As startup workers, most of us feel pretty comfortable hearing about employee stock options or even casually throwing around terms like “vesting,” “IPO,” and so on.
And yet, when it comes to the nitty-gritty of it, it turns out there’s still a lot of confusion surrounding stock options—what exactly stock options are, how they become shares, how and when they become tradeable, and of course, how and when you can make money from them.
Understanding your employee stock options well is at the core of making good decisions, which can potentially be life-changing.
So let’s take a closer look at the different stages of the employee stock option lifecycle.
Stock option lifecycle
1. Establishing the ESOP Pool & Receiving Your Option Grant
When founders start a company, they split the equity between them, owning the company’s shares. As they raise money, investors purchase shares issued by the company.
The company also allocates a pool for ESOP (employee stock option program). Employee stock options are a form of deferred compensation using equity, typically granted by companies to employees as a part of their total compensation package.
This type of compensation serves as a significant incentive and aligns the financial interests of the employees with the company and its investors (e.g., VCs). Employees are given one of two kinds of stock options – ISO or NSO (you can read more about the differences between them here).
At some point, typically at the Seed or Series A investment rounds, VCs will want to make sure that the ESOP pool is large enough. This pool’s size is usually around 10-18%— depending on the founders as well as how many key positions are already filled, among other factors.
This pool may include options allocated to the founders or to various advisors, in addition to employees. Normally, when you join a company, you will receive an option grant.
The actual grant may take a few weeks or months – since the company usually needs to get it approved in the first board meeting following the start of your employment.
The number of stocks you’re given in the grant reflects the number of shares you can later buy (a.k.a., exercise), at the price that the grant states.
To put it in other words, your stock options are your future right to own shares in the company at a pre-defined exercise/strike price. When can you own actual shares? Great question, keep reading and we’ll get there in a bit.
2. Vesting Your options
Vesting is a mechanism that enables employers to retain employees by offering them a progressive number of options based on the time you (the employee) have spent with your company.
Vested option plans typically span four years and at the end of the vesting period, you have become eligible to exercise the full number of stock options detailed in your stock option grant.
Whether you’re granted NSOs or ISOs, your stock options begin unvested, in that they need to first vest before you can exercise your options.
For simplicity’s sake, over time as you continue your journey at your current company, your stock options will vest from 0% to 100%. The first period of vesting (usually one year) is known as the cliff.
This means that you need to pass the cliff to “earn” the first portion of your options. As options are vested, you will now be able to fulfill your right to buy the options (exercise) and become a shareholder.
However, note that if you leave (or have already left) before the vesting period is over, you forfeit your unvested options and will only be eligible to exercise your vested options.
Read more about vesting in part 1 of our beginner’s guide to employee stock options.
3. Exercise Your Options to Officially Become a Shareholder
So your options have now vested, and you now have permission to buy your shares at a specific price by exercising your options.
Exercising your options means you become the owner of shares in the company.
The cost to exercise your stock options is entirely dependent on the strike price. To decipher the cost, refer to your grant letter, and check out the strike price.
Multiply the strike price by the number of options you want to exercise and you’ll be able to find out your exercise cost.
To calculate how much funding you’ll need to exercise your options, you’ll need to add the amount of taxes you’ll need to pay (keep in mind this can change by state).
For example, if you have 8,000 vested options at the strike price of $4.23, the exercise cost will be (8,000*4.23)+taxes= $33,840+taxes.
According to EquityBee data, tax costs at exercise are 2X the exercise on average, and can even reach 22X the exercise cost!
This can vary depending on the type of options you were granted (remember the differences between NSOs and ISOs?), but no worries, an EquityBee representative can help estimate potential tax impact upon exercise.
Because of these costs, many startup employees need to find external financing to afford to exercise their options.
There are several potential ways to obtain financing to exercise your employee stock options.
Here’s a helpful blog post that may help you find the best fit for you.
Some people decide to hold out on exercising until they’ve left their company, some exercise early, and some stay at the company and wait for an exit event.
Nevertheless, once you exercise your options, you own an actual share in your company and you’ll officially become a shareholder.
However, keep in mind that, while you’re officially a shareholder, these shares aren’t tradable quite yet.
You cannot sell your shares because they are shares of a private company and therefore not publicly tradable.
Consider this the official beginning of the waiting game.
4. When Your Company Reaches an IPO/Exit, You Can Make Money by Selling Your Shares!
Let’s say the moment has come and your company has successfully IPO’d. Your shares will soon be publicly tradeable.
Wahoo! After the applicable lockup period (typically a period of 90-180 days when you can’t sell your shares), you can finally sell your shares.
Here’s how you can calculate your payout and profit:
(Company Exit Share Price – Your Strike Price) X The Number of Your Shares = Your Payout – Taxes = Profit
The key figures to understand here are the company’s exit share price, and your strike price; i.e., the share price at the date of the liquidity event, and the strike price according to which you exercised your options.
The difference between these two figures can vary widely.
Let’s stick with our previous example. In that case, your strike price was $4.23 and you had exercised 8,000 options.
If the company’s exit share price was $40 (roughly 9.5X your strike price), your payout would be ($40-$4.23)*8,000= $286,160.
Once you sell your shares for a price greater than your strike price, taxes will incur.
And voila, your payout ($286,160 in this case) – your taxes = your profit.