I worked for a startup and as an employee, was “granted” 34,000 “Options” and “vested” in 8,000 “Options (ISO)”. The company has not gone public yet but likely will in the next 3-5 years. I just left the company and the exit paperwork says “Upon termination, you have three months to exercise your Options before they expire.” I have no idea what this means. What happens if I exercise them? What happens if I don’t? What does it even mean to exercise them? Please help.
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Keeping it ELI5: An option is, as the English word suggests, a choice. You have the option to do something or not do it.
When you “exercise an option” you’re choosing to do that thing. So, if I give you an option to buy a cookie for $1, and you exercise that option, then you give me $1 and I’ll give you a cookie. If you don’t exercise the option, then you keep your $1 and I keep the cookie. No pressure… it’s totally up to you.
Going a bit deeper with start-up stock options, as I have been through this a few times…
When you join a start-up you’re typically given (granted) an option to buy a certain number of shares at a specific price. I’ll use made-up numbers so as to not confuse you with any specifics that match your case. Let’s say you’re given 10,000 options at a price of $1.
You haven’t been given stock… you’ve been give the opportunity, the choice, to buy stock (up to 10,000 shares) at the set price ($1). You’re under no obligation to buy, and if you do exercise the option (i.e. choose to buy) then you’re under no obligation to buy them all in one go.
A start-up may run for many years before going public, getting bought, or shutting down. The thing about start-up stock is that all start-ups are a risk. If you exercise your 10,000 options at $1, and spend the $10,000 then the _hope_ is that one day the company will be successful and you’ll be able to sell those shares for a profit. But, and this has happened to me, sometimes the company doesn’t make it and you’re out the money. The company dies, and the stocks are worthless. That’s the risk, and you have to be comfortable with that.
The Fair Market Value (FMV) of a share is the current value of one share as filed in company paperwork. When you’re granted option, you’re granted them at the FMV price on the day… so $1 in this case.
The value of a share will change whenever there’s a significant financial event, such as getting more investment (i.e. a funding round). If the company is getting lots of customers and lots of orders, its value may also be independently reevaluated.
Why this matters:
If you exercise your options when they’re granted, then you’re buying them for $1 and the FMV of the stock is $1. So you’re not getting a “deal”. You’re paying the fair price. You’re buying a $1 cookie for $1.
If you wait, say, 2 years to exercise and in that 2 years the company has been through a funding round or two and now the FMV for a share is $3, then you’re still only paying $1 per share (per your option grant) but now you’re buying a $3 cookie for $1… and that’s a capital gain of $2 per share. Even though you can’t SELL your stocks. Even though you haven’t made any REAL profit, the tax man sees you buying a $3 thing for $1. You’re getting a deal, and the tax man wants his cut.
So in your case, if you’re leaving the company you need to look at the FMV of the stock and one of two things:
Either, the FMV is the same as your grant. That’s easy. If you choose to exercise your option then buy the $1 cookies for $1 and hold them. Cross your fingers and hope the company does well.
But, if the FMV is now higher than your grant, then if you exercise you’ll need to declare the “gain” on your tax forms, and PAY for the gains (the difference between the FMV and the option price). That may be significant or it may be trivially small.
I’ve seen start-up stock go from $0.01/share to $3/share and THEN the company just die. And, yes, friends who made the hard choice to buy their shares when they left the company (before it died, but when the FMV was high) were TOTALLY SCREWED.
If you choose to not exercise your options, then they just expire. You lose the option to buy them later. No big deal. Don’t feel pressured if you don’t think the company is going to be successful.
By the way: ALL start-ups think they’ll go IPO in 3-5 years. The local cemetery is full of the graves of start-ups who were going IPO in 3-5 years.
I am not a tax advisor or lawyer. Everything above does not constitute financial advice, may be incorrect, and is for entertainment purposes only.
I’ve been in a few start-ups, and these sorts of things were always heavily discussed between staff… everyone talks about this stuff. It’s not a secret. Everyone is at a start-up for the stock. You shouldn’t feel awkward reaching out to your colleagues.
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