Startup Stock Options (ESOP) Explained: What Are they and are they any Good?

Startup Options are not a scam, but they are certainly not as lucrative as some of us might think. What are they and what purpose do they serve?

Are startup options only available in startup companies? Or could I get options let’s say in… Google!? When can options be liquidated? And how many shall I give or receive, and ultimately, what’s their worth?

*** Added Apr/2020: Per the Corona crisis, startups options may become more relevant than ever. Startups may distribute options to employees, to compensate for their inability to pay the same salaries as before. To learn more about startups in the Corona era, see: The Corona Era Startup Survival Guide: From Firing to Funding

According to Henry Ward, CEO of eShare, 95% of startup stock options do not mature. Rather, they end up in the trash (from the perspective of the employee). In some cases, employees may even end up paying gain tax for options. Yes, for options which would never mature. I.e. some employees lose actual money because of their options! OMG!

So… What exactly are options, and are they good or bad for you? The answer: it depends, on whether you are the employer, founder or investor. Oh, and it also depends on tax regulations, luck, and how much liquid cash you may have when you are terminated…

No worries, we are here to clear the fog…

What are Startup Stock Options?

Options are specific type of shares available to startup companies. They are part of the ESOP (more about ESOP here). Startups may allocate options to employees, as part of the compensation, in addition to salary.

The idea behind options is to motivate employees, either by: bridging the startup salary gap; or by making employees part of the company, as they supposedly become part of its success.

What is Liquidity Event?

Employee options transform into cash upon what’s called liquidity event, aka an exit. That is when (and if) a startup company goes public or is sold/acquired.

Subject to the scale of the exit, options may convert into money. But that’s not automatically the case.

In the event of selling the company or M&A, investors make the profit first. If the exit is large enough, founders make a gain too. Last in the food chain are the employees and their options.

Options would most likely have no monetary value, in the case of a low-profile exit. Employees receive non-preferred shares, in contrast with investors, and sometimes founders too.

How Popular are Startup Options?

In the previous decades (from the 90’s) and until just recently, options used to be a standard compensation tool, among smaller startup companies. As startups grow, they are able to pay competitive salaries. This results in reducing the amount of options given. Nowadays we find more and more startups which do not give options at all!

RSU – “Options” of Mature Companies

Can mature companies give options?

No, mature companies cannot issue options. Rather, mature companies such as Google compensate their employees via a similar tool called Restricted Stocks (RSU).

While RSU have higher chance of maturing into cache, startup options may mature at a higher multiplier. This could be looked at as a bonus (RSU) versus winning the lottery (options).

Startup Options Terms – Vesting Period

Do Employees receive all their options at once?

Not at all. Usually employees do not receive all their options at once, but rather throughout a vesting period of 4 years. For example, an employee may receive 10,000 options throughout his first 4 years of employment. Divided by 48 months, that means the employee accumulates 208 options per month.

It is likely that if an employee does not stay with the company for at least 1 year, then all options may be revoked, retroactively.

But hold on a moment, what do those 10,000 options worth anyway? Are they of any value to begin with?

What is the Monetary Value of Options?

Generally speaking, employees do not know the true (virtual) value of their options. In order to calculate the value, one would need to know the number of shares a company has issued, the number of shares he holds onto, as well as the evaluation of the company.

As a rule of thumb, a company’s value is considered to be what investors evaluated it, upon investing in the company. Such information can sometimes be found at CrunchBase.com, or at IVC-Online.com.

Calculating Startup Options Virtual Worth

The Formula: Divide the number of options in the total number of company shares, to know the percentage of the company the options correspond to. Than, multiply that number in the company’s valuation:

# Of Options Received / Total # of Shares * Company Valuation

For example, if an employee received 100 options, and the company has 10,000 shares, then the employee holds onto 1% of the company. If the company worth $2M, then those options virtual value is $20K.

As the company raises funding, it is diluted, and so are its options. In contrast, the company valuation shall increase. Thus the virtual monetary value of the options shall grow…

Keep in mind that the value of options does not directly correlate with company valuation. This is due to the fact that investors hold onto preferred shares. In contrast, options are non-preferred shares.

How Many Options To Give / Ask For?

First, we need to know the company’s evaluation, the salary gap (or the base desired compensation), and the risk multiplier (arbitrary). Then we can use the following formula:

(Salary Gap x Risk Multiplier) / Company Evaluation

Let’s take for example a startup which has not yet raised money, but currently raises 1 million dollars with evaluation of 3.5 million dollars (pre-money). For the sake of calculating options, we’d indeed go with $3.5M as the company valuation.

Let’s assume that the employee’s “assumed salary” is $7,500 per month, though he or she only make %4,500 a month. Thus the salary gap is $3,000 a month. If the employee works 1 year for that salary, then he or she shall be compensated with $36,000 per year.

As our calculation demonstrates, $36,000 are equivalent to 1.02% of the company shares:

36,000 / 3,500,000 = 1.02%

Now we can multiply 1.02% in any number, which reflects the risk factor.

What Happens to my Startup Options If I Get Fired?

A dilemma may occur when an employee receives options, but does not stay with the company for until the liquidation event takes place (ever if it never does). When employment is terminated, a tax implication may occur.

In Israel, once an employee’s employment is terminated, he gets two options: 1. Pay tax for the virtual profit gained by the options, within 90 days. 2. Let go of the options.

Why is that a problem? Because it is unknown at this stage whether the options would ever worth a thing. It is possible that the employee would pay tax, just in order to not to lose the options. However, later on he’d find out in retrospective, that the options ended up being worthless!

Pay or not Pay Startup Options Tax?

Whether the employee shall pay tax to keep the options in times of uncertainty, is a good question.

Let’s take for example a colleague of mine, Josh. Josh worked as a VP R&D in an Israeli startup which raised about $50M at the time, and generated revenues of about 8 million dollars annually.

After nearly 4 years of working for the company, Josh was fired. He could choose whether to pay $18,500 in taxes, within 90 days of termination, or lose his options! Fortunately enough, Josh had such amount of liquid money available to him, but! Josh was unsure of the company’s future: Would a liquidity event ever take place? and if yes, at what evaluation?

Josh met with his CFO to evaluate the situation. He calculated the risk, assessed the potential gain, etc. Eventually Josh decided to let go of the options.

At the moment of writing those lines, it has been few years since, and yet (?) the company has not liquidated. Did Josh make the right decision? We still do not know. For sure if Josh needed liquid cash back when he lost his job, then he had to let go of the options. Weird.

In Conclusion

Options are a tool for startups to compensate their employees for the salary gap, i.e. for paying less than what the employee might be able to earn elsewhere.

Options also play a psychological role, in making employees feel rewarded, or appreciated, or even better: they support in the creation of a sense of mutual success, as if the employee becomes part of the company.

In contrast with the common belief, in vast majority of cases, options would end up in the toilet. Furthermore, in edge cases such as what happened with Josh, an employee may even lose money due to paying tax on options which would never liquidate.

Shall a startup company give options to its employees? We believe yes. But as employees, we’d see this as a bonus, rather than as an equivalent to a salary. Perhaps if we had the choice to give up options and get cash instead, we’d invest that “extra” where chances are better than 5%…