Are employee stock options worth the hype?
Kegs of kombucha. Pet-ternity leave. Unlimited vacay. And employee stock options. These are a few of the ways that startups pry great talent from the grips of huge companies with cushy salaries.
And it’s an alluring promise! What if that startup is actually a unicorn? It’s as good as winning the lottery, if the lottery also involved working insanely hard for a chaotic high-growth company with a probably “intense” CEO.
So, when you get that job offer from an exciting young startup and see those sparkly 50,000 ISOs (incentive stock options) in your compensation plan…what does that actually mean? How likely is it that you’ll make good money on those stock options?
Statistically speaking, it’s a long shot. Let’s talk about why.
ISOs, the IOUs of of the startup world
Before we dive in, let’s cover how stock options work. A stock option gives you the right to purchase a stock at a pre-set “strike price.” Let’s say you were granted 50,000 ISOs with a $1.50 strike price. That means that once your shares have vested, you can purchase up to 50,000 shares for $1.50 each – that’s called “exercising” your options. The only reason you would choose to exercise your options is if the market value of the company’s shares are above $1.50 and you stand to make a profit.
But there are lots of things that stand between you and making bank on those options:
First and foremost, the company needs to succeed – big time. And sadly, 90% of startups fail, with 70% of them failing between years two and five of operating. Not only does the company need to be in that rare 10% that survives, there also needs to be a liquidity event: either the company is purchased or it goes public. Plenty of startups chug along for a long time, making good money for leadership along the way, without selling or going public.
Second, you need to stick around long enough for your shares to vest. A four-year vesting schedule is very common for ISOs, and it’s not unusual to forfeit all of your options if you leave in the first year. Given the unpredictable nature of startups and how much younger people change jobs (every 2.75 years for millennials), a meaningful portion of your ISOs may never vest.
Third, it costs money to make money. Let’s say you got through the first two hurdles – your company went public! Let’s go back to our example we used earlier. You’ll need to find $75,000 to exercise your options PLUS money to cover a hefty tax bill that year. Luckily, there are ways to solve this problem if you aren’t cash liquid. There are companies out there that can loan you the money, like Secfi and Equitybee. Your employer may also offer some resources for you, such as allowing a stock swap. Lean on your manager and HR as hard as possible for support. They aren’t allowed to give you financial advice, but they should have educational resources for you.
And lastly, when you exercise matters a lot for your tax bill. Whenever you decide to exercise your options, you will trigger a tax bill for that year…a big one. So you’ll need to factor that into your cost of exercising your shares. Ideally, you would exercise your options at least a year before you sell your share for a gain because it has major tax advantages. But the truth is that most employees fail to do so because this stuff is complicated, and it’s so expensive to exercise. But exercising early makes a huge difference in your end profit. (Check out how the average DoorDash employee left almost $1 million dollars on the table by not exercising early. Don’t be them!)
The Playbook Take
Employee stock options can lead to an incredible outcome, but it comes with tons of risk. Here are some tips for evaluating an offer that includes ISOs:
- Don’t be shy about asking tons of questions about how the ISOs work, how they arrived at the amount they’re offering you, and the company’s exit strategy. This guide has a list of specific questions you can (and should!) ask.
- Think hard about cash vs. equity. In most cases, you could get a higher salary by working for a more established company. That gives you risk-free cash to put to work towards investing, saving, and your quality of life right now – and that’s nothing to sneeze at.
- If you are ever thinking about exercising your options, definitely get professional guidance from a financial advisor who can help you understand your risks and tax implications.
To financial freedom and beyond!