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The ultimate guide to stock options for employees - Part I

The ultimate guide to stock options for employees - Part I

Stock options basics, how much they are worth and red flags

Giammarco Pacifico
September 27, 2023

Startups can change your life.

One way they do that is by allowing employees to participate in the company’s financial success through becoming owners.

In this post, we’ll explore the world of stock-based compensations in startups and demystify some concepts so you can get the most from your next startup opportunity.

Equity vs. stock options

Having equity in a company means owning a part of that business through shares. This is usually reserved for founders (either individuals or companies) and investors.

A stock option is the right to buy shares in a company in the future at today’s price. Only when you exercise this right you become an owner of the company in proportion to the shares you purchased.

Investors usually get preferred shares for their investments, meaning that in case of a liquidity event (more on this later), they will get paid first. Founders instead have common shares and employees who buy their shares also get common shares. Common shareholders get paid last when distributing proceedings.

How do stock options work?

In simple words, when you join a startup, the company has a valuation based on its previous round of funding and you get the right to buy shares at that valuation, let’s say €10/share.

Over time, if the company does well, its value will increase and ultimately it will get sold (or go public) at a higher valuation, let’s say €100/share.

If you were granted the option to buy 1,000 shares at the initial price of €10/share, you can use that right during the sale process to buy € 10,000 worth of shares (1,000 × €10/share) and immediately sell them to the company buyer for €100,000 (1,000 x €100/share).

You’ll then earn the difference between the two prices: €90,000!

Common terms

Strike price: the purchase price at which you can buy your shares. This is blocked no matter what happens to the company
Issue date: the date the stock option is granted
Exercise: the date you buy the shares at the strike price. You don’t have this option immediately after being hired and it also plays an important role when you stop working with the company
Vesting: stock options will be granted to you over time based on the amount of time you spend with the company. This usually lasts 3 to 4 years to de-incentivize people from leaving
Cliff: the time period where you are not granted any stock options from the day you join the company. This is typically one year and it means that if you leave or get fired from the company in that period you have no right to any stock option
ESOP: employee stock option plan

Why do you need stock options?

If you are a long-time reader of Kickigai Weekly, you know that working at a high-potential startup is not like working at a corporate job.

Anyone who has ever worked there will tell you that it takes a toll on you and if you are a talented professional, why would you do that to yourself?!

Passion only goes so far and when you have high-paying competing offers from corporates and consulting firms, having a financial incentive to make the startup successful makes the difference.

The best thing is that you’ll actually get the chance to directly influence the company’s success, contrary to public companies offering discounted shares to new employees.

After some great successes where early employees helped build multi-billion companies (and became millionaires themselves), most European startups have an ESOP but that does not mean that there are universal plans and you should definitely be ready to dig deeper to understand the dynamics and negotiate as needed.

Stock option pools in early-stage companies

An early-stage startup usually reserves 10-20% of the company to employees.

As a general rule of thumb, startups with a few co-founders would have a smaller starting stock option pool because they probably have all the core expertise in-house to kickstart operations before a funding round.

Otherwise, if there is a solo founder, the company needs one or more key employees to join the team as late co-founders who usually take care of engineering or science parts. In this case, the stock option pool is larger to incentivize those early employees to come on board.

A stock option pool is usually created at founding or before an incoming funding round and it gets refreshed at every new capital increase so incoming employees can be part of the ESOP too.

What should you expect?

Let’s take as an example a medtech seed-stage company that is raising €2M at a €10M valuation with an expected valuation of $2B at exit after Series D (dilution of around 50%).

Here are some scenarios:

A mid-level tech person (3-5 years of experience) should expect €70-80k in salary and €70-80k in options, corresponding to 0.7% equity
A junior non-tech person (0-2 years of experience) should expect €50-55k in salary and €25-30k in options, corresponding to 0.23% equity

If you want to see what the benchmark is for different situations, check out the equity calculator from Index Ventures.

