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Over the past few years, I have helped many of my friends understand options in their employment contracts. Most candidates have a general misunderstanding and discomfort when it comes to options, so I’ll give a brief overview to try and shed some light on the issue.
First, options are not equity. If you receive options, you won’t actually own any of the company yet. You are being given an opportunity to buy shares at a later date for a fixed (and predetermined) price per share. You will make money by buying at the predetermined price and selling during an exit event at a new, higher price. Without an exit event (sale, merger, or IPO), you won’t be able to sell your illiquid shares and your purchase will represent an investment in the company’s future.
Options vest (become exercisable) over time based on your vesting schedule. If you leave the company at any point, you will typically have ~90 days to exercise your vested options or you will forfeit them. If you are leaving the company because it isn’t doing well, it’s unlikely that you will want to invest cash in exchange for shares.
On the flip side, if a company gets bought for a valuation that is 10x larger than it was on your grant date, you can immediately convert your vested options into shares and sell them for a 900% profit (assuming no dilution, which is highly unrealistic).
Almost every company will insist on a 1-year cliff so that none of your options vest until you’ve been with the company for a full year. But what happens if the company gets bought after 10 months of your being employed there? If you don’t have an acceleration clause (and most contracts do not come with one), you get nothing.
Things you should look for in your contract
- A grant date – Important for many reasons including determining when your vesting schedule / 1-year cliff begin and for tax purposes.
- A strike price – At what price you can buy shares of the company. Options are exercised and converted to shares by paying the company the strike price per share.
- Total # of options granted – With this you can determine what your cash outflow will be if all your options vest and you buy shares at the strike price. Keep in mind that the company will probably issue additional shares to you each year or with each promotion.
- Total # of shares currently outstanding or % of the company your options represent – How much of the company will you own (prior to dilution) once all of your shares vest? If they give you the total shares outstanding, you can just divide your # of shares by the # of shares outstanding.
- Dilution – This is where the company issues additional shares, which they will do for multiple reasons. You should assume that your % ownership will be 1/2 of what it is now by in an exit event. They probably won’t give you dilution protection, but it doesn’t hurt to ask!
- Vesting schedule – Typically 4 years. Vesting is the rate at which your options become exercisable. Before any of your options vest, you can’t convert them into ownership and there is typically a 1-year cliff on vesting.
- A 1-year cliff – Will likely be in every contract and prevents the employee from having any options vest in their first year. If you have a 4-year vesting schedule, 25% of your options will vest on your 1-year anniversary. Be wary of any cliffs that have a longer duration, especially if you don’t have an acceleration clause.
- An acceleration clause – Single trigger if the company is acquired and double trigger if acquired and you get fired. At a minimum, 25% of your options should vest in a single trigger and another ~25% in a double trigger situation. Many contracts won’t include anything about acceleration, so make sure to bring this up. This is particularly important if the company is doing well and has already raised significant ($2m+) capital, as they are more likely to be an acquisition target in the near-term.
Have you come across anything that I’m missing? Please let me know in the comments or shoot me an email. I’m happy to dive deeper into any of these topics or speak with you 1-on-1 if that would be helpful.