Stock Options as a Salary Component

“What are stock options?”, “Why are they included in my salary?”, “What’s the real value of stock options in my compensation / salary structure?” “Should I negotiate for more stock options or a higher fixed salary?”. These questions have come to mind to every job seeker who has been offered stock options as part of his pay package. This article gives you answers to these and other Frequently Asked Questions about stock options.

Q. “What are stock options?”
A. Stock options are a part of your compensation which give you the option to buy the company’s shares at a certain price. If you chose to exercise these options i.e. buy the company’s shares then you become a shareholder of that company.

Q. What’s the real value of stock options in my compensation / salary structure?
A. This question depends on the type of company which is issuing stock options. In case of a publicly traded company (i.e. company whose shares are traded on the stock market), the value of your stock options can be easily calculated as:
No of options * (Stock Price – Exercise Price).
What this means is that the difference between the price at which you buy the shares and at which you can sell these in the stock market is your earning per share. The earning per share multiplied by the number of shares is the value of the stock options.

For a start-up or a private limited company, this answer is complicated. The simple answer is that the value of shares of a non-publicly traded company is zero till the time the company becomes publicly traded (through an IPO) or gets acquired by another publicly traded company.
If that is the case, you may ask – why would anyone accept stock options of a start-up?
The answer is simple – it is a high risk – high return deal. The stock options of start-ups or private companies have very low exercise price (Exercise price is the price at which you can buy the shares). If the company subsequently gets bought or goes public, then the amount of money an employee would make on these options is huge and may be several times your salary. In order to understand how much your options can benefit you, you need to do some calculations:
1. Find out the total number of shares of the company (say 100,000 shares)
2. Find out the value of company – usually judged by getting the valuation at the latest funding round (say $1 million)
At this point, assuming zero exercise price, the value of your options (say 100 or 0.1%) is
100 * $1,000,000 / 100,000 = $1000 (approx 55,000 INR).
Now, don’t get discouraged – this is the valuation of the company at the early stage. The valuation of the company at a later stage will jump as per the growth of the company and such increases in valuation are usually very high.
e.g. A company may get valued at $120 million during sale – in that case the value of your options would be 120 * 1000 = $120000 (approx 66 lakhs!!!)
In case you were lucky enough to be an early employee at flipkart and got 0.1% shares – at flipkart’s current valuation of $850 million, your stocks would be worth 4.5 crores!

Q. Wow! If that is how the value is, why doesn’t everyone ask for stock options?
A. There are two factors here:
1. Only early employees get a high number of shares – so if you were one of the first 20 employees only then you would get lot of stock options. Higher number of employees means the company is already doing well and you would be given a smaller number of stock options (0.001%)
2. Not all companies get sold or go IPO – more than 90% startups fail, hence asking for a lot of stock options is very risky, unless you are very confident that the company will succeed.

Q. When and why do companies issue stock options?
A. A company usually issues stock options for the following reasons:
1. It doesn’t have enough cash to pay you a high fixed salary (especially true for early stage startups)
2. If you have stock options, means that you own a small stake in the company – and the value of your stake will increase in direct proportion with the success of the company and of our work. This is a great motivation tool to ensure that an employee also benefits in the company’s success.

Q. When can I exercise my stock options (buy the shares)?
A. Stock options usually have a vesting cycle (time period) which includes a cliff followed by periodic vesting. What this means is that – if you have a 4 year vesting cycle for your stock options, then you usually will get no stock options for the first year and then every month, you will be allowed to exercise (buy) 1/36 of the total stock options you were promised. The vesting cycle is different for different companies and can usually be negotiated.

Q. Should I negotiate for more stock options or a higher fixed salary?
A. By now, based on the above answers, you would have understood that stock options are high risk and high return benefits. In case your risk appetite is high or you are very confident of the company’s future, you can ask for more stock options compared to a higher fixed salary. In case you are not sure how well the company will do, you can ask for fewer stock options but a higher fixed salary. This is a personal preference, but ensure you make an informed decision based after you have made the calculations shown above.

Wish you all the best in your job search!

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6 thoughts on “Stock Options : All You Need To Know

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  6. Finally, I came across an article which clears the ambiguity around ESOP / Employee Stock Options. Thumbs Up for this excellent article.

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