Stock options explained

Northwind Labs hires its first engineer, Cara. Her offer letter has one sentence about equity: “48,000 stock options at a strike price of $0.50, with 4-year vesting and a 1-year cliff.” Cara writes good code, but she cannot read this sentence. What does she own on her first day? What is the grant worth? This lesson reads the sentence one word at a time.

An option is a right to buy

A stock option is the right to buy one share of the company at a fixed price, at a later time. The fixed price is the strike price. Cara’s grant lets her buy 48,000 shares of Northwind for $0.50 each.

An option is not a share. Until Cara pays the strike price, she owns no stock. She cannot vote, and a sale of the company does not pay her as a shareholder. The purchase of the shares is the exercise of the options.

An option costs Cara nothing on the day she gets it. She pays the strike price only later, and only if she wants to buy. Thus an option gives an employee a part of the growth of the company, with no cost at the start.

The spread is what an option is worth

When the company grows, the value of each share increases. The strike price stays the same. The difference between the two is the spread. It is the profit that Cara gets on paper if she exercises:

Spread = (share value − strike price) × options
       = ($3.00       − $0.50)       × 48,000
       = $120,000

The share value can also fall to less than the strike price. Then the options are underwater: nobody pays $0.50 for a share that is worth $0.40. Cara does not have to exercise, so an underwater option is worth $0, not less. It has value again if the share value increases to more than the strike price.

Vesting: you get the options over time

Cara does not get all 48,000 options on her first day. She gets them over time, as she works. This schedule is vesting, and the standard schedule has three parts:

Nothing vests in the first 12 months. This period is the cliff.
At month 12, one quarter of the grant vests at one time.
After the cliff, 1/48 of the grant vests each month until month 48.

Predict first

Cara has 48,000 options with 4-year vesting and a 1-year cliff. She leaves Northwind after 11 months. How many options does she keep?

Type a guess before you continue. A guess first, even a wrong one, makes the answer easier to remember.

After the cliff, the calculation is simple:

Vested options = options × months worked ÷ 48     (from month 12)
Month 12       = 48,000  × 12 ÷ 48 = 12,000
Month 30       = 48,000  × 30 ÷ 48 = 30,000
Month 48       = 48,000  × 48 ÷ 48 = 48,000

Why a cliff? It protects the company and the team. A hire who leaves after two months does not keep a part of the company. After the cliff, each month of work adds more options, so each month gives a reason to stay. Founder shares often vest on a similar schedule. The lesson on vesting and cliffs gives the founder version.

When Cara leaves, she keeps her vested options for a short time, and the unvested options go back to the company. The calculator shows the vested options and their value for each month.

Calculator

What your options are worth today

Select a month at the company and a value for one share of common stock. Only vested options count.

Options in the grant

Strike price

Months at the company30 months

Value of one common share$2.00

Vested options: 30,000; of 48,000
Cost to exercise: $15,000; 30,000 × $0.50
Value of the shares: $60,000; 30,000 × $2.00
Spread: $45,000; Value minus cost, not less than $0

Vested options by month

At month 30, 30,000 of 48,000 options are vested, and 18,000 more vest month by month until month 48. To buy those shares, you pay 30,000 × $0.50 = $15,000.

At $2.00 a share, each share is worth $1.50 more than the strike price. The spread is $45,000. It is a value on paper: you cannot sell private shares until the company is sold, lists its shares, or lets you sell.

Move the month to 11 and then to 12. Look at the jump at the cliff. Then move the share value to less than the strike price. The grant is then worth $0 at each month, because nobody pays more for a share than the share is worth.

The strike price comes from the 409A valuation

Investors in a priced round buy preferred stock. Employees get options on common stock. Preferred stock has more rights. The most important right is the liquidation preference: in a sale of the company, preferred holders get their money back before common holders get anything. Thus one common share is worth less than one preferred share.

The tax law sets the minimum strike price. The strike price must be equal to or more than the fair market value of one common share on the grant date. For a US private company, an independent appraisal sets this value. The appraisal is a 409A valuation. Its name comes from Section 409A of the US tax code.

Here is an example. Northwind gave Cara her grant after its seed round, when the 409A price was $0.50. One year later, Series A investors pay $2.73 for each preferred share. A new 409A valuation sets the common stock at $0.80. Thus a new hire then gets a strike price of $0.80, not $2.73.

The IRS accepts an independent 409A valuation as reasonable for up to 12 months. This acceptance stops earlier if a material event occurs, for example a new priced round. Then the company gets a new 409A valuation before it grants more options, so that the IRS continues to accept the strike price.

Two types of option: ISO and NSO

US companies grant two types of option: the incentive stock option (ISO) and the non-qualified stock option (NSO). The difference is the tax:

	ISO	NSO
Who can get it	Employees only	Employees, advisors, contractors, and board members
Tax when you exercise	No regular income tax, but the spread counts for the AMT	The spread is ordinary income, the same as salary
Tax when you sell	All of the gain is long-term capital gain, if you hold the shares more than 2 years from grant and more than 1 year from exercise	Capital gain on the increase in value after the exercise
Limits	Only $100,000 of grant-date value can first become exercisable as ISOs each year. The rest are NSOs. You must exercise within 3 months after you leave.	No such limits

For example, an employee exercises 40,000 options with a $1 strike price when the 409A value is $5. The spread is $160,000. As NSOs, the $160,000 is ordinary income for this year, the same as salary. As ISOs, she pays no regular income tax this year, but the $160,000 counts for the alternative minimum tax (AMT). The lesson on exercise and taxes shows the numbers.

Why does an advisor get NSOs?

The tax code gives ISOs only to employees. An advisor, a contractor, or a board member who is not an employee can get NSOs or restricted stock, but not ISOs. A grant of ISOs to an advisor is a common mistake.

Options have an end date

An option does not last forever. The law gives an ISO a term of 10 years or less. Most option grants also end 10 years or less after the grant date. A more urgent date comes when you leave the company. Your vested options usually expire 90 days after your last day. This limit is the post-termination exercise period.

Thus “vested” does not mean “yours forever”. To keep vested options after you leave, you must exercise them in time, and that costs money. The lesson on exercise and taxes explains the 90-day window.

Where the options come from

The company keeps a group of shares for employee grants. This group is the option pool. Each grant comes out of the pool, and the unvested options of employees who leave go back into it. Investors usually ask the company to make the pool larger before they invest. The lesson on the option pool shuffle shows who pays for that.

Worked example · step 1 of 5

Cara leaves Northwind after 30 months

1
Find the vested options
Cara is past the cliff, so 1/48 of the grant vested for each month that she worked.
```
Vested = 48,000 × 30 ÷ 48 = 30,000 options
```

Now do the steps yourself for a different hire.

Work it out

Dev gets 60,000 options with 4-year vesting and a 1-year cliff. He leaves after 20 months. How many options are vested?

Work it out

Dev's 25,000 vested options have a $1.20 strike price. The 409A price is $3.00. What is the spread?

Quiz · question 1 of 5

Test what you learned

You get a grant of 10,000 options today. What do you own today?

In this lesson you will learn