A checklist for stock option offers

A friend of mine was looking at some job offers from startups recently and asked me for advice on how to think about the equity awards he was offered.

This depends a lot on details that companies often don’t give you unless you ask. So I ended up writing up the email I’d send asking for all the tricky details on any equity offer—plus instructions on how to interpret the response.

Before you ask for any tricky details, there are two questions you need to answer on your own:

• Do you need the money? If so, don’t rely on equity to get it! Your first priority should always be to have enough cash to pay for everything you need. Equity is usually only a good deal if you’re close to risk-neutral, for instance because you plan to donate it all to charity.

• Do you trust the founders? Equity is really complicated and it’s basically impossible to make sure you won’t get screwed in some tricky way. The below questions only make sense if you trust the founders (and other people with authority) not to do that. Unfortunately, this is hard to assess unless you get some kind of backdoor reference on the founders.

The checklist email

If I had job offers whose equity I was evaluating, here’s the info I’d ask for, in convenient email format:

Hi $NAME,

Really excited about the opportunity to work at $COMPANY! I just have a few questions about the equity offer to help me figure out how to value it:

• If I leave or am terminated, when do the options expire?
• How many shares is the offer, and how many shares in the company are outstanding?
• What were the investment terms of your funding rounds? (Amount invested, post-money valuation, and any liquidation preferences or other protections)
• Is vesting four years with a one-year cliff or something else?
• Do you offer early exercise?
• What’s the strike price of the options?
• Are they ISOs or NSOs?

(Feel free to copy and paste it for your own negotiations! And you should probably be also asking about the company’s metrics and financial health, but that’s for another post.)

PS: If you have suggestions for other questions, or relevant stories or data points, please comment below! If you’d prefer them to stay private you can also email me.

Reasoning

Here’s the reasoning behind each piece of info, and how I’d interpret the answer:

• Option expiry window. The default is for options to expire 90 days after you leave the company. You can prevent them from expiring by exercising them, but this can cause you all kinds of horrible problems. If the option expiry window is short, you essentially need to stay at the company until it goes public to cash out. This is horrible for many reasons:

  • You can’t leave (without giving up the equity you earned) if the work environment becomes bad, or you get a bad manager, or your life priorities change.

  • You have no negotiating leverage with the company because you don’t have a good BATNA.

  • You can’t use the vesting schedule for extra option value.

  This is by far the most important “gotcha” of stock options (though you may be able to avoid it through early exercise—see below). Personally, I’d treat an option package with 90-day expiry as basically worthless unless I was planning to early exercise.

The 90-days provision is the default because of rules in the tax code, so it doesn't mean that a company with 90-day expiry is malicious or evil, just uninformed. (But if they tell you that they want to keep the 90-day window to incentivize people to keep working there, that *does* mean they're at least a little bit evil. There are better ways of doing that!)

• Fraction of the company. This is obviously important because it’s what you multiply the company’s value by, to get the expected value of your stock. Unfortunately, a depressing number of companies will only tell you the number of options they’re giving you (or, just as bad, only tell you “X dollars of options” without telling you how X was computed).

• VC investment terms (previous discussion). In order to figure out how much money you’ll make if the company is acquired, you need to know what terms their other investors got. It’s very tempting to notice that a VC invested at a $100 million valuation, and conclude that your 1% of the company is worth $1 million. But if the VC’s shares have, say, a 2x liquidation preference, then share-for-share they’re way more valuable than yours—maybe up to 3x depending on the terms.

• Vesting schedule. This is low down only because most companies give you the standard vesting schedule: 4 years with a 1 year cliff. Some have a longer vesting period, which is a sneaky way to lower your effective (annualized) compensation. Back-weighting options (e.g. vesting 10% in year 1 scaling up to 40% in year 4) is the other common modification.

  Both of these are potential red flags—for instance, Amazon is reputed to back-weight their vesting because they burn out so many people within 1-2 years that it saves them a lot of money. But it’s also reasonable for companies to want to disincentivize people from leaving after just a year or two. As long as the total grant amount is higher to make up for the worse timing, I wouldn’t be too worried about a slower vesting schedule.

• Early exercise (previous discussion). This is where you pay the strike price of your options up front, even before they’ve vested, so that you own the stock instead of the options. If the options have a short expiry window (see above) you should strongly default to doing this.

  If the options have a long expiry window, early exercise makes less of a difference: it will make your tax situation better if the company succeeds, and make you lose more money if it fails. If you care a lot about optimizing already-awesome outcomes and have disposable cash, you should read the linked discussion to learn the details.

• Strike price. If you’re considering early exercise, the strike price determines how much it costs up front to do that. Otherwise, the strike price doesn’t matter that much unless it’s a late-stage company, because the chance that you ever exercise the options is low.

• ISOs vs NSOs. ISOs are a very strong default and what everyone talks about, but if the company says NSOs, you should look up how that affects the tax treatment, because it can make a big difference (30% or more) in the eventual expected value. Also you should ask them why they use NSOs because it’s a strange decision.

Valuing the offer

If the company refuses to give you any of this information, it’s a huge red flag: they don’t care or don’t want you to be able to value the options effectively, probably because the options aren’t actually very valuable.

If they answer your questions, and the first answer is “90 day expiry window,” you have three options:

• Convince them to change it to 7+ years. This is the best outcome for you, and the company really should want to do it because it makes their offers so much more attractive, at relatively little cost. But they may not want to, or they may not be able to adjust their stock option plan quickly enough.

• Decide to early exercise. This will cost a lot of money (the option strike price times the number of options), but will give you the option of leaving at any time without lighting money on fire. Note that if you leave with unvested shares, you will either get to keep the unvested shares, or get back the money that you paid for them—the company gets to choose which.

• Do nothing. In this case the equity is probably not worth the career optionality that you have to give up to keep it.

If they have a reasonable expiry window or you decide to early exercise, you then have to figure out the actual expected value of the option package. In principle, this is a simple formula:

options expected value = number of shares × (expected value per share − probability of success × per-share strike price)

Of course, you have no idea what the “expected value per share” or “probability of success” values are!

In practice, for early stage startups the probability of success and strike price are usually low enough that you can ignore that term. For late stage startups, though, it can matter a lot, so be careful.

Expected value per share is the harder one. The safest way to guess it is by appealing to the efficient-market hypothesis: assume that the company’s venture investors paid a fair price, and value your share based on that.

The tricky part you can only assume the VCs paid a fair price for their stock, which comes with more protections than yours. That’s why you need to know the actual investment terms. The study I cited in my previous discussion found that common stock was worth between 0% and 66% less than VCs’ stock, depending on the terms. Here’s my guess at a rule of thumb:

• If the VCs’ stock is exactly the same as yours, you don’t need to discount at all.

• If the company has a normal amount of protections for their VCs (basically, 1x liquidation preference) and a normal amount of VC ownership (10-40% for early stage companies), discount by about 25%—that’s the median discount from the cited paper.

• If the company has a high fraction of VC ownership (over 40%), or especially bad investment terms (more than 1x liquidation preference, uncapped participation, etc.), then discount by more like 50%.