Congratulations, you have stock options. What are they worth?
Stock options are an important part of compensation in many large and small companies. And they aren’t just for high-flying CEOs. Nearly 60% of technology companies have some form of stock option plan, as do many other companies in America, according to Culpepper and Associates, a compensation consulting firm. Thus, more likely than not, you have or will have stock options as part of your compensation.
But, do you know how much they are worth? I bet you don’t.
A typical offer of employment for companies both large and small includes at least two important components: the salary, which is obviously listed in dollars in the US, and the options package, which is typically listed in number of options. For example, “we would like for you to come work with our great team at ACME. We’re extending an offer of $75,000 per annum and 25,000 stock options.”
So $75,000 is an easily understood amount, certainly much more so than if it were “75,000 credits”, “75,000 Polish zloty” or “1,234,204 hamster pelts”. A dollar is a dollar throughout the country.
Stock options can be anything. And the disturbing thing is, through my work in venture capital and academia, I witness that employers usually don’t try to clarify and employees typically don’t ask. How much are hamster pelts selling for these days? What’s a zloty worth? Tell me more about these options you speak of.
There are some confusing, academic approaches to figuring out what options are worth. They are useful when companies need to expense their options for reporting purposes. The Black-Scholes Option Pricing model led to a Nobel Prize, after all. It’s complex, works far better for public companies than for private companies, and is not widely known by employees.
Instead, employees need to ask, and employers should voluntarily provide, just two primary pieces of information: option price and percentage of company.
Price me
Option price is typically the price the option holder must pay in exchange for an honest-to-goodness full share of stock. If the stock of a public company is trading at $30 per share and the option is priced at $10 per share (the “strike price” or “exercise price”, in financial jargon), then as of today, each option is worth $20 ($30 share price – $10 “exercise price”).
Most public market options are awarded with the exercise price higher than the current stock price. This is so that employees will work towards increasing value, and also has tax advantages for both the company and employee. The Black-Scholes model does a good job of calculating the odds that these options will someday be worth something. Another, easier but imperfect way, is just to look at the stock performance of the public company, its variability and trends, and imagine whether there is a chance that these options will someday have value.
Private company stock options are more problematic. There is no public data to calculate the value of options. So companies typically price options at a price related to some transaction – either a round of venture capital funding, a price at a merger, or a price calculated by an outside valuation firm.
Then, the company may not tell you this price. Your 25,000 options could have an exercise price of $0.01 per share or $1,000 per share. Without the price, you cannot judge whether your options will ever be worth anything.
Colleagues have recounted this story from Board of Directors meetings for private companies. A company is about to do a new round of funding which would increase the value of its stock by 5 times. There were new employees about to be hired. If the employees were hired immediately after the financing, the exercise price of their options would also be 5 times higher. By waiting to hire the employees, the overall cost of the options to the company declines — while still giving the same number of options (but not exercise price) to the employees.
The oblivious employees, by not asking the price of the options, had the potential of a significant loss in value for the same negotiated compensation.
I do not know the outcome of this temptation in board rooms throughout the country. I do know that if the future employees were savvy enough to ask questions about the exercise price and stock value of the company, then the temptation to play such games is drastically reduced.
My slice of the pie
For a public company employee, the exercise price can often be enough to understand the value of options. Extensive data on stock trends and total outstanding shares are readily available thanks to information disclosure rules required by public markets.
But for private companies, market information is not readily available. Once the exercise price of stock options is known, one additional piece of information is immensely helpful: your percentage of the company. This information can come in two ways. Either “your options represent 0.1% of the company” or “you have 25,000 shares and the total is 25,000,000 shares”, in which case you can divide one by the other.
Your percentage of the company allows you to think about what your shares might be worth. If you have 25,000 shares and the company has 25 * 10^25 shares, you have such a tiny percentage of the company that even if the company is the next Google, you will not be able to buy a Big Mac with your stock options.
Your percentage ownership allows you to do quick math on any exit that is contemplated. “Our competitor was just purchased for $200,000,000,” you read, “if we get purchased for that amount, my 1% of the company is worth a cool $2,000,000. Honey! Let’s have steak for dinner.”
I have witnessed companies struggle with percentage ownership. A private company was recently trying to hire employees. It was offering 10,000 options for hard-to-hire, mid-level engineers. At 0.5% of the company, the offer was well above the average in Silicon Valley. The engineers had other offers from a company that was offering 25,000 options. While always difficult to know, our protagonist company expected the competing offer to be a lesser percentage of the competing company.
Our heroes tried to explain this to its coveted future hires and suggested they ask what percentage the competitive offer implied. The other company didn’t provide the data, and the temptation of a bigger number (with an unknown value) led the engineers to accept the competitor’s offer.
The solution? The company split its shares 10 for 1, so that its generous offer increased from 10,000 options to 100,000 options (but the same 0.5% of the company) versus the competition’s 25,000 options.
Details, details
There are a range of additional clarifying questions to ask a private company about your percentage ownership. “Is the total number of shares you just mentioned inclusive of all shares and options?” This seems like a ridiculous question, but in many cases companies do not include certain shares in their total (employee stock options are one common example, because they are not yet full shares, just a promise to let you buy shares later). The number of shares you want for your calculation is called the “fully diluted” number of shares.
Another clarifying question: companies that have raised large amounts of venture capital often must pay that money back before your options are worth anything. This is called “preference” and the venture capitalists are called “preferred investors”. If a company is sold for $100,000,000, yippee! Your stock options are going to make you rich. Oh, the company raised $150,000,000 in preferred venture capital? Then your options are worth zero.
There are some questions to ask yourself when considering a private company offer. Tantamount is “What do I think the odds are that this company will go public or get sold? At what price?” Stock options in a private company, like all stock in a private company, have no real value until someone wants to buy them.
Risky Business
In the same way that you wouldn’t accept a check denominated in Klingon currency, so should you not accept stock option offers that are not clearly understood. Even further, you should hold in suspicion any company or management team that prevents you from knowing the data necessary for you to make an informed employment decision.
For companies, a clear articulation of the circumstances surrounding a stock offer is not just morally justified, but prudent public relations and human relations. Few things will enrage employees more than the sudden realization that, for any happy outcome below a billion dollar IPO, their stock options won’t pay for extra pepperonis on their pizza.
And they will find out.
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