Options 101

Joining a startup? Here’s what you need to know about employee stock options

Hey! I just joined Jump.ly, a Google Glass-only social network for parachuting enthusiasts. I’m employee No. 4 and got 10,000 stock options. Can I put in my Tesla pre-order now?

Maybe you should ask your HR department a few questions first. Most new hires receive only cursory information about options, how they work, and what they could be worth; there’s no standard for communicating this information. Knowing the details of your options will be essential when you decide to leave Jump.ly and whether to exercise the options.

First, let’s define a few of the terms.

Option: An option is the right, but not the obligation, to buy stock at a pre-determined price. In plain English, an option is kind of like a bet with no downside, like when your cousin offers you $5 to snort wasabi. No harm if you turn him down, just as there’s no harm if the option is worth less than the stock—just don’t exercise it.

Strike price: This what it costs to buy each unit of stock. A grant of 10 options with a strike price of $5 means that when you exercise them, you’ll pay $50 for those 10 shares — which you’ll obviously only do if the shares are worth more than that. If not, the options will be a very Valley way to line the litter box.

Okay, got it. My 10,000 options have a strike price of $2, which sounds pretty low (i.e. good). So how much are they worth right now?

That’s easy. Nothing. At least in the eyes of the IRS.

The rules around options are complex, but one key rule is that companies have to grant options at “fair market value”—i.e. you’d neither make nor lose any money if you exercised them immediately. If your company is worth $10 a share when you join, you should get options with a strike price of $10. They’re worthless unless the company builds value, which is presumably what you’ll be doing over the next few years.

Okay, but what’s the “fair market value” of Jump.ly? We’ve never made a dime.

Good question! The IRS uses something called a 409A valuation. Once or twice a year, startups pay independent evaluators (Silicon Valley Bank is one example) anywhere from a couple thousand dollars to $15,000 to derive a fair-market value for the company. The valuation is based on factors like intellectual property, the value of similar companies, and cash flow (if there is any). The 409A valuation is what your strike price is based on.

It’s important to note that the 409A valuation is not the same thing as the fundraising valuation that blogs like TechCrunch write about all the time. When a startup like Fab raises money at a (probably ridiculous) $1 billion valuation, that number has little or nothing to do with its 409A valuation. Venture capitalists base their valuations on a whole host of factors—like the skill of the founding team, the size of the potential market, user growth rates—that aren’t considered during a 409A valuation, which is governed by strict rules set by the government.

The upshot: Make sure you know the 409A valuation that your stock options are based on. If it’s $1 million, and then Jump.ly’s VCs kick in another half million at a $10 million valuation, you know that your options are worth 10x your strike price—at least according to investors, who are of course always right.

It’s been a couple years and I’m thinking of leaving Jump.ly—turns out there aren’t as many parachute enthusiasts as we thought. Should I exercise my shares?

As soon as you leave the company, you have 3 months to decide whether to exercise your options. So think hard on it beforehand.

If your company hasn’t gone public yet, then chances are it will be hard to sell your shares right away. There are places like Second Market which specialize in trading the shares of non-public companies, but they’re expensive and most investors are only interested in household names like Twitter. With that in mind, exercising your options means you’re betting that your startup will eventually go public or get sold at a hefty sum—it’s a bullish bet on the future of the company.

Once again, however, the IRS makes things more complicated.

Chances are you received what are known as incentive stock options, in which case, you’re in luck: You don’t owe any taxes until you sell the shares. You can exercise them, hold on to them until Jump.ly gets bought, then cash out and pay taxes.

There are lots of ways that your stock options might become “non-qualified” stock options, though. If you exercise them less than a year after receiving them, or sell them less than a year after exercising them, you could owe a ton of money to Uncle Sam. At this point, it’s best to call your accountant.