Employee Stock Options as Explained By an English Major
Part One of a three-part series wherein I, an English Major, explain incentive stock options and how they work for employees at startups.
In 2009 the economy was tanking, and I had my first real job at an internet startup, though I wouldn’t have known to call it that. I was an aspiring writer who desperately needed a job and was thrilled by the prospect of getting paid to hang out on the internet all day. I’d heard about stock options before, but really just that back in the day even the secretaries at Google got rich.
When I signed my contract and went full-time, I got my stock agreement in an email. Along with it came an offer from my boss to sit down over coffee so he could explain how all of it worked. I was so grateful to be employed, so ashamed of my luck, so afraid of jinxing myself, and so perfectly 24 that I never replied, just signed the paperwork without reading it and ignored the whole thing.
One day in the elevator on the way to lunch, my same boss mentioned that if things went as planned, those stock options would buy me my very first apartment in New York. When I left this job a year later, the apartment line was edited to reflect my short tenure: “One day these stock options will help you buy your very own studio apartment in New York.”
In between then and now I’ve scoured Wikipedia, filled out hypothetical tax forms, had phone calls with an accountant that cost me more than a month’s rent, sent late night emails to the fathers and husbands of people I call friends, and have tried but mostly failed to explain what I’ve learned over drinks with former coworkers, many times over.
Most of them, I found, hadn’t given it much thought.
In fact, stock options at startups seem to be the one very relevant topic the “community” doesn’t have meta-conversations about. There are no panels. No posts on Medium (okay a few posts on Medium). Not even a years-late trend piece in the Times.
Which I get because 1) This kind of money, and this kind of privilege, is uncomfortable to talk about. You sound like an asshole, and you basically are. 2) People are afraid of getting sued.
So, disclaimer: please don’t sue me or think I’m an asshole, but I’m going to tell you what I’ve learned. I’m no expert but I already went to the trouble of writing all this out so off we go.
While getting stock options at your internet job is totally hypothetical and could mean nothing, if it does end up meaning something you’re really going to want to have looked it up ahead of time. They are not a gift. They are not a perk. They are an opportunity. The decisions you’ll make regarding them will affect, if not the rest of your life, then at least your retirement fund. You don’t want to have to make them on a tight deadline.
So as much as you want to dismiss it, or avoid it, or say it’s not your thing, if you find yourself in the ridiculously, embarrassingly lucky position of working at a startup and having this paperwork crammed into a tote bag somewhere, get your act together and start Googling the shit out of Incentive Stock Options. Or at least read this article.
First things first:
Stock options are just that: an option to buy shares in your (“your”) company’s stock. You don’t have the stock yet, someone is just setting it aside for you — kind of like layaway for horribly privileged people.
And yes, stock is a tiny bit of ownership in a company.
Owning shares in a company is like owning a square inch of a house. If they sell the house, you get your little share of the profit. If the house starts turning a profit, you might start getting your share of the money they make (dividends!). And, if you get sick of your square inch or really want to pay off your student loans or something, you can sell off your little square inch, or a part of it.
I’m sure there are better, more accurate ways of saying this (all of this!) but it’s how I’ve wrapped my head around it.
The value of stock, and therefore also the “valuation” of a company, is kind of fake and based on projections and human error and just general “hunches.” However, this is not an excuse to say “it’s not even real” and throw your option grant in the bottom of your metaphorical adult book-bag and forget about it. Because rich people will give you real money for this imaginary shit! And money is real. Okay money is symbolic and fake, too. But student loan debt is real. Madewell Industries is real. Your electric bill is real. Credit is not that real but broker fees are, though they shouldn’t be, real.
Most employees of startups get this stock option “agreement” which explains your option grant. That means what they are giving you (“grant”, it’s kind of obvious, c’mon) — the type of options, the number, the vesting schedule, the strike price, and any other picky rules and stipulations. It behooves you to read this contract, or better, have someone familiar with contracts read this contract. Remember that contracts are open to interpretation, and built only on language, which is flimsy and often misunderstood. Read it on a Saturday morning just after you’ve had your coffee. Or on a quiet train ride. Send emails to whoever sent it to you with lots of questions asking for clarification. It’s almost weird if you don’t.
Incentive Stock Options, or ISO’s, are probably what you’re getting — the incentive being you don’t quit when they start hiring people over you in approximately a year. These are what I’ll be talking about and referring to throughout.
If you’re an early employee and the company is new, your options are pretty much worthless for now. If the company succeeds later on, though, this is to your advantage. This is why people shittier than you always want to “get in on the ground floor.” Getting in on the ground floor just means you paid less to get more. Your “strike price” is way lower, and maybe you got your option grant before they hired a lawyer who advised them to stop giving people so much stock, you newbs, you’re giving away the farm.
TIP: Always join a company before the lawyers do.
Your strike price is just a really cool (“cool”) way to say how much the stock will cost you when you buy it. It’s the price you’ll pay per share of stock, and it is set when you get hired and sign the grant. For better or worse, it never effectually changes. I say “effectually” because in the event of a “stock split” a company can decide they didn’t originally cut enough pieces in the pie, and magically cut everyone’s piece smaller. Still, you’ll get your same fraction, your stock will just be cheaper and you’ll have a higher number of options — e.g. 100 shares at $1/share becomes 1,000 shares for $0.10/share.
Your option grant will also tell you how many shares you’ll potentially be eligible to buy. Barring firing you before you vest, they can add to this but they can’t take it away. (NB: If they try to, this is a problem. Email a lawyer or business-y person about it. Don’t worry, when the time comes, desperation will drive you to get over your hesitation and fear of these types of people.)
This means that one day in 10 years when this company you work for is wildly successful, and worth $100 a share, you still pay only the 60 cents they quoted you when you signed the stock agreement (or much less, if the company has gone down in value). It means all the investment banker husbands of your former roommates would wonder how you got so lucky, if only they knew.
If you join the company later, your strike price will probably be higher. That’s not because someone is trying to screw you (well, always a possibility). It’s because of the IRS, mostly. You pay the “fair market value” of the options at the time you are granted them. This sets your strike price, which rarely changes, stock splits aside, even as the fair market value rises, or falls.
If you come in later, the company is (if they’re lucky) presumably worth a little more, so you have to pay a little more. You are marginally less lucky but still you can’t complain.
TIP: Complaining about this shit, overall, is frowned upon. Only do it to the most trusted friends who will wear their potential annoyance with you on their sleeve. Learn to change the subject quickly, and without apologizing. “I’m so sorry I’m complaining about all this MONEY,” does not help your case.
The fair market value, or FMV (money people love an acronym), is pretty hypothetical but it’s usually more conservative (ie, cheaper) than what the stock is bought and sold for. Why? Because 1) all of this is fake, and 2) it’s kind of like the difference of wholesale and retail. Or not at all. But the third parties who are hired to establish a fair market value of stock shares are just being super realistic. They look at money in the bank and graphs and crap like that — tax shit. But when you buy or sell shares on the market — when investors invest in your company, for instance — you mark that shit up. You say, “One day this will be worth a billion dollars!” And because it’s all kind of fake and everyone is making educated guesses about the future, the investor is sometimes like, “Okay sure! Here’s a ton of money!”
When they do that, provided it’s a good round, it ups the value of everyone’s shares.
Apparently (per the hours I have wasted having bourgeois fantasies on Trulia) this is like the difference in “property value” of a house, which determines what you pay in property tax, and the actual price you pay for a house, determined by the “market,” i.e. what people are willing to pay for it.
NEXT WEEK: vesting, exercising, and the dreaded AMT tax, which I won’t even try to explain other than tell you to watch out for it. You can read it here.