Understanding Stock Options
As emerging market startup activities continue important questions around start-up option grants will become relevant. Its critical for potential employees to understand how option grants work and what questions need to be asked of the startup founder(s)/CFO before accepting any employment agreement which offers stock option grants.
For example in Dubai, recently we are asked by aa prospective C-Level officer who was offered 100,000 stock option on whether she was getting a good deal or not. This is what compelled us to provide this overview article on critical questions to ask.
- How many shares will be granted?
The size of your initial option grant should be articulated in your Offer Letter, as well as in a separate Stock Option Agreement. In most cases, your shares will vest over a 3, 4 or 5 year period (in emerging markets you likely wanna seek a short a period as possible) with a minimum one-year cliff. Under such an arrangement, if you leave your company within the first twelve months, for any reason, you will not vest any shares. Once you have completed your first anniversary of employment, vesting usually occurs on a monthly basis. Any vesting terms that do not conform to these standards should be challenged.
- What is the company’s capitalization?
To help the CFO/Founder(s) understand your request, indicate that you are seeking a “fully diluted” view of the company’s capitalization. Also, be sure that all “authorized” options are included, which will ensure that the capitalization figure includes granted and ungranted options.
- How many additional options will be authorized?
Authorized options include those which have not yet been granted. In order to calculate your potential future dilution, estimate the number of additional options that will be authorized and added to the option pool.
The size of a startup’s option pool will vary, depending on its maturation. It is very reasonable to ask for an estimate of additional options to be authorized before the company’s exit. If the founder(s) don’t comply might be a red flag.
- How many additional shares will be issued to investors?
As is the case with future options, a well-managed company can reasonably estimate the amount of investor capital it intends to raise in the future, along with an estimation of the valuation(s) at which such investment(s) will be made.
Future capital requirements are based on a variety of unknowable factors. However, it is imperative to understand the company’s underlying assumptions with respect to its future capital needs. A response of, “We have no idea,” is indicative of a company that is either: (i) poorly managed, or (ii) does not respect its prospective employees enough to provide them with a thoughtful response. Do not settle for a non-answer to this important question.
- How many options will be granted in the future?
Clearly, the number of any additional options you will receive will be dependent on your tenure and performance. Some companies provide their employees with small options grants annually, usually in conjunction with either year-end or the employee’s anniversary hire date, while others seldom make such “refresh” grants.
- What is Management/Founder(s) best estimate of the Company’s valuation upon an exit?
This variable is obviously an educated guess, at best. Even so, your prospective employer should be able to provide you with a valuation range that would be acceptable to the management team.
- What is the Exercise Price of my initial options?
This should also appear in your Offer Letter and Stock Option Agreement. Do not be satisfied with a response such as, “The exercise price will be defined by the Board of Directors, based on the Company’s Fair Market Value.” Ensure that your exercise price is defined in writing before you accept the position, even if it is subject to subsequent Board approval.
Above and beyond the questions mentioned above – have a friend or if you have lawyer handy to review whatever your signing. You can always reach out to email@example.com as well and we will happy to provide you our opinion.