You’re joining the hot new startup in town, and your offer letter informs you that it will be “recommended to the Board Of Directors” that you be “awarded an Award” of a certain ambiguous number of shares or percentage of “Class A common stock.”
You eagerly sign without regard to the fine print. You believe in the product, the founders, the team they’ve built so far— you’re joining the next Facebook. You promptly begin researching Lamborghinis and find out you’d better learn how to drive stick sometime in the next year or two.
Pump the brakes.
Startup equity is not a simple concept, so before you fix your eyes on the Forbes 400, it’s important to gain at least a basic understanding of the legal and financial implications of accepting such an offer.
Am I getting a fair deal? What does the number of shares actually represent? When do I get them and — most importantly — how do I cash out?
And the big question that most of us don’t understand:
How do I go from job offer to Forbes? What are all the steps in between?
There appears to be a void of information on the internet regarding the subject of startup stock options. In this series of posts, I’ll try to get to the bottom of all these questions and more, from both the company’s perspective and the employee or grantee’s.
Let’s lay down some of the ground work and cover the most common terms you’ll see throughout this series, starting with “stock option” itself.
Most simply, stock options are, literally, the option to buy shares of a company’s stock at a specific time for a specific price.
Offering such options to employees and advisors ensures that they have skin in the game and therefore an incentive to add value to the company. It’s also the founders’ way of sharing the success of the company with those who help them build it.
Granting is what happens when you sign your stock option agreement. Your employer (the “grantor”) grants you (the “grantee”) the options.
Vesting is the process of earning your right to actually purchase the options. Vesting can either be time-based (most common) or performance-based (less common).
A “four-year vesting period” means that the options will be earned over the course of four years. This encourages the grantee to stay with the company for a longer term than they otherwise might. Since you can’t purchase shares until they’re vested, leaving after two years could mean giving up half your options.
Performance-based vesting is typically used for executives or high-level managers and is conditional upon reaching certain milestones, such as profitability levels.
Cliff is a term related to vest. “Reaching your cliff” refers to the point when the first options become exercisable.
Example: You’re granted 160 shares with a “four-year quarterly vest and a one-year cliff.” This would imply that the right to purchase any of the options is not earned until the one-year anniversary of the option agreement, at which point 40 of the shares (1/4 of the options) would vest.
Each quarter thereafter, 1/16 of the shares you’ve been granted would vest until all of the options are vested by the end of the fourth year. This table shows this quarterly schedule a bit more clearly:
Exercising stock options is the process of actually purchasing them. Basically, once a stock option is exercised, it’s your property, subject to the terms of your stock option agreement.
Exercise price, also known as strike price, refers to the price at which the option can be exercised (purchased) and is included in your stock option agreement. It’s important to know both the strike price for individual shares and the total you’ll have to pay to exercise all your options.
A general timeline of the vesting process would look like this:
Day 1 — Grant: You’re granted the options when you sign your stock option agreement.
Days 2 to 365 — Vesting period: You’re earning the right to exercise your options during this time.
Day 366 — Cliff: You’ve reached your cliff. The first portion of your options has vested, and you may exercise (purchase) them.
Days 367+ — Vesting and Exercising: Beyond your cliff, your options continue to vest according to the company’s vesting schedule, and you have the right to exercise your options as they do.
Finally, Liquidation is the process of selling or “cashing out” your exercised options. This will be discussed at length in a later post.
Now that we’ve defined the terms I’ll be using throughout the series, we’re ready to dig deeper into the process.
The next post will discuss the different types of options and the tax implications of each step to both the grantor and the grantee, which tend to be one of the most overlooked details of the process.
Later, we’ll get into the actual exercising process, what the number of shares means, and I’ll define and explain the importance of understanding “dilution.”
Note: This post and my blog contain my own views and are intended to provide general information on the subject of stock options. You should consult an attorney or tax accountant if you are looking for advising on your individual stock option agreement or plan.