Stock Options 101: The Basics of Equity Participation
This is eleventh in a series of blogs on launching, growing and ultimately selling a technology company, with a corporate finance focus. Topics include cap structures, equity plans, financing, corporate partnering, board matters and how to achieve a successful exit.
So the founders have come together, incorporated the company, determined their roles and initial split of the equity, and dealt with the sticky issue of founders vesting (see past blogs). They each carry a C-class title and they all sit on the board (bad idea, see future blog). They have a nice core executive team and they understand that they will all be working in the trenches. But what about the rest of the work that needs to be done? Well, that’s where having the best supporting team possible comes in. To mix a metaphor, we have founders who want to drive the sleds but we need to assemble the best sled dog teams to pull them. And we need to reward them as they are the key assets of the business.
Building a team of frontrunners
We have all heard the clichés: “What are the three most important things venture investors look for? People, people, people.” “What do the assets of a technology company do at the end of the work day? They walk out the front door and go home.” It’s all about the team. If great technology or a great product idea alone made for a great company, Microsoft would never have gotten as big as they did. Did they have the best technology? No. Did they execute? Sure did. (Oh, wait, Windows just froze on me).
Competition for employees in the tech space can get very fierce in a bullish market. Foosball machines, funky office spaces and fun office parties only go so far. Competitive salaries are table stakes. Where a company can differentiate itself is equity participation. And this is done by using stock options as a powerful compensation and retention tool. Biscuits for the sled dogs.
What is a stock option?
Simply put, a stock option is a contractual right for the holder (the optionee) to purchase shares of the company at some predetermined price (the option exercise price) for some predetermined period of time (the option term). Why would an employee care about options? Because the exercise price will typically reflect the value of the shares in the company at the time the options are granted. If the value of the company goes up over time, the options can come to have material value.
People still confuse what stock options are. They are not issued shares, but the right to buy shares from the company. Stock options do not factor into the undiluted share capital, but count towards the fully-diluted total. They do not come with any entitlements to vote, to receive dividends, or receive shareholder information. Stock options are one thing and one thing only – the right to buy shares at a predetermined price for some predetermined point in time.
Stock options in private companies
If the company is private the option holder will typically not exercise the option until the company is sold. The reason being that it just makes sense to wait rather than pay the exercise price and end up holding an illiquid investment in a private company. The only situation where it makes sense to exercise options in a private company is in the case where the options are about to expire and the company is doing so well that the options are well in the money (meaning their exercise price is well below the current price of the shares).
Stock options in public companies
Public companies, different story. If the company is publicly traded, then you can usually exercise the options and concurrently sell the shares in the market in order to realize the difference between the exercise price and the current trading price. If you have a friendly stockbroker, you may even be able to sell the shares first (essentially, a “short” sale) into the market before you exercise the stock options, receive the proceeds from the sale which you in turn use to exercise your options to fulfill the sell side of your order (covering the short). No fuss, no muss, and you are not out of pocket.
Comparing warrants to stock options
What is the difference between a warrant and a stock option? Nothing other than the name. A warrant is just another name for a right to buy a predetermined number of shares at a predetermined price for a predetermined period of time. The term stock option usually refers to equity incentives for the team, and the term warrants usually refers to sweeteners for investors or incentives for one-off situations.
Perhaps you know all this but my experience is that many people are confused about the basic principles of how stock options work. My next few blogs will drill down into how best to use stock options and what mistakes to avoid. You should think of your equity like currency, and spend it wisely.
Next up, how many biscuits do I need to attract the best sled dogs?
David practiced corporate finance law for 20 years representing numerous technology companies before retiring to co-found a venture capital fund where he was a partner and portfolio manager for ten years. He now provides corporate finance/M&A advice to a portfolio of tech companies with a view to growing them to the point they are ready to exit and then leading that process.
Back to blog