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I am considering joining a start-up company and as a part of the compensation package I am offered a certain amount of stock options.

How do I evaluate and negotiate this part of the offer, given the rest of the compensation package (salary, vacation days, etc.) are at the market level?

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I'm assuming that when you say that "the rest of the compensation package (salary, vacation days, etc.) are at the market level" what you mean is that you are being compensated at a level similar to what you would receive at an established firm. The alternative is that you've been fed the "market rate is lower at a startup" line, which is a falsehood.

Usually when you join a startup you accept compensation that is below market rate, and your equity component is essentially used to "make up" the difference. So if you're being offered the full market rate, you're already somewhat ahead of the curve as far as startups go. It also means that you're less likely to receive a huge amount of equity.

The main things you'll want to ask after are:

  • Allocation - How many shares/options you are being issued.
  • Share Pool - How many shares currently exist, in total. If you know this and your allocation, you can work out the size of the equity stake being offered in terms of percentage of the company.
  • Strike Price - Since you are receiving options, you'll want to know what the strike price is. Lower is better here (and something like $0.001 is ideal). Your options only have value if the company's share price goes above the strike price.
  • Vesting Schedule - How you actually receive ownership of the options. Typically they will vest incrementally (often quarterly, sometimes monthly, semi-annually, or annually) over a 4 year span. Shorter is better here.
  • Cliff - How long you have to remain at the company before you receive the first tranche of options. Durations of a quarter to a year are common; during the 'cliff' period you will not receive any options. They still accrue in accordance with the vesting schedule during this time, but you receive them all at once when the cliff ends. Again, shorter is better.
  • Dilution - Do your shares dilute any differently from anyone else's. If they do, be sure you understand how.

In terms of negotiations, the major "gotchas" to watch out for are unfavorable vesting, cliff, or dilution terms. In particular, a cliff longer than one year or a vesting schedule longer than 4 years would both be suspect. And ideally the shares you receive should dilute the same as everyone else's.

It's unlikely that you'll be able to negotiate the strike price on your options (generally this must be set to whatever the share price happens to be on the date of the grant), so focus on the allocation size.

Options packages are difficult to value in tangible terms, as they technically have zero value when they are granted. The simplest way to approach it is to look at how much equity you are being granted, as a percentage of the company. And, since we're talking about options, you need to place that in context against the current valuation of the company and what you think is a reasonably attainable future market cap/acquisition price. Assuming no dilution, the "value" of your options package is:

[options allocated] / [total shares] * ([future company value] - [current value])

Note that if you know your strike price and the total number of shares that currently exist, [current value] is simply [strike price] * [total shares].

Lastly, and this shouldn't be an issue, but definitely make sure that whatever terms you ultimately work out are included as part of your written employment contract. It's easy to get burned if you do not.

And if that wasn't verbose enough for you, try this.

  • And one thing to keep in mind if the options are for shares that are already publicly traded--check the current stock price. The only way you make any money is when the strike price is less than the current price. If your strike price is $0.001, this is a moot point, but if the strike price is $10, and the current price is $10.50, you have to invest $10 of your own money to make $0.50 of profit. Also, factor in that to avoid paying normal taxes, you'd have to hold the stock for a year (to qualify for capital gains rate). If the stock goes below the strike price in that year you lose money. – Garrison Neely Apr 17 '14 at 13:00
  • Excellent answer, to which I would add two things: (a) make sure you understand when you can exercise those options (at any time? only at valuation events? only if the company goes public?), and (b) options turn into pumpkins when you leave the company, so if you leave before there's a way to sell them (this usually means IPO) then you have to gamble on investing now against the possibility of selling later at an unknown price. Options are not cash, but they can turn into cash if the stars align. – Monica Cellio Apr 18 '14 at 0:30

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