Startups often give employees stock options as a potential perk to working for the company, especially if they can’t afford to pay larger salaries. Stock options with a startup company are a little bit like a lottery ticket. If the company doesn’t go public or has at best mediocre performance, they probably won’t help you much. But if the company does quite well, or if you end up working for a unicorn, those options might pay for your retirement overnight. We cover how it works, and how to consider stock options with a startup company, below. If you’re not sure about what you should do with your stock options, or how they might work, consider working with a financial advisor to go over your situation.
What Are Stock Options?
Stock options work a little bit differently in an employment context than they do for investors. For investors, an options contract is a financial asset that gives you the right to buy or sell another asset at a later date. A stock option is an options contract written around stocks. So, for example, you might buy the following options contract:
- 100 shares of ABC Corp., Expires August 1, Buy/Call, Price $25
Under this contract, on August 1 you would have the right to buy 100 shares of ABC Corp. stock for $25 per share. If you choose to exercise this right, the person who wrote the contract would have to acquire those shares of ABC Corp. stock and sell them to you. Since this is an options contract, though, you can also choose not to exercise that right. In that case, the contract will expire worthlessly and nobody buys or sells anything.
Employee Stock Options
Employee stock options are somewhat similar to regular stock options. Stock options are a form of compensation offered by some employers in which you, the employee, get shares of stock in the company once you meet certain conditions. Those conditions depend on the exact terms of your employment, but most employers build their stock options around one or both of two terms: vesting and purchase.
With vesting, you have to work at the company for a minimum amount of time. Once this “vesting period” is finished, you become eligible to receive your shares of stock. With purchase, employers will offer you the option to buy shares of stock for a pre-determined price. While some employers may waive the purchase price for employee stock options, virtually all of them require a vesting period.
So, for example, you might have an employment contract that offers you the following terms:
- 1,000 shares of Employer Corp., Vesting Period: Five years, No purchase price
In this case, you have to work at Employer Corp. for five years before your stock options vest. Once that happens you will receive 1,000 shares of stock in the company at no additional cost to you.
These are options rather than requirements. You can choose not to exercise your stock options if you want. While relatively uncommon, if your employer wants you to buy your shares of stock (as opposed to giving them to you) it may be wise to consider how expensive it will be to exercise your stock options and whether the stock is worth that purchase price.
How Do Startup Stock Options Work?
Mechanically, startup stock options work almost identically to standard stock options. The main difference is that, with a startup, you are being offered shares of privately traded stock. This can have significant consequences.
The term “startup” is a loosely defined term. For businesses that seek investors, it generally means a phase before the company has an IPO and issues shares of publicly traded stock. For these companies, during the startup phase, they will often issue and sell shares of private stock to banks, venture capital firms and other investors. Employees with stock options also receive this private stock.
For investors, founders and other shareholders, the goal of a startup company is to reach that IPO. Those private shares that the company issued during its startup phase will convert into public shares of stock, which early investors can hopefully sell for a significant profit.
As noted above, for employees who work at a startup, stock options are a little bit like a lottery ticket. When you receive them these shares typically aren’t worth much. While not illegal for retail investors to own, you can’t trade private stock freely. Only the company itself or an accredited investor can buy those shares from you, which means that you usually can’t sell them for much money.
If the company does go public, however, the shares of stock might be worth quite a lot.
This is the goal of startup stock options. Your employer offers shares of stock in an unproven company. If things go well, those shares will increase dramatically in value once the company goes public. Unless and until that happens, though, your shares won’t have much value. It can be a tradeoff but once that can pay off quite well at the right company.
Are Startup Stock Options a Good Idea?
As with any employment contract, it’s difficult to give a single answer for the terms of employment. However, when it comes to startup stock options you should particularly consider three issues.
1. Why are you offered stock options?
Many startups offer stock options as a way to cut costs on employees. These companies are usually cash-strapped in their early years, and offering shares of stock is a way of adding value to their employment contracts without any additional up-front costs. As a result, they will usually offer you a lower salary and stock options to balance that discount.
This can work at the right firm, but there’s an upper limit to how far that argument will take you. Don’t get distracted by the potential for big gains down the road. Make sure you take a hard look at the actual salary and benefits as well. That’s the money you’ll be living on in the immediate future, and it’s the only part of your compensation that’s guaranteed.
2. What’s the plan for an IPO?
Your stock options may have value, but it’s important to ask when. In recent years, companies have been extending their startup phases near indefinitely. Historically a company would generally seek investors for around four years before issuing an IPO. Today, it’s common for companies to seek private funding for 10 years or more.
This creates a real problem for you as a shareholder. If your compensation depends on receiving stock in this startup, it’s important to know what the plan is for turning that stock into real value. It might be an awkward question to ask, but it’s an important one.
3. What’s the strength of the company overall?
It’s one thing to spend a few years working for a weak company. As long as your paychecks are clear and you have a sense of when you need to leave, the strength of the business overall is often none of your concern. When you are sacrificing pay for equity, though, it becomes very much your concern.
So ask yourself seriously, do you think this company has what it takes to go public? Do you see them making it in the long run? If not, think twice before you invest time and opportunity costs on stock options that may end up going nowhere.
The Bottom Line
Employer stock options are when your employer offers you stock in the company as part of your compensation package. With a startup company, this can be very valuable but it’s a risk too. It is difficult to predict when a startup will become successful enough to one day go public to the point that your stock options will pay off. It can be a great way to accumulate enough to retire, but it’s rare that startup stock options pay off to that degree.
Tips for Investing
- Before you make any kind of decision about your compensation, make sure you get the right financial advice. A financial advisor can help you understand your stock options and what choices you have financially when it’s time to exercise them. Finding the right financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Startups are the rock-and-roll of business right now. If you’re looking for a quick look at exactly how they work, check out our infographic on the subject.
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