Spending the majority of my career in Silicon Valley, I’ve often witnessed an interesting phenomenon in which stock options are overlooked.
You’re probably thinking, “everyone talks about stock options in Silicon Valley. All the time. How can you say they’re overlooked?” What I mean is, does anyone really know what they’re worth?
I think many people, even in the tech industry, don’t value stock options as they should. Stock options are an extremely important piece of individual compensation and a vital part of driving the innovation economy.
First, some perspective. We have an advantage here in Silicon Valley. I believe that the larger the organization, the less probable innovation is. I’m sure you’ve seen it before. Anything truly innovative within a large organization is very new, has little revenue associated with it, and thus garners little attention. And when you reach the budget cycle, every time something needs to get cut, it’s the product that has yet to produce huge profits that ends up on the chopping block.
Also with large organizations, talent is frequently rotated through various parts of the organization. Sure, this can be great for career development and beneficial to the organization, but often times an individual is left to a project started by a constellation suddenly rendered homeless when leadership roles change.
I’m a believer in the Silicon Valley model of fostering innovation. One particular product or service is the focus of attention, funding, and leadership. This is, of course, the Silicon Valley mold of a startup.
Inherent to this mold are stock options. Stock options give you the purity of focus to reflect or mirror the business into the compensation of the participant; they share value creation, milestones and success with the entire team. By offering stock options it’s possible to achieve complete alignment on one shared goal that isn’t possible with cash compensation and bonuses alone. So stock options end up being a terrific way for an organization to measure success.
Unfortunately I don’t think people really appreciate the financial power of stock options. Let’s look at a basic stock purchase as an example. Say you buy a stock for $100. You’ve instantly taken on the risk that if the stock price goes down, you will lose money. You also have $100 tied up and unavailable for any other use. With a stock option, you get the same upside as having actually purchased the stock – potential gain – and you didn’t have to put up $100 to do so. It is a financial instrument with nothing but upside. It’s also a magnified incentive for you to stay with your current employer because you’re actively working with the company, putting everything you can into it, to build value and make it successful.
So what are the basics? First we look at the valuation of the company and the shares outstanding. Divide one by the other and you get price per share. This is usually calculated first on a preferred basis. In my industry it’s usually convertible on a one-to-one basis with common stock. The difference with preferred is that preferred stockholders have preference in the event of liquidation. Beyond that, if the company is successful, preferred value ends up being very similar to that of common and can ultimately be converted into common.
In the early stage, because of the difference between preferred stock and common stock, common is typically discounted. A rough rule of thumb is that common can be discounted by a 10 to 1 ratio. For example, if the preferred is $10 per share the common is $1 per share. The discount tends to dissipate over time until you have a major event, such as an IPO, when all the shares have the same price.
One of the great things for the employee in this common discount situation is that in the early days it sets the strike price well below the ultimate value that could be realized.
It’s also important to look at how many share are granted and the strike price at which they are granted. The strike price is the price the holder of the stock options has to pay in order to exercise the options and turn them into actual share ownership. The strike price is almost always set at whatever the calculation for fair market value may be for the common stock at the time of the grant.
Next we consider the vesting schedule. Vesting in my industry typically lasts four years. I like to do a five-year vest because I think it’s important to have people engaged for as long as possible, staying focused on the long-term goals of the company. Usually there is a one-year cliff, which means that vesting on the options does not kick in until the employee has fulfilled at least one year at the company.
There are two types of stock options – ISOs and non-qualified options. At small companies, ISOs are typically granted to employees while non-employees receive non-qualified options. A big difference between the two is that upon exercise, for ISOs the spread between exercise price and fair market value is not taxable except in some instances. ISOs are valuable because you can exercise, hold for a year, not have taxes from the exercise and build yourself a long-term capital gain. Ordinary income tax rates, however, would apply to non-qualified options and also any kind of cash compensation, whether it’s salary, bonus, etc. That’s why ISOs provide a tremendous advantage. You may be able to take this income as long-term capital gain at much lower rates than ordinary income. It is important to note that exercising ISOs can prompt an alternative minimum tax (AMT) hit.
Stock options are the super-charged way to give employees a highly concentrated stake in the success of the venture. But while there is a time for concentration, there is also a time for diversification. Concentration risk is a bad thing. You take on a significant amount of risk when you join an early-stage company. But as it matures, and liquidation opportunities present themselves, it’s a very good idea to cash out, diversify, and take some money off the table.