Keep in mind that tech people are usually given a higher stock option incentive than non-tech employees and companies that are working on deep tech are even more generous with their ESOP because retaining tech talent who built the product from day one is often very critical.

How much are your stock options worth?

Stock options are only worth something if you can exercise that right (more on that later) and if there is a liquidity or exit event at a price higher than your strike price.

There are two types of liquidity events:

Acquisition: the company is bought by another business
Public listing: the company lists and sells shares on a public stock exchange (this can happen via an IPO, Direct Listing or a SPAC)

Based on when you joined the company (and the correlated strike price), one of the liquidity events above does not guarantee that your stock options are worth exercising.

The key is that the buyer (or the public market) is buying shares at a higher price than your strike price.

This is not always the case and many employees have been left with nothing after the company valuation plummeted.

Rare footage of a WeWork employee

The #1 formula you need

Investors are interested in maximizing the % of the company they own in equity.

Employees should only be interested in the number of shares they have the right to purchase and how much those did (or will) go up in value.

This is why, even employee #500 at a tech company who is offered 0.005 % can still make millions if the company if the share price goes up significantly.

Red flags

No ESOP: this usually means founders don’t believe in hiring the best talent let alone incentivizing them to do great work. The most common situation is that they are looking for people to follow orders
Too low salaries and too high stock options: money is tight in startups but offering wages lower than 30% market rate is wrong and ethical founders should not offer this (unless you are joining a pre-seed company for sweat equity). Keep in mind that most startups fail and you’d be gambling your salary for a risky outcome.
And if you are offered 5% of the company to join as a sales engineer to make up for a minimum wage, there is probably something wrong going on.
Paying upfront to exercise your stock options: exercising your options might come at a cost based on the strike price and the number of vested shares. During a liquidity event, this cost is deducted from the profits but if you leave the company beforehand, you might be forced to buy your shares immediately or lose the right to do so in the future
No acceleration clause: a liquidity event marks the company's success and employees should be rewarded for helping the company get there
Buyback rights: the company can purchase equity back from employees without their consent.
This basically means buying back the employees’ pool instead of issuing new shares and it can lead to the wrong incentives between founders, investors and employees.
Unless clearly justified, you should ask to remove this clause.
It’s impossible to get answers to your questions: ESOPs can be confusing and you have the right to ask for additional explanation. Moreover, ESOP plans are pre-approved by the board so if it’s hard for you to get answers from the founder of the company lawyer, you might need to get external advice before joining the company

In the next issue, we’ll cover more complex yet important topics on how to exercise stock options, the role of sweat equity in pre-seed companies and some non-trivial questions you should ask before accepting your next startup offer.

Stay tuned!

This week's top scientific reads

An inverse vaccine against autoimmune diseases (Nature)
New functions for Circular RNA (BioRxiv)
A catalogue of missense mutations (Science)
Learning from past experiences (Cell)
microRNA activity in single cells (Nature Biotechnology)

Read my comments on these articles here.

Latest funding rounds in health & bio

Ready to turn this news into your next career opportunity? Here is how

AIRNA closed a $30M round (coming out of stealth) to further their work on RNA-editing therapeutics for rare diseases 🇩🇪 🇺🇸
Broken String Bioscience raised $15M for its sequencing platform to accelerate cell and gene therapy development across the industry 🇬🇧
CMR Surgical raised $165M to accelerate the commercial footprint of their surgical robotic systems for cancer and bowel diseases 🇬🇧
Awell raised $5M to automate clinical workflow and patient care pathways while pioneering value-based healthcare at scale 🇧🇪
Corti closed a $60M round to globally scale their generative AI tool for the everyday tasks of doctors and nurses 🇩🇰
Navenio raised $6.3M for their hospital platform that tracks both patients and medical staff within the premises 🇬🇧
HelloBetter raised €5M for its digital therapeutic solution against mental health disorders 🇩🇪

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