esop

What you Need to Know About Stock Options as a Startup Employee

Stock Option may look tempting but one needs to know the basics of it in order to take advantage of any such offer
What you Need to Know About Stock Options as a Startup Employee
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Guest Writer
Founder, www.cutshort.io
6 min read
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Employee Stock Option Plans (ESOPs) are not new in India. Infosys famously offered generous options to their employees and made hundreds of first time millionaires.

It’s been several years since then and barring a few exceptions, there haven’t been success stories where employees got to share the wealth they contributed to building. There was a period of high startup valuations between 2014 to 2016 that made employees rich on paper but with the failure of many of those, the value was eroded fast enough.

But now with the recent headlines about Flipkart employees getting rich via stock options, there is a renewed interest in startup Employee Stock Options (ESOPs). While companies are boasting about generic stock options plans they have, the prospective employees are wondering how much they are really worth.

Basics of stock options

Whenever hype strikes, it’s time go back to the basics.This post is for those who are not very much familiar with stock options. And it can also be a recap for others.The basics such as vesting, strike price, cliff period, etc are important.With that done, let’s get to the FAQs.

How much your stock options are worth?

The first thing to understand is — the average value of a startup stock is near ZERO. However, the top 5% outliers could be valued in millions.ESOPs are nothing but equity that is awarded to the employees as per some ground rules. Since it’s equity, it’s a high risk asset. And since this is startups we are talking about, the ESOPs are several order riskier.So while ESOPs of most startups are worth $0, the outliers can be extremely rewarding. For example, after the Walmart deal, Flipkart employees are expected to get around $150/share, with the total worth of all employee shares pegged close to $2Billion.

Stock options are granted in “numbers”, not “percentages”

Although it’s common for people to express stock options in percentages (like “1% equity”), you need to understand that you are being offered a fixed number and not a fixed percentage. This number will stay the same. Percentage might change — it will fall mostly as the company issues more shares (called “dilution”).

Your % share will go down over time. But it’s mostly not bad.

Like all other equity holders, you will face dilution as well. Let’s say

  • You got 10,000 ESOPs out of 1,000,000 total shares at the start. This means you had 1% of total outstanding shares.

  • The company raises money and issues 500,000 more shares to new investors.

  • Total outstanding shares are now 1,5000,000. Your % share has now fallen to 0.67% (10,000/1500000).

Your ownership reduced by 33% overnight. Feels bad?

Don’t worry. Your 10,000 shares are likely worth much more. This is because startups usually raise money at a higher valuation/share. Which means while you hold less stock options now, they are likely worth more than what they did previously.

In this example, your 1% ESOPS might have been valued at $10,000 assuming the startup was valued at $1M. After the deal, you had 0.67% ESOPs, but they might be worth $15,000 if the company is now valued at $1.5M after the investors have come in.

How many stock options you should expect?

It depends on the when you join the startup, your role and most importantly — how desperate the startup is for you.

Benchmark Pre-funding stage: At a pre-funding or pre-revenue stage, it largely depends on what value you bring and how much you ask for.

  • 2 to 5 year experience: You can expect 1% to 5%.

  • 5 to 10 year experience: Up to 10%.

  • Cofounder: 10% to 25%.

After funding or first revenues: As team crosses 8 to 10 people, a startup typically develops a formula for equity calculation.

Employee Stock Options are taxable, but it likely doesn’t matter

As per Indian laws, ESOPs are taxed at two occasions:

  1. When you buy the options: If you were offered stocks at a discount on the market price, the difference is treated like a “perk” that your employer paid for and gets added to your income for that year. Note — this is not a capital gain — think of it’s just like a bonus.

  2. When you sell the shares: The profit is a capital gain and depends on your holding period (from the time when you exercised your options to the time you sell them.

But that shouldn’t bother you.

ESOPs are mostly worth nothing. When they become valuable, they almost always become so valuable that you actually won’t mind paying a 30% tax. :)

If your startup is taking off in a big way, one way to reduce your tax is to exercise your stock options early. This results in longer holding period so that you pay long term capital gain (10%) versus short term capital gain (15%).

ESOPs are worth nothing if you can’t trust the founders and management team

As I said above, startup shares are mostly worth $0. Numbers get added to the left of this zero only when the startup grows tremendously AND is able to get buyers for your shares.

But here is the rub — even if the startup grows, you may still end up with nothing.

This is because most ESOPs holders are vulnerable — they hold little stock individually and can be easily sidelined by other stakeholders.

Since it’s up to the founders and investors to ensure the interests of ESOP holders are protected, you really need to make sure that the company management can be trusted with this responsibility. How deeply they value their employees, how they think about sharing wealth, what are their exit goals from the startup are important to understand.

If there is anything wrong with the founders/investors/management, your ESOPs are most likely to be worth $0, even if the startup goes on to cross $1Billion in valuation.

Conclusion: Have a practical view of ESOPs

ESOPs are an important part of compensation in a startup. But employees, especially those new to startups, don’t understand them well. They often end up being disillusioned (It happened to me way back in 2006) and attach no value to getting stock options.

Being over-optimistic is correct, but also don’t be pessimistic. When you get meaningful ESOPs, you can actually make decent amount of money if the startup does well.

The key is to think of startup ESOPs as the super-risky part of your compensation. Evaluate the job opportunity on the quality of work, growth potential, the team and so on while thinking of ESOPs as bonus. You won’t be disappointed.

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