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Understanding an option grant

Lesson in Course: Finance at work (beginner, 5min)

We received stock options from our employer. What are they, and what do we need to know?

Eureka!

What it's about: Understanding the important numbers and dates found in an options agreement.

Why it's important: The numbers and dates give us an indication cost and value of the equity offered.

Key takeaway: Each options agreement will spell out the share count, strike price, grant date, vesting date, and vesting period. Some will include a post-termination exercise window.

So we've decided to work at an exciting startup. Awesome! The company we work for also granted us stock options, making us joint owners. Sweet! Billionaires aren't billionaires because they get paid well by companies; it's because they own companies. 

The first step to potentially retiring early is to understand what's spelled out in our options agreement. Companies can grant options in two flavors: incentive stock options (ISOs) and non-qualified stock options (NSOs). We will dive deeper into the difference between the two in other lessons. Let's first understand the details of our grant.

 

Demystifying the options agreement

The options agreement spells out all of the important parts we need to know about our stock options.

Option agreements are complex legal docs that can be broken down into some need-to-know sections

We can make sense of the legalese by identifying important numbers and dates.

Important numbers to grasp

The first question most of us are wondering is how many shares can we buy. Or, what is the share count?

What is Share count?

The number of stock options granted is the same as the total number of shares we can purchase. We can buy 10,000 shares of common stock if the company gives us 10,000 options.

More shares are generally better than fewer. However, the share count isn't everything. When comparing employment offers, a higher percentage of the company is more valuable.

Example of share count vs ownership

For instance, an offer of 100,000 options out of 100 million shares is worse than 10,000 options out of 1 million shares because the first is 0.1% of the company compared to 1% of the company in the second offer.

Bigger percent ownership means more of the pie (or cake)

Once we know how many shares we are entitled to, we need to know the cost to buy the shares at the strike price.

What is Strike price?

The strike price is the cost per share we pay to exercise the option to buy shares in our company.

The strike price is how much we have to pay for a single share of company stock. To understand the cost to buy all of our shares, we need to calculate the total exercise cost by multiplying the strike price by the share count. 

Total exercise cost example

For instance, 10,000 stock options with a strike price of $0.10 would cost $1,000 to exercise.

We need to pay special attention to the strike price because we use it to calculate taxes when we exercise or sell our stock. We are taxed on the difference between the strike price and the fair market value of the shares.

What is Fair market value ?

The fair market value (FMV) is the current value of the shares if they can be bought or sold.

The FMV can be thought of as the current price of each share. For startups, this is often determined by an independent business appraiser and the investors in the company—the value increases as the business grows. For more mature companies, the FMV is the price the shares are trading on the stock exchange.

In many cases, the FMV is usually the same as the strike price when we are granted stock options at a startup. 

Important dates to understand

Options agreements have two very important dates

While any company can offer stock options to employees, employees don't receive anything until the board approves the specifics and the grant date

What is Grant date?

The grant date is the date that the company's board approves any employee option grants. 

Our options contract only becomes valid on the grant date even if we had already begun working for the company. The grant date is an important date to keep track of because it is used for the tax benefits of ISOs.

While the company's board may require some time to approve all options grants and the grant date, our vesting date could start sooner.

What is Vesting date?

The vesting date is the date our vesting period starts and is typically the same as our start date or first day on the job. 

The vesting date specifies the beginning of the schedule of when we can expect to start receiving our options or the vesting period. Vesting dates tend to be before grant dates since board meetings happen less frequently.

What is Vesting period?

A vesting period is a schedule for when we receive our stock options as long as we are employed by the company.

Most traditional grants have a 4-year vesting period and include a cliff for the first year of the vesting period. This means the company requires us to work for four years to receive the full benefits of the equity compensation. If we leave before the 12-month cliff, we forfeit any equity we are otherwise entitled to.

We receive nothing if we leave before the cliff

After passing the cliff, we'll get 25% of our options and then start earning the remainder 75% on a monthly basis until we receive the total share count, four years from the vesting date.

It's important to note that vesting periods and cliffs are up to the discretion of the company. Periods may be longer or shorter than 4 years and cliffs can be longer or shorter than 12 months.

Post-termination exercise period

Let's assume we are past our cliff and decide to leave the company. We need to make a decision to exercise our options and buy the company shares within the post-termination exercise period.

What is Post-termination exercise period?

The post-termination exercise period is the window of time we have to exercise our vested options before we lose them all. 

Post-termination exercise period lengths usually vary between 30 and 90 days—it's uncommon for it to be longer than 90 days. If we don't make a decision within the window or if we can't come up with the money to pay to exercise, we run the risk of losing all the shares promised to us.

We need to decide on exercising after we leave our jobs

It's good to know the length of the post-termination exercise period before we decide to take another job or quit. We can always refer back to our option agreement or ask our employer to double-check. 

Putting it all together

Let's use the following as an example options purchase agreement.

You have been granted an option to purchase Common Stock of NextUnicornStartup, a Delaware corporation (the "Company"), as follows:

Date of Grant:11/18/2020 
Exercise Price Per Share:USD$ 0.10 
Total Number of Shares:10,000 
Total Exercise Price:USD$ 1,000.00
Type of Option:

5,000 Shares Non-statutory Stock Option

5,000 Shares Incentive Stock Option

Expiration Date:11/18/2030 
Vesting Commencement Date:11/1/2020 
Vesting/Exercise Schedule:So long as your Continuous Service Status does not terminate (and provided that no vesting shall occur following the Termination Date (as defined in Section 5 of the Stock Option Agreement) unless otherwise determined by the Company in its sole discretion), the Shares underlying this Option shall vest and become exercisable in accordance with the following schedule:  2,500 of the Total Number of Shares shall vest and become exercisable on the 12–month anniversary of the Vesting Commencement Date and 1/36th of the Total Number of Shares shall vest and become exercisable on the last day of each month thereafter (and if there is no corresponding day, the last day of the month). 
Termination Period:You may exercise this Option for 3 month(s) after the Termination Date except as set out in Section 5 of the Stock Option Agreement (but in no event later than the Expiration Date).  You are responsible for keeping track of these exercise periods following the Termination Date.  The Company will not provide further notice of such periods.
 

Actionable ideas

Stock options are great opportunities for us to become owners. However, we cannot sell them the way we can trade options in some of our brokerage accounts. 

To realize the value, we must exercise the options first to own shares in the company, which gives us the right to sell them later. Don't forget that we can't sell our shares whenever we'd like if we work for a private company. We need to wait for specific liquidity events. 

Glossary

What is Strike price?

The cost per share we pay to exercise a stock option. 

What is Grant date?

The date that the company's board approved our employee equity grants, such as stock options or restricted stock (RSAs and RSUs).

What is Vesting date?

The date our vesting period starts, and it's typically the same as our start date.

What is Vesting period ?

A schedule for when we receive our equity compensation, such as stock options or restricted stock. A typical 4-year vesting schedule gives us 25% of our shares after a 12-month cliff, and then we receive shares each month until we receive the total share count, four years from the vesting date.

What is Post-termination exercise period?

The window of time we have to exercise our vested options before we lose them all.

What is Fair market value ?

The current value of the shares if they can be bought or sold.

What is Share count?

The number of stock options granted is the same as the total number of shares we can purchase. We can buy 10,000 shares of common stock if the company gives us 10,000 options.