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Understanding an option grant

Lesson in Course: Finance at work (beginner, 5min )

We received stock options from our employer. What are they, and what do we need to know?

So we've decided to work at an exciting startup. Awesome! The company we work for also granted us stock options, making us joint owners. Sweet! Billionaires aren't billionaires because they get paid well by companies; it's because they OWN companies. 

stock option is a right, but not an obligation, to purchase the stock at a price. If the company is doing well, we can choose to exercise or convert our stock options into the company's shares at any time. Since there is no obligation, we don't have to exercise our stock options either. 

 

Demystifying the options agreement

The options agreement spells out all of the important parts we need to know about our stock options. 

Companies can grant options in two flavors: incentive stock options (ISOs) and non-qualified stock options (NSOs). We need to understand the details of our grant before we break down the two options. We will dive deeper into the two types in other lessons.

Let's break down what it all means.

The share count

The number of stock options granted is the same as the total number of shares we can purchase. We can buy 10,000 shares of common stock if the company gives us 10,000 options.

More shares are better than less. However, if comparing offers, a higher percentage of the company is more valuable.

For instance, an offer of 100,000 options out of 100 million shares is worse than 10,000 options out of 1 million shares because the first is 0.1% of the company compared to 1% of the company in the second offer.

The strike price

The strike price is the cost per share we pay to exercise the option

Since this is the price we pay for a single share of company stock, we can calculate the total exercise cost by multiplying the strike price by the share count. For instance, 10,000 stock options with a strike price of $0.10 would cost $1,000 to exercise.

We use the strike price for calculating taxes when we exercise or sell our stock, as shown in the lesson about taxes and stock options.

Fair Market Value (FMV)

The fair market value is the current value of the shares if they can be bought or sold.

The FMV can be thought of as the current price of each share. This is often determined by an independent business appraiser and the investors in the company. Early startups are risky and don't typically have a lot of buyers and sellers of shares within the company. The FMV is usually the same as the strike price when we are granted stock options, but the price changes as the value of the business goes up or down.

Grant date

While the company can offer stock options to employees, no employees receive anything until the board approves it. 

The grant date is the date that the company's board approves any employee option grants and when we officially receive the options. The grant date is used for the tax benefits of ISOs, as we'll learn in the lesson about ISOs vs NSOs.

Vesting date

The vesting date is the date our vesting period starts and is typically the same as our start date. 

The vesting date specifies the beginning of the schedule of when we can expect to start receiving our options. Vesting dates tend to be before grant dates since board meetings happen less frequently.

The vesting period

vesting period is a schedule for when we receive our stock options.

Most grants include a cliff for the first part of the vesting period which represents the time period we are employed for to receive any of our options. For example, a typical 4-year vesting schedule gives us 25% of our options after a 12-month cliff. If we leave the company before 12 months, we forfeit any equity we might otherwise be entitled to.

After passing the cliff, we'll get 25% of our options and then start earning the remainder 75% on a monthly basis until we receive the total share count, four years from the vesting date.

Post-termination exercise period

The post-termination exercise period is the window of time we have to exercise our vested options before we lose them all

It's good to know the length of the post-termination exercise period before we decide to take another job or quit. We can always refer back to our option agreement or ask our employer to double check. The lengths vary, usually between 30 and 90 days, but it's pretty uncommon for it to be longer than 90 days.

Putting it all together

Let's use the following as an example options purchase agreement.

You have been granted an option to purchase Common Stock of NextUnicornStartup, a Delaware corporation (the "Company"), as follows:

Date of Grant:11/18/2020 
Exercise Price Per Share:USD$ 0.10 
Total Number of Shares:10,000 
Total Exercise Price:USD$ 1,000.00
Type of Option:

5,000 Shares Non-statutory Stock Option

5,000 Shares Incentive Stock Option

Expiration Date:11/18/2030 
Vesting Commencement Date:11/1/2020 
Vesting/Exercise Schedule:So long as your Continuous Service Status does not terminate (and provided that no vesting shall occur following the Termination Date (as defined in Section 5 of the Stock Option Agreement) unless otherwise determined by the Company in its sole discretion), the Shares underlying this Option shall vest and become exercisable in accordance with the following schedule:  2,500 of the Total Number of Shares shall vest and become exercisable on the 12–month anniversary of the Vesting Commencement Date and 1/36th of the Total Number of Shares shall vest and become exercisable on the last day of each month thereafter (and if there is no corresponding day, the last day of the month). 
Termination Period:You may exercise this Option for 3 month(s) after the Termination Date except as set out in Section 5 of the Stock Option Agreement (but in no event later than the Expiration Date).  You are responsible for keeping track of these exercise periods following the Termination Date.  The Company will not provide further notice of such periods.
 

Stock options are great opportunities for us to become owners. However, we cannot sell them the way we can trade options in some of our brokerage accounts. 

To realize the value, we must exercise the options first to own shares in the company, which gives us the right to sell them later. Don't forget that we can't sell our shares whenever we'd like if we work for a private company. We need to wait for specific liquidity events. 

Glossary

What is The strike price?

The cost per share we pay to exercise a stock option. 

What is Grant date?

The date that the company's board approved our employee equity grants, such as stock options or restricted stock (RSAs and RSUs).

What is Vesting date?

The date our vesting period starts, and it's typically the same as our start date.

What is Vesting schedule (Vesting period)?

A schedule for when we receive our equity compensation, such as stock options or restricted stock. A typical 4-year vesting schedule gives us 25% of our shares after a 12-month cliff, and then we receive shares each month until we receive the total share count, four years from the vesting date.

What is post-termination exercise period?

The window of time we have to exercise our vested options before we lose them all.

What is Fair Market value (FMV)?

The current value of the shares if they can be bought or sold.

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