Equity 101

Key takeaways

  • Equity in a company could be in the form of stock options or shares.

  • Stock options give you the right to purchase a certain number of shares of the company’s stock at a certain price.

  • You will need to exercise your stock options, which will cost money.

  • Shares represent actual ownership in the company.

Are stock options worth it?

Imagine you’ve just received an offer from an exciting startup. They have a great chance of becoming the next unicorn (or maybe even deca-corn), and they’ve offered you stock options so you can participate in the upside. If the startup strikes it big, so do you — or so you think.

Many startup employees dream about this scenario. They’ve heard tales of how stock options held by the early employees at Big Tech firms turned into life-changing wealth. But many people don’t understand that owning stock options is very different from owning the company’s shares. 

Take the case of Julie, a former Marking Operations Manager at a supply chain technology startup. She was already 18 months into her role before she discovered a big oversight—she had confused stock options with shares. And when Julie realized she would have to spend a substantial amount of money to exercise her options (money she didn’t have and couldn’t save for, given her other financial commitments), she panicked.

Don’t confuse stock options with free shares

Stock options are not free shares. They’re actually not any kind of shares. They simply give you the right to purchase a certain number of shares of the company’s stock at a certain price. And the main catch — you must still pay money to exercise those options and receive the shares. 

Many inexperienced startup employees miss this crucial fact. And when the expiration date of those options looms, people realize too late that they don’t have the necessary savings to exercise their options — forcing them to walk away from their hard-earned equity.

This nearly happened to Julie. She had mistakenly thought she had received shares (with the technical name “Restricted Stock Units,” or “RSUs”), when really what she had been granted was stock options. Thankfully, she found us here at Vested and was able to exercise her options

Before we dive into the risks of stock options, let’s first understand the other side of the equation — the potential payoffs.

How stock options can pay off

You need to know two concepts to understand how stock options can pay off — fair market value and strike price.

The fair market value is the current price of the company’s shares. If the company is still private — the most likely scenario — the fair market value will be based on its 409A valuation.

The strike price (or exercise price) is the price you can “buy” the shares at—no matter what their current fair market value is. Typically, your strike price is the fair market value of the shares at the date you joined the startup. The earlier you join, the lower the strike price. 

The difference between the current fair market value of the shares and the strike price is your actual compensation.

Going back to the earlier example, if you had 10,000 stock options with a strike price of $5/share, you would have to pay $50,000 to fully exercise your options. But if the fair market value of the shares was $15/share, that means those 10,000 shares are actually worth $150,000—giving you a profit of $100,000. 

Of course, unless the company is already public and you’re able to sell the shares right away, this is just unrealized profit. That’s a big part of why stock options are a risky bet.

👉 What could your equity be worth? Check out the Equity Outcome Simulator to see the potential value in different scenarios.

Why stock options can be a risky bet

Stock options are a risky bet for one simple reason: you have to pay money to exercise them. If you don’t have the money, like Julie before she found Vested, what are you going to do?  The ideal scenario for most employees is for the fair market value of your startup’s shares to rise higher and higher compared to your options’ strike price. But the truth is, early-stage companies can go either way, meaning the opposite could also happen — the value of the startup’s shares sinking below your strike price.

What does this mean in normal human speak? Say your strike price is $5/share, but the per-share fair market value is only $4. When that happens, your options are said to be “underwater” and are essentially worthless. (There’s no point exercising them and paying more for the shares than they are currently worth.)

Shares can also fall in value after you’ve exercised them. This is even worse, as it means you’ve spent money to buy shares that are now falling. Instead of your options going to zero, you’re now taking (unrealized) losses—oof!

There’s also the possibility of missing out on gains. Say you leave the company and decide not to exercise your options. They typically expire within 90 days of leaving. A few years later, to your surprise, the company secures a huge exit. You’ve now missed out on a significant payday. 

But the question is — could you really have known that the startup would have made it big back then? And would you have been willing to bet tens of thousands of dollars (or more) of your own money on that outcome? Stock options are a risky bet because you never know what scenario will play out. Don’t lose sight of this when negotiating your next offer.

This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for investment, tax, legal, accounting, or other professional advice. Vested does not provide investment, tax, legal, accounting, or other professional advice. You should consult your own investment, tax, legal, accounting, or other professional advisors before engaging in any transaction or equity decision.

Related Stories