Understanding Startup Stock Options

Thanks to the AngelList blog and its guest author Nate Matherson:

How Do Startup Stock Options Work? 6 Questions to Ask When Interviewing

Startup stock options are one of the most lucrative and misunderstood opportunities when working at an early-stage startup.

Options can provide substantial rewards through returns on the contracts as well as the ultimate goal – an increased equity stake in the startup as it develops, expands, and enters mature-stage growth.

How do startup stock options work?

In short, options are derivative assets that allow an employee to buy a set quantity of company stock at a fixed price within a predetermined time frame.

Understanding the function of stock option grants is vital in calculating your total compensation package at a startup. Here are 6 stock option grant questions to ask when negotiating your compensation package at a startup.

1. "What is the strike price?"

A strike price is important in calculating the number of shares you could purchase. For employees, the strike price is the price at which they can purchase shares of the company. Future or expected profits will be earned when the value of the shares rises above the strike price.

How does a startup set the strike price of stock options, and how do you know it’s a fair valuation? The IRS issues specific guidance on setting strike prices that centers around determining a fair market value (FMV) for the stock at the time of issue. Determining the FMV of the stock can be a challenging and opaque process, but Section 409A provides structure to the process. After the 409A valuation assesses the stock’s FMV, a strike price that cannot be lower than the FMV is assigned to the stock.

Typically, employees who join a startup earlier in its journey will have a lower strike price versus employees who join a later stage, or growth stage, startup.

2. “What is the 409A valuation of the startup?”

The 409A valuation is this valuation that will drive the strike price, and have a future impact on profits for employees. This helps the employee understand the valuation of the common stock, versus potentially higher valuations given to preferred equity. At a later stage or growth stage companies, the 409A valuation of common stock might be significantly lower than the valuation of preferred stock. In these cases, the employee could benefit from the eventual, and hopeful, a convergence of valuations between preferred and common stock.

A 409A valuation is the IRS’ prescriptive guidance and sequencing to determine FMV. Its primary use is to provide transparency and protect potential option grantees. The valuation then takes place in three discrete stages:

Calculating Enterprise Value (EV)

The EV can be calculated in one of three ways: the market approach, the income approach, and the asset approach.

• The market approach is used in early-stage firms to measure the company against a set of market-equivalent peers. For example, an early-stage software firm that is not yet profitable is measured against more mature software companies to determine a relative valuation against those comparable firms (i.e. comps).
• The income approach is used when a startup is at or trending towards profitability, and financial performance can be more readily predicted. EV is measured using revenue modeling from past performance and growth expectations.
• The asset approach is used early, often for companies' pre-financing. It measures EV based purely on...

Read the rest of this article at angel.co...

Thanks for this article excerpt to the AngelList blog and its guest author Nate Matherson.

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