Stock option 101: Understanding your startup stock options

Ryan Logue

Startup equity continues to be one of the most powerful hiring tools available. Equity grants align employees to drive successful outcomes and exits for the business in ways that a typical salary and bonus could never match. While there can be incredible outcomes for early employees at highly successful startups, the reality is that most early employees do not strike it rich. Not every startup turns into an Uber or an Airbnb.

In fact, most startups won’t be able to raise a Series A, let alone have a successful IPO. Having worked with successful private companies on over $40B in private secondary and M&A transactions for the past decade, I can assure you that bringing startup stock options to a level where they can allow their shareholders to have a successful exit is an ideal outcome, but not a typical one.

You may be wondering what your FMV, dilution, and percentage ownership are, let alone why they impact the value of your equity, so here is a quick primer on how to value your stock options:

What is fair market value (FMV) stock?

Fair market value (FMV) stock is the price at which the stock would be traded between a willing buyer and a willing seller in an open market. The FMV will determine the price you are granted options at, among many other things. To calculate your share of FMV stock, if the FMV at the time you receive your grant is $2/share and you receive 10k options, that means you will need to pay $20k to exercise those options. The difference between your FMV and the exit price for your company (e.g. M&A or IPO) is what the eventual value will be (assuming you are lucky enough to exit). To oversimplify how this works, if you get 10k options at $2/share and the company has an IPO for $100/share, your upside is $980k before taxes. Keep in mind that there are a whole host of tax-related complexities depending on the type of option grant and many ways to optimize for tax performance, but we recommend you talk to an accountant about that to get personalized advice based on your financial situation for the best startup FMV arrangements. 

What is dilution and percentage ownership?

Dilution is important because it will decrease the value of each share you own. What does that mean? Here's a simple example of dilution: Let’s say you get 10k options and your company has issued 1 million shares at the time of your grant. At this point, you own 1% of the company's total shares. Every time your company raises capital, they are likely issuing brand new shares to those investors. As your company continues to issue new shares to investors, your 10k options become a smaller percentage of the overall total. This could mean that at the time of exit your 1% ownership stake is now diluted down to 0.25% or less. This isn’t necessarily a terrible thing, as many startups offer refresh grants and raising capital is essential for your startup to ever make it to an exit, but it will have a material impact on your outcome.

How to value startup options?

In valuing your startup options, it is important to have a clear understanding of the terms of the stock options, including the exercise price, vesting schedule, expiration date, and any other relevant terms. Once that is done, assess the stage of your startup. Startups go through different stages, such as seed, early, or growth stage. The stage of the startup can have a significant impact on the value of the stock options. Reviewing your startup's financials can also provide some insight into the company's current financial position, revenue growth, and burn rate.

How to calculate stock option valuation?

There are various methods to calculate stock options; the two most common stock option valuation calculators are:

  1. Black-Scholes Model: This model uses inputs such as the option strike price, the underlying stock price, the time to expiration, and the volatility of the underlying asset to estimate the fair value of the option. It is a complex formula, but it is the most reliable method and is widely used in private startup option grants and publicly traded options pricing.
  2. Option Pricing Method: This method considers the unique features of startup options, such as the possibility of dilution, liquidity, and uncertain future prospects, to estimate their value. It is more complex than the Black-Scholes model but may provide more accurate estimates for startup options.

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Disclaimer
The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Information about the company is provided by the company, or comes from the companies’ public filings and is not independently verified by LTSE. Neither LTSE nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding LTSE-listed companies are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. Advice from a securities professional is strongly advised.
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