John D. Perrings
I think there is a misconception about what employee stock options are and why people get them.
In Part 1 of this 3-Part series, we laid out three risks that startup employees take that can cause “triple-pain” in down markets:
Higher risk should have an associated price that is not usually covered by a startup employee’s salary. We are told that we are compensated for this risk by being awarded employee stock options…
Most people look at employee stock options as a “bonus” or an incentive for working hard and bringing a startup company to life. While I agree that it is indeed a strong incentive. I do not agree that it is a “bonus.” At least not in the way many people think. For many, there is a fundamental misunderstanding about the underlying principles of stock options. And I think this misunderstanding can lead to a large amount of risk and/or lost opportunity cost for the startup employee.
Options, at their heart, are really a form of insurance. Buyers of options pay a small, certain, amount of money in order to offset the impact of larger, uncertain changes in the price of a good (stock, other asset, contractual right, etc). You either protect against possible downside risk or lock-in possible upside gains
Wikipedia has a great historical example of the “first” option being used to lock-in the use of an olive press. I like this example because it does a good job of explaining the principle of options by taking it out of the context of employee stock or the stock market:
The first reputed option buyer was the ancient Greek mathematician and philosopher Thales of Miletus. On a certain occasion, it was predicted that the season’s olive harvest would be larger than usual, and during the off-season, he acquired the right to use a number of olive presses the following spring. When spring came and the olive harvest was larger than expected he exercised his options and then rented the presses out at a much higher price than he paid for his ‘option’.
In this context, I think it’s worth identifying what the actual “bonus” is. Most people think of the potential future payout of the appreciated stock as the “bonus.”
Bonus: "an amount of money added to wages on a seasonal basis, especially as a reward for good performance."
Meaning: if you do a good job, you will be granted additional compensation as a reward
If this is the case, the only thing you are definitively being granted are the options to buy the shares of stock, and only the options. Thus, the real value of the “bonus” is simply the cost of the options. To crystallize this concept, let’s compare this to acquiring options in any online trading account:
In your brokerage account, you buy the options themselves. At your startup company, you are granted the options at no cost to you. That’s the only thing you are guaranteed to get if you perform.
That’s your bonus. In this example, $1,000.
What you are being granted is “the right but not the obligation” to then buy your participation in the possible upside success of the company.
Since you are paying for it and it’s not guaranteed, I do not consider that a bonus. A possible opportunity, yes. A possible great opportunity, yes! A bonus? No.
1) Options expire worthless or are greatly diluted in later rounds of funding
I have personally been involved with both types of startup companies. Companies that folded and laid me off (the crazy 2000’s, man!) and companies that, in late rounds of funding, diluted the shares of stock to such an extent that the payout on my shares of stock was less than one month of my regular pay.
How do you adequately compensate yourself to recover the lost opportunity cost of the higher “interest” the company owed you (see Part 1) and was not covered by your employee stock options (because they were worthless or diluted)?
If this point comes off as a little academic, I will tell you this: Banks, insurance companies, and investors don’t think so. They care about risk profiles and their associated returns. A lot. Why would you treat your own personal economy with any less concern?
2) Significant upside is thrown out the window when exercising options
Now, what if your startup company is successful and the underlying stock for which you own options increases in value? This is the potential upside you were hoping for. It’s happening! Now: what is your plan to cover the cost of exercising the options?
According to a Schwab survey, 75% of employees never exercise their options at all, mostly due to fear of making a mistake.
Most employees, when they do take advantage of stock options, choose (or must choose) a “cashless exercise” to buy their shares of stock. This is because they do not have the cash on-hand required to buy the stock (at the grant price) nor pay the taxes due.
A cashless exercise is when you liquidate a portion of your shares of stock to cover the cost of purchasing the shares at the grant price as well as to cover the cost of the taxes owed at the time of exercise.
As in the above example, if you have 1,000 options to buy shares at the grant price of $1/share and the current valuation on those shares is $5/share, to purchase the shares using a cashless exercise, you would have to liquidate 400 of your hard-earned shares:
So, in order to simply own the stock, you had to liquidate 40% of your shares!
Using simple math, if the stock price then increased to $8.50/share, for example, you’d miss out on $8.50 x 400 = $3,400 (before taxes). That’s a lost opportunity cost of 34%.
Some employees are given the opportunity to “early exercise” their options. It is a highly efficient way of taking advantage of upside potential because it eliminates the compensation tax due at exercise. It also starts the clock earlier so that you can more quickly sell your newly owned shares at a lower, long-term capital gains tax rate after vesting.
However, to take advantage of an early-exercise, you must have cash on-hand to buy your shares at the grant price. Many people simply do not have the available cash to buy their shares. Because of this, some people resort to liquidating other investments, pulling cash out of the equity of their homes, taking loans from their 401(k), or borrowing from family just to participate. As was the case for some Uber employees ->
In Part 3, we will take a look at some examples of how options are exercised and the money that can be left on the table if exercised inefficiently
On to Part 3: Leaving Stock Option Money on the Table
My mission is to teach people how to strategically accumulate capital in a way that makes all of their other financial activities perform better, and with less risk.
What are you doing, today, to ensure that you are in a position to take advantage of change, rather than react to it?
John D. Perrings