Understanding Employee Share Options
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You land a job with a startup. On top of your salary, you get 4,800 options with a $10 exercise price. Your options vest monthly over four years with a one year cliff.
Employee equity is not always well understood in Australia. It's a topic far too large for one blog post, but we can break it down into small chunks.
The above scenario is as close to a default as we'll get so it's the focus for this post. Once you've learned the concepts behind "options vesting over four years with a one year cliff" you're partially equipped to interpret your own equity offer. Even if you understand all this, you still need adult supervision in the form of an accountant: 542 Partners are amazing.
Breaking down the example:
- 4,800 options in your options package.
- They vest monthly over four years.
- There is a one year cliff.
- The strike price (aka exercise price) is $10.
Options are the right to purchase shares in the company at a pre-determined price. In this example you pay $10 to convert an option to a share. $10 is the strike price.
Vesting monthly over four years means you earn your options in equal monthly chunks over four years. It's your equity progress bar. Leave after two years and you've earned half your options package: 2,400 options. Still there after four years? All 4,800 options are yours.
If you quit before a year you get nothing, because of the one year cliff.
Looking ahead to four years later:
You stuck around and earned your 4,800 options. You don't yet own shares in the company, but you do have 4,800 vouchers to buy a share in that company for $10 per share.
If you joined a rocket ship and they're worth $210 per share - you can exercise your options at the $10 strike price and sell your shares immediately. You need to spend $10 to convert each option to a share but if you exercise your options and sell shares in one go, this can be done without transferring money.
The paper transaction would be:
4,800 shares at $210 per share = $1,008,000. minus $48,000 to turn your options into shares ($10 strike price x 4,800 shares)
= $960,000
This is what winning the startup lottery looks like.
Here's a not so great example:
You put in four great years, earn your 4,800 options but decide to move on. Your contract has a clause that says when you leave the company you have to exercise your options within a period of time or you forfeit them. In this case it's 90 days.
At the time you can't (or won't) come up with the $48,000 required to turn those options into shares, so you give them up. The company goes on to be worth $210 per share but you already let your options expire.
The only thing worse than that is spending the $48,000 converting your options into shares and seeing their value go down, meaning you lose money.
The biggest thing to look out for is: what happens to your options after you leave?
If your options expire 90 days after you leave, you'll need to make a quick decision on whether spending the money is a good investment, and you'll need the cash on hand.
If they don't expire right away then that's far better. You can hang onto them and see how the company does. Your chance of having those options when an exit event happens are far greater.
Wrapping up for now
This is a huge topic and there are many others in the community who are able to help. Feedback on this post is welcomed, as are ideas on what else we can cover.
Would any founders care to make their equity plan public? Explaining it here would be a big help to others.
In the meantime, here are a few things worth looking into that aren't covered above:
- Why do you get options instead of shares? Basically, tax. Matt Barrie explains this well. I've linked to the specific part of his video but the whole thing is worth watching (🎩@tkrawiec)
- Fullstack advisory tackles this from the employer's side. This advice helps you understand why employers structure things differently (🎩@nikkiricks)
- If your company is listed on the stock exchange, equity is simplified. If not, you're in a private company and there may be restrictions on exit events or how you sell your shares. This is a topic on its own.
- Employee Share Schemes: the government made changes in 2015 that made it easier for startups to give employee equity. Details here.
- Capital Gains tax is worth reading up on.
- Your contract will probably have a scenario for if you are a good leaver or a bad leaver. That's also worth looking into.
Huge thanks to Simeon, Sox, Imogen and Stu for helping me edit this post.
