually knows what they’re talking about before making any financial decisions, this is for entertainment purposes only, etc. Also, the numbers used below do not match any startup that I know of, they’re just hypothetical.

Intro to Stock Options

Stock options are the option to buy X shares of stock in a company at a guaranteed price of $Y per stock. Generally, they have some time constraints: they are doled out to you slowly over 3-5 years (the vesting schedule) and expire after a certain number of years if you don’t buy them.

$Y is the strike price, the price of the stock when you’re given your stock grant. Basically, it is determined by taking the value of the company (say, $2,000,000) and dividing it by the number of shares that have been issued (say, 5,000,000). This would give you a strike price of $0.40.

If the company is successful, the stock price should be higher when you sell the shares. For example, say that the startup above is successful and their stock price rises to $5.00. Now you can buy your shares for $0.40 and sell them for $5.00, making a nice $4.60 profit on each share.

Except you can’t, because of taxes. If you are the kind of person who doesn’t know what a stock option is, you probably have common, or non-qualified stock options (companies prefer this type because you’ll be footing the tax bill instead of them). For non-qualified stock, you get taxed twice: when you buy (or exercise) your options and a second time when you sell the stock (these are called taxable events).

Let’s say you’re in the situation above: you have 10,000 shares with a strike price of $0.40 and you want to exercise your options. The current price is $5. You exercise your options for $4,000 ($0.40 * 10,000). However, according to the government, you just “made” $46,000 ($5*10,000 – $4,000), which you’ll now be taxed on. I have no idea how this tax rate is computed, but for me it was ridiculous. If my options matched this example (they don’t), I would have had to pay ~$30,000 in taxes (about 60% tax rate). Also, you have to hand the company a check for these taxes when you exercise the options, you can’t put it off until April.

So be careful: if you own a lot of options and the price rises a lot, you can “golden handcuff” yourself to a place because you cannot pay the taxes to actually buy your options.

The second taxable event is when you sell the stock. If you sell the stock within a year, you’re hammered again with short-term capital gains taxes. If you wait for more than a year to sell, you “only” get hit with long-term capital gains taxes.

Negotiating Options

When you get a job at a startup, often part of the offer will be stock options. If the startup is early stage, I’d recommend pretending that your options will be totally worthless forever. Is the salary acceptable on those conditions? (Almost every other startup I know of has failed in the time 10gen’s been around).

In retrospect, I wish I had negotiated more stock options instead of more salary when I started at 10gen, but if I was joining an early-stage startup again, I would do the same thing: not sacrifice salary for options.

The exception is if you’re joining a startup at a later stage and you’re pretty sure they’ll be successful. In that case, you might want to negotiate for more options.

Option Expiration

Typically, options have an expiration date. Make sure you buy them before they expire (if you want them). Also, options are typically designed as an incentive to stay, so they don’t follow you after you leave the company. If you quit or are fired, you’ll have to buy any vested ones before or shortly after leaving.

Buying Unvested Options

You can buy unvested options, but I can’t see why you would unless you’re pretty sure the company’s going to succeed, you’ll be there until the options vest, and you’re trying to avoid the tax hit. If all those hold true, Max Schireson wrote a good blog post on what you need to know about that. In fact, go read his post regardless, because it’s a really good and more technical coverage of a lot of these points.

Dilution

In the example above, you have 10,000 shares out of 5,000,000, meaning you own (or could own) 0.2% of the company, you tech mogul. However, whenever there’s a round of funding typically more shares are issued. Thus, instead of there being 5,000,000 shares, there are now 10,000,000 and you only own 0.1% of the company. Your company should tell you how many stocks are outstanding (the number issued in total) if you ask. I think this number is typically confidential, but I’ve heard people advise that you should ask during salary negotiations, so YMMV.

The other significant event is board meetings, where the board decides how much the company is worth. This changes what the current stock price is. Funding rounds also often have an effect on price.

Stockholder Privileges

Even if you’re at an early-stage startup, it might be worth buying a few shares to get stockholders rights. Find out how many shares you need to buy to get these, if you want a look at the books and so on.

Keeping Your Documents

Particularly at an early-stage startup, there may not be anyone keeping track of this stuff. When 10gen got an Finance/HR person, I asked them about the options grants they had on record and they were missing my original hiring grant. Luckily, I still had the paperwork. Keep everything safe somewhere, just in case.

Exercise Quickly

If you’re leaving a company, get on exercising your options as quickly as possible. You generally have a limited time period before your options disappear and your company might have arbitrary restrictions on when you can exercise (like “not within a month of a board meeting”). Also, it’s not exactly a speedy process: it took 10gen three weeks from when I signed the paperwork and gave them the checks to actually send the stock certificates. You don’t want to have to be dealing with HR at your last company while you’re dealing with new hire HR at your new job.