Employee Equity

tl;dr

Treat your stock options like lottery tickets. Maybe someday they'll be worth a lot, but you don't buy $5k worth of lottery tickets, do you? Don't trade base salary for lottery tickets.

Why? Your company will probably eventually fail. Options vest over four years and you shouldn't work that long at your first company. Even if the company becomes valuable, it takes forever for it to go IPO so you can sell shares. Your grant will be small and you'll be diluted as the company takes on more investors.

Negotiate for salary, not for options. A high base salary means bigger raises in the future. Future employers won't understand that you took a low salary because you traded cash for a bunch of options. They'll just look at the lower salary.

Also: I am not a lawyer.

Stock Options

This is a very abbreviated discussion of what stock options are.

Many companies offer stock options to their employees as part of their compensation. An option is a right to purchase a share of the company at a pre-arranged price (the strike price). The company will set the strike price when it grants you the options; they are obligated to set this based on the current fair market value (FMV) of the company.

Because the strike price is set to the current FMV, options only become valuable if the company appreciates in value. If the company is worth $1/share when you join, you will be granted options with a strike price of $1/share (the FMV). If the company does not appreciate in value, you can exercise your options to pay the company $1/share to buy a share worth $1. However, if the company has not appreciated in value, this doesn't make you any money.

The hope (read: dream) is that the company will appreciate in value so that it becomes worth, say, $2/share. Then, since you have been granted the right to purchase a share at $1/share, you can exercise the option to purchase shares worth $2 at a price of $1/share. This is the good scenario.

The good news is that unexercised options don't lose you money. If the company declines in value to $0.50/share, then it would be irrational to exercise your options, because you would be paying $1 to buy something worth $0.50. In this case, your options are worthless, but at least you didn't put any of your own money in the game.

The key to options is to wait until they are worth more than the strike price, and then buy. There is no benefit in exercising early (well, there are tax reasons); just let your options vest and exercise when they're worth something.

Options vs Shares

Companies may offer you shares (they often call these restricted stock units, or RSU) instead of stock options. The difference is that options are a right to buy a share, whereas shares are just shares.

If you ignore tax implications, receiving shares is better than receiving options. This is because if you are granted shares, you don't have to pay to buy the shares, which is what you have to do with options.

Let's take an example. Say the FMV of a company is $1/share. If the company grants you 1k shares, they have given you assets that have an FMV of $1k. On the other hand, if the company grants you the right to buy 1k shares at the FMV, then these are currently worth nothing: you have the right to buy 1k shares at $1k, but they're only worth $1k.

If the company appreciates in value to $2/share, an option grant of 1k shares becomes worth $1k, since you can buy 1k shares worth $2k at $1k. On the other hand, if you received a grant of 1k shares, these are now worth the full $2k. So again, shares are better than options.

Lastly, if the company declines in value to $0.50/share, your options are worthless. Exercising them would mean you spend $1k for 1k shares worth $500, so you would have lost $500. This is important: disregarding tax reasons, you should not exercise options until they are worth more than the strike price. In fact, ideally you won't exercise the options until you can sell shares on the open market. The whole point of options is to eliminate this downside risk. You can't lose money on unexercised options.

On the other hand, if you were granted shares, your shares that you paid nothing for are still worth $500.

Why Do Companies Grant Options?

Companies grant options to motivate employees to grow the company. They also do it because they only have granted you something of value assuming the company grows. If the company grows, it's a win-win for investors and employees. If the company shrinks, they gave you nothing of value. In this sense, options are "cheaper" than cash.

Why not stock grants? There are a few reasons. First, you are not required to pay any tax on the option when it vests. That's because you were granted the right to purchase something worth $1 at the price of $1. This is currently worthless, so the IRS does not treat this as income.

If, on the other hand, you vest 1k shares worth $1k, you would have to declare that as income and pay income tax. This can be especially painful if the company is not public and you cannot sell the shares. Imagine a scenario where you vest $1MM worth of shares, but you have no cash. Then the IRS will send you a bill for X% of $1MM, but you have no cash to pay them. You can't sell the stock, because the company is not public yet. So you can't yet turn your stock into cash, but the IRS wants to tax you anyway. Of course, the IRS only accepts USD to pay taxes...

