“In addition, subject to the approval of the Company’s Board of Directors, you will be granted 300000 shares of option grants of the company, which share will vest in accordance with the following vesting schedule: 25% on your first anniversary, and the remainder for 1/36th for each month of continuous service thereafter.”
Have you come across this sentence before? Where? Probably on a recent offer letter that you (or someone you know) got. First of all, I guess congratulations are in order because you have just been offered some stake in an up-and-coming (and probably promising!) company.
Excited? Not sure? I understand the skepticism. I am sure that you would have come across statements like, “Those are not shares, just stock options.” or “Hey, that’s not the same as salary, means nothing.” or “That’s all fluff”. There’s also another side of the story where you’d find people telling you, “That’s a huge deal, they must be giving you a big position in the company”, or “That’s a great long-term investment and a part of your salary only.” So which side is correct? If you ask me, both of them are partially correct and partially wrong.
Here’s why:
- Stock options are a big deal and reserved for valued employees for retention.
- Stock options are not shares of the company.
- It’s not all fluff and is indeed a good long-term investment.
- It’s over and above salary and cannot replace your salary entirely.
Confused, don’t worry. Let’s decode this one by one.
Stock Options
“…you will be granted 300000 shares of option grants of the company”
For the record, shares of option grants mean the same as Stock Options. More often than not, when candidates read the word “shares”, they consider these as getting some shares of the company. However, Stock Options are slightly different. They do not mean that you get equity in the company. Instead, you have the right to own a certain amount (in this case, three lakh) of shares of the company at the price decided at the time of your joining – which is locked for the future. Loosely translated, if and when you buy these shares, you just have to pay that locked price to buy them irrespective of how high the actual share price is in the market at that time.
The fixed price at which the shares can be purchased irrespective of their market value at that time of purchase is known as the strike price. For example, if the strike price one gets in their equity offer is ₹10/share. Four years down the line, after the company grows and its share is valued at ₹100/share, the person still gets to buy those shares at ₹10/share only. This means that the stock options give a person an ‘option’ to buy shares at the strike prices even when the company’s valuation increases over time. And the difference between the current valuation and the strike price is known as the spread.
Vesting Schedule
“… will vest in accordance with the following vesting schedule”
The next term to deal with is the vesting schedule. It is essentially the plan or schedule laid out by the company according to which your equity stock options would be granted to you. You won’t get them all at once. Instead, they would be “vested” out to you in parts.
In the above example, the vesting schedule will get you 25% of your stock options after you complete one year at the company and after that, you would get 1/36th of the remaining options each month.
This is done to ensure that not only the employee stays for long in the company but also only those who serve the company get their due share in the stake of the company.
Wait, are you wondering what happens in the first year? Why do you get 25% (in this example) altogether and nothing before that? Well, that’s a one-year cliff to check your commitment to the company and devotion to the work. This is the minimum time period the employee needs to serve before any equity is granted in order to prevent the company’s shares from going to people who are in it just for the equity. The cliff period could vary anywhere from one to four years, though it’s usually one year long.
Strike Price
Remember how I talked about a fixed price at which you would get to buy your company’s share based on the number of stock options granted to you? Well, that fixed price is the strike price of your equity offer. Even though this is determined by the board of directors or founders of the company, more often than not, it is way below the fair market value (or “FMV”) of the company’s common stock at that time so that the employee can benefit right away.
How do you use your stock options?
To understand whether or not you have a beneficial deal – you first need to understand how you can use these options or in other words, “exercise your options”. Exercising your options means buying shares of the company at the strike price offered in your equity offer.
There are three company scenarios that you would encounter.
Scenario 1: When you exit the company.
First of all, know that even if you leave the company after two years, your stock options stay. So, if 50% of your options have been vested so far, you can exercise them. If you ask me, do exercise them if you believe in the company’s growth and vision – you won’t ever get those shares at a price better than the strike price.
Scenario 2: When you see an exit via acquisition
It is great to exercise your stock options when your company is getting acquired. That time, if you have shares of your company, you get your due payout as a part of the acquisition and benefit instantly because most likely you would have to sell your stake.
Scenario 3: When you see an exit via IPO
IPO is when your company goes public. That’s again a good time to buy the shares of your company at the strike price because their market price would be way higher at that point. Then your stock options become tradeable stocks that you can play around with, in the share market.
So should you go for it?
Let’s put up all the numbers here for easy reference.
Imagine if you plan to quit after two years based on the above example.
Stock option to buy: 10000 (50% of 20000) (if you leave after 2 years)
Strike Price: $0.25
Cost = $2500
Current Price (predicted): $4/share (at the time of your exit/exercise)
For 10K stocks = $37500
So, you are in a virtual profit for $35,000 right away. Now, imagine if the company gets acquired at $100M, after 2-3 years.
Your stocks would be worth: $10/share, so in total = $100000
Acquisition cost today: $2500
Potential Upside: $100000 (~INR 75 Lakhs)
Max Loss: $2500
Clearly, while there’s some risk involved, the upside of stock options is a great investment. If you come to think of it, in today’s times, every investment that comes with decent returns has some risks involved. Stock options are one of the most profitable ones if you ask me. Having said that, understanding your options, their scope, benefit, and the downside if you leave the company before accepting any offer is important so that you know exactly what you’re signing up for. Hope this piece has been able to get you some clarity on what your equity offer has in store for you.
