In your grant, you are given the option to buy (exercise) a set number of shares at a given price. In the future, if your company does well, and there is a liquid market for your shares via a merger or IPO, you should be able to sell your exercised shares—and pocket a profit if the then-current fair market value exceeds your exercise price. Any such profit, of course, would be subject to applicable taxes.
Vesting is the process of earning your stock options over time, typically through continued service with your company. Once an option vests, you then have the option to exercise it, subject to all of the terms of your grant. For example, in a four year vesting schedule, your employee options would vest over the course of four years of service. Your vesting schedule is defined in your grant, but options frequently begin vesting one year after they’re granted. This one-year anniversary is known as the cliff.
The grant date is the date your equity is approved by the board. This may be before or after the vesting start date. Please note that all option grants are subject to approval by your company’s board of directors.
The cliff date is the date when the first portion of your grant vests. Frequently, for a new hire grant, this will be one year after you join the company.
Options that vest are able to be exercised. Grants typically vest in regular intervals, such as monthly or quarterly, beginning after your cliff date.
Valuing your grant
If your company is successful, the value of your grant will generally increase over time. This is because the share price typically grows with the company’s valuation, but not always in a 1:1 relationship. For example, your shares may be “diluted” over time if, among other reasons, the company issues more shares as it raises money and takes on new investors. However, if your company uses that capital for growth, then even though you might end up with a smaller percentage, it may be of a larger pie—in which case, the value of your equity may increase.
If your company’s share price grows over time, the net-value of your grant typically grows as the company share price grows. Whether you can realize any of that growth depends on a number of factors, including those discussed in the Liquidity section below.
Liquidity refers to when you’re able to sell your vested equity. Liquidity events may include IPOs, acquisitions, company buy-backs, tender offers, or secondary sales. Publicly traded companies do not have a liquidity event: vested shares can be sold on the market per the limitations of the grant.
Selling your shares
The value of your options—once you’re permitted to exercise and sell them—would be calculated as:
IMPORTANT NOTE: These materials are provided solely for informational purposes. They are not intended to be and should not be construed as tax, accounting, legal, or financial advice or opinions, and do not create any fiduciary or similar relationship.
Notes About Estimating the Value of Your Option Grant
Avoid using “expected value” calculations. The probability distribution of an individual company’s outcomes is unknown.
The lower bound value of your option grant is $0. Remember, if the company fails, your grant is worth $0 and you may lose money if you have exercised your options (e.g. by paying the strike price and any applicable taxes).
Top tier venture-funded companies often return somewhere around 10x. If your company is lucky enough to be one of the best, the upper bound of your grant may well be roughly 10x your current grant value. However, depending on the grant date and your exercise price, the upper bound of your grant could be significantly lower.
Roughly speaking, to compare equity offers, many will choose the company they believe is more likely to succeed in the future. In case of a tie, the option grant with the higher theoretical (notional) value is more likely to be the better offer.
Stock Options vs. RSUs?
- Stock options (ISOs and NSOs) require employees to pay money to own ("exercise") the shares.
- Restricted Stock Units (RSUs) are automatically in possession of an employee as soon as they vest.
The Optionality of Stock Options
What does this mean for employees? With RSUs, employees are generally taxed on the market value of the shares as they vest. Stock options, on the other hand, provide employees with optionality to choose how and when they want to exercise (own) the shares as well as when to be taxed. In general, stock options are not taxed until they are exercised.If you have questions about different taxation strategies, please consult an independent tax advisor.