This happens to paper millionaires sometimes; they might mortgage their house to pay the IRS.

Even worse, stock can decline in value. If you're granted shares (not options) you have to pay income tax on stock that you can't sell. If later the company fails (which happens all the time), you paid tax on an asset that later turned out to be worthless. Dang. In the options scenario, you would just let the options expire and owe no tax.

The other reasons benefit the company. By granting options, they are ensuring you only make money if the company grows. In the case where the company does not grow, they gave you something that wasn't worth anything anyway. If they gave you shares, they'd be giving you something of value even if the company shrinks.

Vesting

Your stock options will vest over time. This means that you can't immediately exercise your options and quit. The standard setup is that 25% of your options will vest after 1yr at the company; you lose all your options if you leave before then. After that date, 1/48th of your total options will vest each month. After a total of four years, your options will be fully vested.

The company does this because it wants to use the options as an incentive for you to remain over several years. This is a form of golden handcuffs.

As your options vest, you may exercise them. You write a check to the company and they give you a letter saying you own stock. Once you own the stock, it's yours to keep even if you quit. However, you will lose all your unvested options the day you quit the company. Also, any vested but unexercised options are lost ~30days after you leave the company.

Actually, you can even exercise before vesting (you can do this for tax reasons), but the company will take back the shares if you quit before they vest.

Details, Valuing Options

To begin to evaluate an options offer, you need to know a few things:

How many options are you being granted?
What is the vesting schedule? (Probably 4yrs)
How many outstanding shares are there? That is, what percentage of the company are you be granted the option to purchase?
What is the FMV of a share? That is, what is the strike price? Alternatively, the most recent valuation of the company, divided by the number of outstanding shares should give you the FMV of a share.

It is typical that a company will tell you that they are granting you options on X thousand shares, or to buy $X thousand dollars worth of shares. For some reason they often don't tell you the share FMV or numer of shares outstanding unless you ask. You do need that, because without context, the number of options or FMV of the options is useless...

NB: employee stock options needs to be approved by the board. The offer letter you receive will say that your options require board approval. This is a legal formality, totally normal, and the board would never deny you your option grant. Do not be weirded out by this. The board normally may meet only four times a year, so it will take ~3mo.

Calculating value

If you want to value an option grant, you need to:

Make up a future valuation of the company. For instance, maybe you think that the company will eventually be worth $100MM. Note: no one, not even the CEO, has any idea what this will be.
Subtract out the current FMV of the company. The difference is how much you think the company will appreciate. Say, for instance, that the company is currently valued at $10MM. You think the company will grow by $90MM. You have to do this because you buy shares at FMV.
Multiply by the size of your option grant, as a percentage of shares outstanding. This is how much of the appreciation in the company you have the right to buy. If your option grant is 0.1% of the shares outstanding, you are being granted the right to $90k of the appreciation.
Divide by the vesting period. This is how much of the appreciation you'll vest each year. With a four year vesting period, this is $22.5k/yr. Everyone forgets to do this.
Multiply by zero, because
1. the company will never meet your wild-ass guess of its future value (99% of companies eventually fail and are worth nothing),
2. you'll be diluted (your % ownership will drop) as the company takes on new investors/employees and issues more outstanding shares,
3. the company takes forever to go public anyway. No matter how great the company does, you can't turn shares into money until IPO or purchase (a liquidity event). It's hard to sell your shares on something like Second Market because you'll have a very small block of shares, plus only the most fabulously successful companies will trade there.
4. you'll quit before 4yrs to take a better, higher-paying job, leaving unvested shares on the table,
5. Taxman,
6. the company does something evil like fire you when your options become too valuable (cf., Skype, Zynga).

An example: I vested 2k shares of Quantcast options while I worked there (four years ago). I purchased them at a strike price of $0.25. The latest round valued them at $1.09/share. That means I made a grand total of ~$1,800 over two years from options. Except that of course the company isn't public so actually my shares are worth zero in real dollars that I can use to buy food and toys for my cats. Quantcast is ~8yrs old and does >$100MM of revenue, so this is actually the good case.

That's why it's important to multiply by zero.

83(b)

There are tax reasons why you might want to exercise early. Read about 83(b) elections if you want to waste more time on this, or just enjoy tax laws.

Equity