In addition to an offer letter spelling out the expectations of your position, compensation structure, benefits, and perk, some companies also offer stock options. There are several reasons employers may offer stock options, including increasing employee loyalty and building a strong corporate culture. With stock options, workers help to grow the company as owners rather than merely employees.
If you’re looking at an offer letter that describes your compensation package including stock options, you should know how stock options work. This article lists 10 questions that are important to consider when addressing the prospect of a stock option in an employment offer.
1. Exactly what is a stock option?
A stock option provides an employee with the opportunity to purchase a set number of shares of company stock at a certain price within a certain period of time. The price is called the “grant price” or “strike price.” This price is usually based on a discounted price of the stock at the time of hire. Buying the stock shares at the grant price is called as exercising your stock options.
Remember that you aren’t being gifted shares of the company—you’re being given the opportunity to buy stock or shares in the company. You aren’t required to purchase stock when that opportunity arises, and it will not happen automatically.
As is discussed below, an employee with an option to buy stock must wait for her stock to vest before she can exercise her option to buy shares of the company.
Make certain that the size of your initial option grant is clearly stated in your offer letter and in a separate stock option agreement. An employee’s shares will usually vest over a four-year period, with a one-year “cliff.” This means if—for any reason—you leave your company within the first 12 months, none of your shares will vest.
But after you’ve finished your first year of employment, vesting typically will occur on a monthly basis. If the vesting terms presented to you don’t correspond to these standards, you should ask about it.
3. What’s the exercise price of my initial options?
The exercise price should be in your offer letter and stock option agreement. Be certain that your exercise price is clearly defined in writing before you accept the position, even if it is subject to subsequent Board approval.
4. What is the company’s total capitalization?
Let your boss know that you’re looking for a “fully diluted” view of the company’s capitalization. This means that, at any given time, the number of shares of the borrower’s common stock issued and outstanding and common stock ultimately issuable upon conversion, exercise or exchange of any outstanding rights to purchase the borrower’s capital stock, including preferred stock, options, warrants, employee stock plans, and convertible debt. This will give you a sense of your potential percentage ownership and the economic value of your stock.
You should make certain that all “authorized” options are included, which will ensure that the capitalization figure includes granted and ungranted options. Authorized stock, or authorized shares, is the maximum number of shares that a company is legally allowed to issue pursuant to its articles of incorporation in the United States.
Authorized options include those that haven’t yet been granted. To determine your potential future dilution, calculate the number of additional options that will be authorized and added to the option pool.
It’s not uncommon for a corporation to increase its option pool over time. A well-run company will manage a capital budget as a way of estimating its future option grants. Therefore, it’s reasonable for you to request an estimate of additional options to be authorized before the company’s exit.
Like future options, a well-managed company will be able to judge the amount of investor capital it intends to raise in the future, as well as the valuation(s) at which such investment(s) will be made.
Future capital requirements are based on a variety of factors, but you should understand the company’s underlying assumptions with respect to its future capital needs. It’s the number of funds that the company needs to achieve its goals.
7. How many options will I be granted in the future?
Of course, you’ll want to know if this is a one-time perk, or if you’ll have future opportunities. Subsequent stock options may depend on your tenure and performance. A company may annually give its employees small options grants, in many cases at year-end or tied to the employee’s anniversary hire date. On the other hand, some companies won’t make future “refresh” grants.
8. What is the vesting schedule?
It’s important to understand when you take ownership of the value of your shares. As mentioned above, the standard vesting schedule is over four years with a one-year cliff. If you depart prior to the cliff, you will receive nothing. After the cliff, you would vest 25% of your shares with additional options vesting monthly. You will usually be permitted to keep any shares that you vest provided that you exercise within 90 days of leaving the company.
Some companies have the right to buy back your vested shares at the exercise price if you leave the company before a liquidity event. As such, if you were to leave a company in two or three years, your options would be worth nothing, even if some of them had vested. Make sure you understand how this works.
9. Do you allow early exercise of my options?
Letting employees exercise their options before they’ve vested can be a tax benefit to employees because they have the chance to have their gains taxed at long-term capital gains rates. This is frequently only offered to early employees because they’re the only ones who stand to benefit.
10. When should I negotiate stock options?
Always negotiate your base salary before you discuss other types of benefits, like stock options. That’s because companies typically have a framework for stock options that they offer to employees at certain levels in the company. When negotiating stock options, ask if the company has a standard scale.
That scale typically means that those on the executive level (CEOs, CFOs, COOs, CIOs, the VPs will be given a much greater amount of stock options than a person coming into the company at a middle management role.
Ask if your offer fits with the position you’re being offered. If not, ask for the rationale and argue to be included in the standard range. In addition, perhaps you can negotiate your way into the next bracket and gain greater stock options.
Stock options can be a great perk for a new employee. There are pitfalls as described here, so be sure you fully understand how stock options work at your new company. Click here for more information.