Stock options: What they are and how to value startup stock options

Working for a startup can be an exciting opportunity. Not only can you help build innovative products or services from the ground up, but you can also potentially participate in significant financial gains. In many cases, that upside comes from getting stock options in startups.

If all goes well, early employees can exercise their stock options and cash out for big returns. That puts employers and employees in alignment, considering that the more you help the company grow, the more you can financially benefit.

Still, employee stock options aren’t guaranteed winning lottery tickets. Much still depends on the startup’s trajectory, broader economic conditions, and the specifics around the stock options you receive.

Here, we’ll examine some key points you should understand about stock options in startups so you can better evaluate equity compensation offers and consider how to diversify your assets.

What Are Stock Options?

While stocks are actual equity shares, i.e., ownership stakes, stock options give you the choice to purchase company stock in the future.

This choice is based on the strike price, also known as the exercise price, as well as the vesting period. The strike price is generally set at or above the fair market value of the startup at the time you’re granted the stock options, due to tax rules.1

Then, once you've held the options long enough to satisfy the vesting period (often four years to fully vest, but generally fractions of your total option grant vest, and are therefore exercisable, throughout that period), you have the right to exercise the stock options at the strike price.

For simplicity’s sake, suppose you have 100 vested stock options at a $10 strike price. That means you could exercise your startup stock options for $1,000, and you would then gain 100 actual shares of the company’s stock.

Ideally, that strike price sits below the market value at the time of exercising. After four years, for example, maybe your startup has gone through multiple seed stages. So, owning 100 shares of the company might equal $10,000 after the last funding round valuation, compared to the $1,000 you purchased them for.

But you don’t have any obligation to make the purchase. If the startup’s valuation has gone down below your strike price valuation, for example, you might not want to exercise the stock options.

What Are the Different Types of Stock Options?

There are two main types of stock options: incentive stock options (ISOs) and nonstatutory or non-qualified stock options (NSOs).

ISOs: ISOs are often considered to be the more tax-friendly type of stock option, as you might not have to pay income tax on them until you ultimately sell the stock. Still, exercising ISOs can trigger the alternative minimum tax (AMT), so it’s important to check with a tax professional to see how stock options affect your financial situation.

Also, ISOs tend to have more restrictions, such as only being granted to employees, not advisors. They also typically can’t be transferred.2

NSOs: NSOs generally provide more flexibility than ISOs, such as your employer potentially letting you transfer these stock options to other people. Also, you might have a longer post-termination exercise period with NSOs than ISOs (though your employer might still allow ISOs to convert to NSOs if they want to give former employees more time to decide whether to exercise).

The downside, however, is that NSOs are often taxed earlier than ISOs. That happens either when you’re granted the options or when exercising, depending on if you can readily determine the fair market value at the time of the stock option grant.3

How to Value Startup Stock Options

Valuing stock options in startups isn’t always easy, as private market pricing data isn’t as transparent and readily available as it is for publicly traded stocks.

However, you might be able to get some sense of what startup stock options are worth, such as when reviewing equity compensation offers or when weighing whether to exercise your stock options.

One way to do so is to see what trading activity looks like on a secondary marketplace like Forge. Stocks for that specific startup might already be changing hands on the marketplace, or you might see what trading activity looks like for similar companies. The latter might be used as a guidepost to predict future valuations for your startup, though there’s no guarantee that your company will follow the same path.

Similarly, you might look at recent valuations following funding rounds. If a venture capital fund acquires startup equity at a higher valuation than what your strike price is based on, for example, then you might be encouraged to exercise the options, receive company shares, and hopefully sell that stock at some point for a profit.

Key Takeaways

Stock options can be powerful yet confusing. You can get a better understanding by reviewing these key takeaways:

How do stock options work in startups?

Stock options work in startups by companies granting employees options — but not obligations — to purchase company stock in the future. If the cost to exercise the options is less than the current value of that equity, then it could be beneficial to go forward. After exercising, you might be able to sell the stock for a profit through secondary marketplaces or wait for a liquidity event, like an IPO.

How do you get stock options in startups?

Stock options in startups usually come as grants from companies. This might be part of your overall compensation package or a bonus, for example. Keep in mind that employee stock option plans, which issue stock options to staff, differ from employee stock ownership plans, which are used for retirement planning.

Why do startups use stock options?

Startups use stock options to reward and/or incentivize employees. For example, stock options might be used to make up for a lack of base pay if the startup has limited funding, and perhaps the stock options end up being more valuable to the employee than salary. Stock options can also motivate employees to stick with startups until they reach vesting milestones.

What does it mean to exercise stock options?

Exercising stock options essentially means purchasing stock shares. When exercising, you go from having the right to buy stock to actually buying the stock.

About the Author

Jake Safane specializes in financial reporting and is a former thought leadership editor for The Economist with articles appearing in Business Insider and The Washington Post among other media outlets.

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