I recently wrote a short aside about stock options:

But in general, for regular employees, I think options are rarely worth it. They typically require an up-front investment that many employees simply can’t make, so it’s a bit of a fake benefit to begin with, and their future value is little more certain than a lottery ticket.

Hunter Walk kindly reshared it on a few networks with some of his own thoughts; a conversation with Tony Stubblebine arose in the comments that Hunter wrote up as its own post. In particular, he says it helped him articulate the ups and downs of private stock to the average person:

For much of a startup’s life new FUNDING VALUATIONS are LEADING indications of POTENTIAL. They are what someone is willing to pay for shares today based on what they believe the company CAN DO in the FUTURE.

DOWN ROUNDS and RECAPS are LAGGING indications of PERFORMANCE. They are what someone is willing to pay for shares today based upon what the company HAS DONE in the PAST.

It’s a great post, and the comments from Tony were thoughtful. Which led me to feeling a bit bad about how flippant and imprecise my original post had been.

So, on that note, I’d love to define options, make some corrections, and dive a little deeper into my core argument.

The ins and outs of options

First, let’s define options and explain why they’re so common as a factor of startup compensation.

An option is the right to buy a specified number of shares in a company at a specific price. That price is typically defined by an external auditor. It’s good practice for this to happen once a year, but it’ll also be triggered when the company raises a round of equity funding (i.e., when it sells shares to outside investors in order to raise significant capital).

If a startup were simply to grant stock directly to employees, it would be taxable as compensation. Options are almost always non-taxable at the point where they are issued, so they’re a favorite way to give employees the ability to see some of the potential upside in a venture.

Typically in a startup you’ll receive an option grant as part of your compensation package. So, for example, you might receive the right to buy (“exercise”) 40,000 shares at 50 cents a share (the “strike price”). This is almost always on what’s called a vesting schedule: you won’t be able to buy any shares in the first year, but then when you cross that threshold (the “cliff”), you’ll be able to buy 25% of your allocation (the first 10,000 shares in my example). Over the next three years, the amount of your allocation that you can exercise will increase proportionally, until you can buy them all at the end of four years.

If you leave the company, you usually only have 90 days to exercise whichever options have vested. Some particularly progressive companies extend that exercise window — sometimes to a couple of years. But for 80-90% of startups, it’s 90 days.

If the startup is excited about keeping you, you may find that they’ll grant you more options periodically, each with their own vesting schedules. This, they hope, will keep you at the company.

In my example above, you might have done the math to realize: 40,000 shares at 50 cents a share is $20,000. You would need to lay out that amount of money to acquire the shares — and you need to hope that the company’s shares increase in value in order to see any upside.

If the company’s share price has increased in the time between the options were granted and when the employee exercises them, the difference is taxable. In the above example, recall that my options are for 40,000 shares at 50 cents a share. Let’s say I choose to exercise them all at the end of my four year vesting period: as we’ve discussed, I pay $20,000. But let’s say that the real fair market value has risen to 75 cents a share. The difference between 40,000 shares at 50 cents and 40,000 shares at the market value of 75 cents is $10,000 is usually taxed as income. So I’m actually paying $20K + income tax on another $10K. (This isn’t by any means the full extent of potential tax implications; I’m not going to touch ISOs and AMT in this post, for example.)

Early employees, who join before most funding rounds have taken place, will receive options with a very low exercise price. Later employees will usually receive options with a higher price, because more growth and fundraising has taken place in the interim. (Down rounds and recaps are certainly possible, though: many startups go through tough times where their valuation decreases. Not every graph always goes up and to the right.)

In both cases, any stock they buy is largely illiquid. Because the startup is likely a private company rather than a publicly traded one, their shares are not liquid. They will need to wait for the company to go public or hope that management will allow them to trade their stock on the secondary market.

Some corrections

So the first thing to say is: no, options are not really like a lottery ticket. They are a sort of gamble, but it’s one where (depending on your position, seniority, and what size the company was when you joined) you have a say in the outcome.

The second, which I’ve already corrected in the original post is: as Hunter pointed out in his post, a recap is not the thing that actually lowers the stock price. It’s a trailing signal of what the company has already done. A change in stock price is an effect of what has already happened.

And a clarification: options don’t require an up-front investment at the time that they’re granted. You invest at the time when you exercise them, which may still be as a lump sum.

Why I think exercising options isn’t worth it for many employees

If you’re on a rocket ship startup, exercising your options is almost certainly worth it (depending on the strike price of your particular options grant). The problem is: how do you know you’re on a rocket ship? Or, given that most startup employees won’t be part of a startup with hockey-stick growth, how can you be reasonably sure that your company will grow in such a way that exercising your options is worth it?

90% of startups fail. That doesn’t mean that every startup has an equal 1 in 10 chance of success: a lot depends on a range of factors that include internal culture, management expertise, execution quality, and market conditions. Still, there is not a small amount of luck involved. Most startups won’t make it.

You should never make an investment that you can’t afford to lose. As Hunter says in his post:

Don’t behave as if they’re worth anything until they actually are

Don’t over-extend yourself to exercise [options] in scenarios which put your financial well-being at risk.

If you’re obviously, unquestionably on a rocket ship: by all means, buy the options. (Yes, sometimes it really is obvious.)

If it’s not clear that you’re on a rocket ship, but you’re feeling good about the startup, and you can definitely afford to spend the money it would take to exercise your options: knock yourself out. Honestly, I don’t really care what people with wealth do in this scenario. My worries do not relate to you.

If it’s not clear that you’re on a rocket ship and spending the money to exercise your options would be a stretch: I would suggest you think twice before doing so. I also would warn you to never take out debt (which many startup employees do!) in order to exercise your options.

And that’s really the crux of my argument.

Startup employees without significant independent spending power who work for a venture with an uncertain future and who did not join their ventures at a very early stage — which I would argue describes most startup employees — should think long and hard before exercising their options.

It’s more than a little bit unfair that the people who can most easily realize upside from the startups they work for are people who already have wealth. Granting the ability for employees to buy shares directly at their fair market value is limited, too: this would make them investors, who the SEC says mostly need to be accredited. The definition of accreditation is either being a licensed investor, earning over $200,000 a year for the last two years, or having a net worth of over a million dollars excluding the value of their home. So the door is effectively closed to people from regular backgrounds.

I wish more equitable systems were commonly in use. Some different tactics are in use, which include:

• Restricted Stock Units. Here, stock is granted directly as part of an employee’s compensation. Upside: the employee has the shares. Downside: they’re taxed on them as soon as they vest, and selling them is restricted. So the employee effectively receives an additional tax bill with no way of recouping the lost funds until much later (if they’re lucky). RSUs are common in later-stage companies but very uncommon in riskier, early-stage companies for this reason.
• Phantom stock. Really this is a bonus plan tied to stock performance, income tax and all.
• Profit sharing. Which is only useful if the startup makes a profit (most don’t).

While some have value in their own right in particular contexts, I see them as compensation strategies that might sit alongside stock options, rather than replacing them.

I would love it to be less risky for the employees who are actually doing the work of making a startup valuable to see more of the upside of that work. But, at least for now, my advice remains to take those inflated Silicon Valley salaries and bank them in more traditional investments.