At Workship, we typically work with US-based companies which have their development office in India. More often than not, all the startup offers include stock options. And this makes it imperative for candidates to understand what their startup equity offer really means.
While candidates may have a basic understanding of equity and stock options, I have noticed that they tend to not pay much heed to it in their overall package. On the other hand, companies really emphasise on the stocks given to the candidates. We deal with this situation every day. Candidates claim: there is no value to the stocks right now. And the company claims: how can you ignore the stocks that we are offering.
Noticing this difference of opinion in what the company is offering and what the candidates are perceiving, I decided to write this blog. Through this blog, I would like to share what getting stock options really implies and whether or not it is a good deal to take for a candidate. I’d also clarify why there’s a difference in perception of equity amongst candidates and companies towards the end of this blog.
Typically, your letter has two figures related to stock options:
- First, the number of shares
- And second, the strike price (sometimes communicated orally)
While the numbers may not seem much significant when seen on paper, they carry a lot of meaning. Let’s start with clarifying what the mystery behind strike price is.
Strike Price of Your Stock Options
A typical definition of strike price would be, “The fixed price at which the shares can be purchased irrespective of what their market value at the time of purchase is known as the strike price.”
I am sure that clarifies nothing for you. So let me explain this with an example.
The Company’s Valuation
Let’s say the current valuation of the company is $10M and there are 10M shares of the company. So the value of each share is $1. Now the company decides to have a stock options program so that they can pass on the equity to the team members joining them. The simplest way is to allocate these stocks of $1 to new members. But what if the company decides to pass it on at $0.2? Well, that would be a big advantage for the new members. As they are going to get the stock at a price much lower than the actual price. Thinking how is that possible?
When the companies define their stock options program, it is mandatory to be compliant with 409A code in the USA. Under this section, companies need to do a valuation of themselves which is used to decide the strike price of the stock option and hence it is a big advantage to keep it reasonably low. This valuation could be totally different valuation than the one used for funding or other purposes. Remember, the strike price is the price at which vested shares can be purchased. So, lower the price, better for the people who are getting/buying it.
Suppose the 409A valuation is $2M for the company. So, the strike price is simply $0.2 ($2M/10M shares). This the strike price at which options are given to team members. This also implies on the day you receive these stocks you are in virtual profit of $0.8 per stock as the actual share price is $1.
The current price of each share, as well as the number of shares, valuation of the company, is generally not made public. Only the strike price is something that is shared with the new joiners. So, if you are allotted 20K shares with a strike price of $0.2, then you are getting options worth of $4K. But remember, its virtual price as of the day itself is a lot more. In this example, it would be $20K. I am calling it virtual because the stocks are not tradable. There is no liquidity with those options.
Moving on, the next term you’d see in your offer letter would be vesting period. Here’s what that means.
Vesting Schedule of Your Stock Options
Vesting schedule typically means the time you need to wait before actually being able to buy the stock at the strike price you’ve been offered. Once you join the company, it is expected that you spend some time and contribute to the company to make yourself eligible to own part of the company. Hence typically a one-year locking or cliff is there when your first batch of shares get vested. The remaining shares are vested equally per month or per quarter.
You can buy the vested shares at the strike price anytime if you would like to. But you are not required/forced to buy them right away. This is the beauty of options.
Vesting of your stock options
Now that you have the stock options and you understand the vesting period, I am guessing the next question in your mind – But how do I really own those stocks? What are the implications of that?
So, let’s move on to that.
Exercising The Shares
How and when you buy the shares will be subjective to you, the growth of the company, your position there and mostly when you choose so. But I’d like to put forth two common scenarios for you:
Scenario 1: You decide to leave the company
More often than not, candidates are not interested in their equity is because of the thought- but what if I choose to leave the company?
Well, then you leave. Your stock options still stay with you. Let me explain this better.
After two years of joining the company and you decide to leave the company for a better opportunity. By now, 50% of the shares would have been vested. At this point, you have an option to buy these shares or let them go. To make this choice, you must ask yourself a simple question. “Do you believe in the company and its mission?”
If you do, exercise your options. If not, you can let go of the options. There is no secondary market for the options you are letting go.
This is the first time you are required to put in money from your pocket to buy the shares. The current stock price or the strike price may have gone up by now, but you would be buying them at the strike price only. This is the advantage of stock options, you buy them at the price you were committed to at the time of allotment.
If you want to buy the shares after you leave the company, you would need to do so within three months of leaving the company. However, if you fail to do so within time, you lose your option to buy them.
