If you’re a startup employee, there’s a very high chance that you’ll be offered stock options in your company. Stock options are an exciting opportunity to change your financial future – but there’s also a risk that you’ll end up losing your acquisition cost and be left holding shares that are worth almost nothing.
If you’ve already read Part 1: How to Evaluate and Negotiate Your Stock Options Package, then you already have an understanding of what to look for when you negotiate your stock options. For the purposes of this article, we’ll assume that your company has a positive valuation and you believe it will succeed (otherwise, you wouldn’t be reading this). Now we’re going to dig deep into a more difficult decision: What should you do if you’re faced with the choice between employee stock options and a higher salary in private companies?
Here are 4 steps to help you make this decision.
#1 Weigh up your options
Before you can make an informed decision, you need to know what your options really are. That means working out how the difference would be in your salary, versus how much your shares might be worth.
Consider the value of your drop in salary. For example, if you’ve been offered a salary that is $10,000 less per year, then over a four-year vesting period (which is standard), you’ll lose out on $40,000.
Next, work out the prospective value of the shares you’re being offered:
- Imagine that you were offered 1,000 stock options across a 4-year vesting period, at an exercise price of $50.
- If you exercise all your options, once they have vested, you’ll pay $50,000 for your 1,000 shares.
- The value of the company may have risen fivefold by the time you exercise your options, so each share is now worth $250. You now own shares with a relative value of $250,000 ($250 x 1,000 shares).
- Once you subtract the exercise cost that you paid for your options, you’ve effectively gained an extra $200,000.
This gives you an approximate set of figures to use to begin your evaluation. But first, stop to think about whether you intend to stay at the company for long enough for your stock options to vest. If you expect to leave before the end of the vesting period, will enough options have vested to be worth exercising? How long is the exercise period once you leave the company? If you leave after just a year or two, and then have to make a fast decision about your shares, you might not be able to form a reliable opinion about the company’s value.
#2 Consider the terms
The next step is to examine the terms of your employee stock option plan. Every ESOP (employee stock option plan) is different, so even if you’ve negotiated 20 of these before, you should still read this one carefully. Here are some key issues to look out for:
What is the value of your stock options package?
It’s a given that the value of your stock options is going to make a difference to your decisions. Ideally, the management would share their latest independent valuation with you, along with the number and type of options that are part of your package, so that you can get an idea of what your options are worth. Read the fine print in your employee stock options plan carefully to discover what the value is of your compensation package. If you’re unsure, don’t be afraid to ask for clarification.
How much money has the company raised?
This might sound contradictory, but the more money the company has raised before exiting, the lower your chances are of enjoying a sizeable slice of the profits. The company needs to be acquired for an amount that is higher than the money it raised in earlier funding rounds. Otherwise, all the money that it makes on exit goes to repay the investors, and there’ll be nothing left over to pay shareholders like you.
What is the vesting period?
It’s standard to have a vesting period that lasts for 4 years. Typically, the first cliff comes after 1 year, and the rest of the shares vest proportionally every month or every quarter. If your stock options plan has a vesting period that is very different from this, it should raise a red flag.
Are you offered ISOs or NSOs?
The difference between ISOs and NSOs could be a sizeable tax payment, so it’s important to notice which type of options is on the table. You can read more about ISOs and NSOs here.
#3 Coldly assess the company’s chances
Now you need to take a long, objective look at your company. You have to decide whether you’re likely to make a profit on your stock options. Ask the management for a recent, unbiased valuation of the company’s worth. If your request is repeatedly avoided or refused, consider that to be a red flag. A company that’s confident of its chances for success won’t be scared of sharing the most recent valuation.
If the last valuation was too long ago or you can’t get hold of an objective assessment for some other reason, you’ll have to try to weigh up its value on your own. Here are some points to look out for in the process:
How mature is the startup?
On the one hand, the earlier you invest, the bigger the profit you’ll make when the company exits. On the other hand, the risk of the company failing is greatest in its early stages.
How are the business metrics doing?
If you’re at an extremely early-stage startup, you’ll want a reason to trust that the company will succeed. Ask the management to convince you of their success, and if you aren’t convinced, consider it a sign that you should seek a different opportunity. If the company has passed Series A or B, there should be some business metrics that you can view, such as revenues, user numbers, and customer growth rate. If these are rising, it will give you the reassurance you need that the company has a reliable chance of making money and becoming profitable. You need to see evidence of an actual product or service, and a reliable way that the company can expect to make money by selling it.
Has there been any interest from larger corporations?
You’ll need to be careful here because rumors abound in startups. Sift your information carefully to find out if there’s a real chance of an exit within the next few years.
At this point, take the most pessimistic view possible. Remember that if the company fails, you’ll lose your salary anyway. If you chose stock options in exchange for a lower salary, then you’ll lose even more.
#4 Think about your personal circumstances
Finally, you need to be realistic about your personal circumstances. Your colleague might do best to take the stock options, but a higher salary could be better for your situation, or vice versa. You could ask yourself these questions to help come to a decision:
What is my attitude to risk?
If you choose the stock options, you’ll have to spend years wondering whether you’ll come out with a profit. If you’re not comfortable with that level of risk, you’ll probably do better to lower your stress levels and take the higher salary.
Do I need the cash now?
If you’re buying a house, just starting a family, or need immediate cash for any number of other personal reasons, you might not be able to wait the 10, 15, or even 20+ years until you can liquidate your investment.
How much tax will I have to pay?
Depending on your income tax bracket, the type of stock options you’re offered, and how long you expect to hold on to your shares before you sell them, you might have to pay a sizeable tax bill when you exercise your options.
Can I pay the acquisition cost?
When you exercise your stock options on leaving the company, you’ll need to pay the exercise price, also called the acquisition cost. Depending on the circumstances, you might also need to pay this cost if you exercise your options while staying at the startup. If you don’t have enough funds to cover this cost, think carefully about what you’ll do to acquire them. It’s not recommended to take out a loan or add to your mortgage in order to buy shares.
Making the choice between stock options and a higher salary is rarely black and white. Ideally, you want to get the salary you need to cover your living costs, along with stock options in a company that will exit and thereby transform your financial future. If you spend the time to understand the terms of your employee stock options plan, you’re confident that its value is higher than the pay cut, and you can afford to wait until you can liquidate your shares, then it could be worth it to seize your stock options with both hands. Once you’ve made this decision, if you find that you can’t afford to pay the acquisition price, EquityBee could be able to help out.
All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.