There's a mad rush for stock options at high-tech start-ups. But just because people want them, doesn't mean they know what they're worth.
How many of you know someone--a friend, family member, or coworker--who has joined an Internet-based, pre-initial public offering (IPO) company? Perhaps you know what business the start-up is in; less likely, you've been told about the management team's former accomplishments. But most definitely you've been told, in the breathless words of someone imagining himself or herself a millionaire, "and they gave me stock options!"
Getting stock options today is like getting a trip to Las Vegas and front-row tickets to an exclusive show, all wrapped up in one package. For those initiated into this fast-growing club, there's some measure of status in being in on the latest high-tech trend, and it's pretty entertaining to imagine your riches if the best-case scenario--a successful public offering--comes to pass, even if it is just a big roll of the dice.
However, they're past the initial thrill of getting options, a lot of people don't really know what it's all about. "Especially in the high-tech sector, there's a lot of hype around options," says Ed Carberry, director of communications at the National Center for Employee Ownership in Oakland, Calif. "A lot of people don't understand what [stock options] are, except to know that they want them."
For instance, how many options are "a lot" vs. "a little"? How do you cash in on them? Can they be considered "real money"? Especially for anyone in the business of hiring IT employees, these are important questions to know the answers to, whether your company is offering stock options or competitors are luring away your talent with them.
Getting to know options
There are lots of stock option plans with many different variables. Put simply, a stock option gives employees the opportunity to buy a certain number of shares at a set price for a certain amount of time. For instance, Carberry says, an employee might be given the right to buy 100 shares of stock at $100 per share for up to 10 years. Over that time period, employees hope the share price will rise so they can purchase the stock at the lower price and sell at a higher price. Maybe eight years later, the shares are worth $175, and the employee can buy them at $100. Or maybe the shares will be worth only $75, in which case the employee probably wouldn't buy any.
Of course, in a pre-IPO company, the stock is worthless until it can be sold; for most high-tech start-ups, that means when the company goes public or is acquired.
There is no guarantee, though, that either event will happen. For every successful start-up, there are many others that fail. "Employees at start-ups are gambling that the company will do well enough to be acquired or go public. But there is this notion that you just have to get the job with a start-up and you'll make millions of dollars through options," Carberry says.
The other limitation is that options are usually subject to a vesting schedule, or a time period in which the employee has to wait before being able to buy and sell shares. There are many different schemes with different rules, but the most common formula allows employees to exercise one quarter of their options every year for four years. In other words, they can exercise the first 25% of their options on the first day of their second year of employment. They can exercise the remaining 75% over the three following years, either 25% each year, 1/12 each quarter, or some other incremental fashion.
Another scheme is cliff vesting, where employees can access all their shares at once, after a certain time period has passed.
Neither formula is better or worse, but keep in mind that in a pre-IPO company, you may be vested before you can actually sell the shares.
How much is "a lot?"
One thing that people perhaps spend too much time focusing on is how many options they are offered. A friend of mine who recently joined an Internet pre-IPO firm told me she'd been offered a couple thousand stock options as part of her compensation. Her next question was, "Is that a lot?"
It's hard to assess how many options are a lot. One measure is to know what percentage of the total number of issued options you've been offered. "A common number of issued shares is 10 million," says Dudley Brown, a managing partner at BridgeGate LLC, a management search firm in Los Angeles and Irvine, Calif. "So if you're offered 50,000 options, that's [one] half of one percent."
| "There has to be a lot of communication and education to tell people what the stock option is and how their jobs can affect the stock price," says Ed Carberry, director of communications at the National Center for Employee Ownership.|
Of course, the number of options granted to employess is also determined by how risky the venture is to begin with. "The earlier in the company's life, you're likely to get more options, at a lower valuation," Brown says. But as time goes on, and more money is invested in the firm, there's less risk. At that point, the company will likely give out fewer options, but they'll come at a higher valuation.
"Obviously, getting options to buy 1,000 shares in one company is not the same as 1,000 shares in another company," Carberry adds. It all comes down to the company's prospects. "Getting 10,000 options at a penny per share at a company without a lot of capital and backing might not be very good," he says. "But if you've got a good management team, backed by good financing, and you're getting 100 options at $5 a share, you might be better off."
A whole new world
At one time, most of us didn't need to concern ourselves with this type of high-flying finance. Although stock option plans have been around for some time, they were offered only to top executives in order to gain their loyalty and buy-in. Today, more companies are offering options to a wider range of employees. According to the National Center for Employee Ownership, an estimated eight million Americans have stock options, which is up from one million in 1992. Part of the reason is the low unemployment rate, Carberry says. When companies can't lure people with cash and benefits, they turn to employee ownership plans. Employees are also starting to ask for a piece of the pie, as stories about successful IPOs swarm in the media.
The stock options craze will likely continue, although it depends partly on what happens in the stock market, Carberry says. "If there's a correction and stock prices of IPOs come down to reality, it might become less attractive as a benefit," he says. At the same time, companies are seeing a lot of benefit to giving employees a stake in the company. Anecdotal evidence has shown that employee ownership can have a positive impact on the company's bottom line.
But as in all things in life, there is a caveat. You can't just give people stock and expect it to motivate them. "There has to be a lot of communication and education to tell people what the stock option is and how their jobs can affect the stock price," Carberry says. In other words, the whole culture needs to reflect the ownership opportunity given to employees.
So if you find yourself in the position of negotiating for stock options yourself--or tussling with a competitor for your own in-house talent--look beyond those seemingly magical words and see the more balanced reality of what stock options really are. //
Mary Brandel is a freelance writer and editor in Norfolk, Mass. She can be reached at email@example.com.