And if you decide not to buy the stock options as you feel the company is not doing well and the future is blink, then you don’t need to do anything. The stock options will lapse automatically.
Scenario 2: You stick with the company for long
In this case, you are enjoying the work in the company. Your shares are getting vested every month. Also, you have no intention of leaving the company sooner.
So what now? More and more stocks are getting vested and you don’t know when should you be buying them?
In this case, you have these options to choose from. Each of these has different tax implications. Do consult your CA for taxation as I am not the expert here.
Option 1: Don’t buy till you actually see an exit (via acquisition)
This is for people who like to play safe. You are not risking your money to buy the stocks and hoping that something positive would come out. As you are still with the company, you are not risking your claim on the stocks, either.
During acquisition, buying and selling happen transparently. You don’t need to do anything as such. The company on your behalf is doing all the transactions.
In most of the cases, you need to also exit from your options – that is, you need to sell your stake. The money you get is the difference between the actual price and the strike price. The money you get would be subject to short term capital gains as per Indian Taxation which is currently at 15 %.
This also would allow for accelerated vesting. This essentially means that if you still have some stock not yet vested at the time of the acquisition, there could be accelerated vesting that would speed up your vesting. This is highly dependent on the acquisition deal that is signed.
Option 2: Don’t buy till you actually see an exit (via IPO)
IPO is another instance when your stocks become tradable. Your (long) wait for the stock options to realise is over. During IPO, the stock options would get converted into tradable stocks. You can exercise them before the IPO, during IPO or can still wait and keep the option open. Each would have a different tax implication.
Option 3: You buy in parts (the Hybrid Model)
You can keep buying a part of the vested stocks – something like SIP model in mutual funds. In that, you can decide the percentage of stocks that you want to buy say per quarter. Or you can be aggressive and keep buying as soon as you vest the stocks. This option becomes even more lucrative when your company grants you more options to you based on your performance.
However, there is an inbuilt risk of complete loss in this model. On the other side, you can get benefit on taxation as long term capital gain on these stocks. Currently, long term capital gain is taxed at 10%.
(Side note: This model was very lucrative in the past as long term capital gains were exempted from Tax in India. With the introduction of the new law, this has become less attractive.)
My Take: To be or Not To Be
After all these technicalities, you might still have the questions- So, is getting stock options a good deal? Well, frankly, yes. Should I buy the shares? Well, that’s not such a simple question to answer and I cannot make the decision for you. But here’s what I feel.
The first thing to consider is the company. If you think the company is doing great and has good chances of getting exit via acquisition or IPO, then you should buy the shares.
If you are a person of logic, here’s an explanation that’d definitely work for you:
The Mathematical Reasoning
Let’s put up all the numbers here for easy reference.
Stock option to buy: 10K ( 50% of 20K) (if you leave after 2 years)
Strike Price: $0.2
Cost = $2K
Current Price (predicted): $2/share
For 10K stocks = $20K
So, you are in a virtual profit for 18K right away. Now, imagine and this is really the imagination and not real – if the company gets acquired at $100M, after 2-3 years.
Your stocks would be worth: $10/share, so in total = $100K
Price today: $2K
Potential Upside: $100K
Max Loss : $2K
Above maths should be enough for you to make a decision.
(These are indicative calculations. Actual calculations are little complex due to the preferential and common stocks. We would give it a miss in this blog and cover in a separate blog sometime later)
One of my friends was early/founding engineer (meaning a large number of stocks) of a company and left the company for better prospects. He left the company and decided not to buy the stocks. Few months after he left the company, it got acquired at a good valuation. Well, the person got nothing from the deal.
About a year and a half ago, another friend of mine joined a company. The company got acquired. And even though he still had nearly two and a half years of vesting period left, he got all the benefits of his stock options through accelerated vesting.
So, one cannot really predict how your options unfold and how you reap their benefits.
Not to delusion anyone here, I have gone through the dark side of this too. I was working with a startup before founding Workship. The product was great and there was a very high chance that the company would succeed. When I left, I bought the stock options and was dreaming of the $$. But after a year, the company shut down and I lost the money I had invested.
However, I still don’t regret my decision as the upside of that decision was very high, of the order of 50-100 times which is nothing compared to what I lost. If a similar situation arises in my life, I would still go ahead and buy the stocks. Because at all times, the possible gains outweigh the losses.
In The End
From what I understand, candidates are caught up in short term gains i.e. their in-hand salaries which makes them overlook the long-term profit they might have through stocks. While companies think of long-term rewards for people who’ve made their growth and success possible and so pay more heed to the stock options. And hence, the difference in perception.