Stock price for Airbnb, since their IPO in December 2020

How exactly do Employee Stock Options work again?

As more venture capital pours into Africa, we need operators (startup employees) to become smarter and more educated about employee stock options.

Talented professionals across Africa are increasingly considering joining high-growth, venture-backed startups. Equity is one benefit of joining a startup — others include the potential for accelerated growth, ability to see different parts of the business, a vibrant workplace culture, visible individual impact and deeper connections to a mission or purpose.

Over the course of my interactions with operators within the Black Ops operator community and elsewhere, it is clear that many operators have limited understanding of how startup equity and stock options work. I’m not an equity expert or financial advisor, but I’ve had enough first-hand experiences worth sharing from working at, investing in, and advising startups.

The difference between a well-negotiated equity compensation plan and a poorly negotiated one can lead to materially different financial outcomes for an operator. Unfortunately, most operators do not fully understand stock options and most companies do a poor job helping to educate them.

In this post, I illustrate how stock options work using a completely fictitious example of a startup named TechCo, which raised a series A round at a $50m valuation in November 2021, and an Operator named Temi who joins TechCo on January 1, 2022.

My hope is that this will provide a foundational understanding of the complex workings of equity to operators. You can do additional research to go deeper in specific areas.

Temi joined TechCo as an Operations Manager on January 1, 2022, and received 4,000 stock options. TechCo’s share price in the series A round was $2.50 per share. You would assume that Temi owns 4,000 shares of TechCo worth $10,000 right? Well, not exactly. What is Temi’s equity really worth today, and what could it be worth tomorrow?

Read on to learn more about how Temi’s equity and financial outcomes are affected by concepts like options vs. shares, strike price, valuation and future value, vesting, cliffs, exercising and liquidity events.

Stock options are not *yet* company stock or shares

Stock *options* are not shares (or stock), yet. This means that Temi needs to buy them to convert them into actual shares. That’s how options work. Temi has to buy them at the Strike Price (also called the Exercise Price).

Let’s imagine that TechCo issued those stock options to Temi at a $0.85 strike price per share. This means those options are not worth $10,000, but instead are worth 4,000 x ($2.50 - $0.85) = $6,600. Temi can buy each option for $0.85 and then sell for $2.50.

In reality, there are more complications around selling startup shares, but let’s skip those for now.

The Strike Price impacts the value of your options

The earlier Temi joins a startup, the lower the strike price on Temi’s stock options. If Temi had joined TechCo at the seed stage, the strike price may have been $0.50 per share. If Temi had joined pre-seed, the strike price may have been $0.10 per share, or possibly less. The lower Temi’s strike price, which is based on how early Temi joined TechCo, the less Temi pays to convert those stock options into actual shares.

Here are some scenarios to illustrate the difference in value of Temi’s stock options when they were initially granted, based on different strike prices:

Temi’s equity value as a function of the strike price

A startup’s success (future value) has significant impact on your equity and financial outcomes

Now let’s move into the future. TechCo has crushed it and goes on to raise a Series D round at a $1.5B valuation early in 2027. And let’s say that the price per share grows to $25. Temi’s 4,000 options would now be worth $96,600. So Temi has earned about $19,000 per year in incremental compensation from 2022 to 2027. This might make up for the salary cut that Temi took to join TechCo, making the venture into startups worthwhile.

If TechCo raised the Series D at a lower valuation (e.g. $500m) and the price per share was $8 instead of $25, Temi’s 4,000 options would have been worth $28,600. This is about $5,700 per year in additional compensation. This may be a less exciting outcome for Temi given the pay cut and all that hard work.

The value of Temi’s equity could be even lower if TechCo doesn’t successfully secure future funding, or eventually shuts down. As such, Temi is taking a big risk particularly since TechCo likely would have paid Temi less than a large company during the period.

Here’s a table showing the potential value of Temi’s stock options based on different future equity values during the series D round. These are all hypothetical scenarios where the company price increases:

Temi’s equity value as a function of company performance (share price)

In any case, there are additional steps required to convert any of this into cash in the bank. We’ll get to that later.

Your ability to negotiate for more equity has a massive impact

100% equity in a failed startup = $0. That’s a no-brainer. So it’s always more important to focus on picking a company that you think will do well and where you will enjoy working (or at least where you’ll do well), rather than one that gives you more equity, if you’re not confident in their potential. However, it is extremely difficult to know which company will do well and which won’t, especially early on. Most startups fail. Startup life is about risk and reward.

But if we assume that a startup does very well, then the outcomes for operators can vary considerably based on the number of options received in the initial (or subsequent) grants.

If Temi had negotiated the equity package during the initial offer, or was able to get promotions and additional equity after joining TechCo, the value of Temi’s equity could vary considerably by the series D round in 2027.

What would Temi’s options be worth if Temi had received more TechCo had equity? Here are some scenarios below. For simplicity, let’s assume that the strike price for all of Temi’s options is still $0.85, and let’s assume that the company’s share price was $25 at the series D round.

Temi’s equity value as a function of number of options granted

Keep in mind that TechCo has 60 million shares ($1.5B valuation divided by $25 share price). Even with 40,000 options, Temi’s equity accounts for only 0.07% of TechCo’s total shares. What this means, quite simply, is that while most people tend to optimize for more cash, if a startup does very well then you’ll wish you had negotiated for more equity particularly if your role had significant impact on the company’s success. On the flip side, if the startup doesn’t succeed, you’ll likely wish you had opted for more cash and ignored equity completely.

How should you balance cash vs. equity, and how much of your cash compensation should you be willing to forego in order to get more equity? That’s a debate for another day.

But you’ll first need to “own” those options. Oh yes, they’re not yet yours.

Now, let’s switch over to how you take ownership of these stock options. The concepts that matter most here are Vesting schedule, Cliff, Exercise and Exercise Window.

Vesting schedule: When stock options are first issued to you, they still belong to the company. Think of it as a similar concept to your annual salary. After you work each month, you get paid. Similarly, after each month of work a portion of your stock options is issued to you. Vesting your stock options is simply working each month to “unlock” those options. Whereas the vesting schedule is the time frame during which all of your stock options fully unlock. The most typical period is a 4-year vesting period.

This means that Temi has to work at TechCo for 48 months to fully vest those 4,000 options. In real terms, Temi would unlock 1/48 of the stock options each month, which translates to 1/4 of the stock options each year. By Jan 1, 2023, Temi would have unlocked 1,000 options. By Jan 1, 2024 Temi would have unlocked 2,000, and so on. By Jan 1, 2026, Temi will have unlocked all 4,000 stock options. Congratulations Temi!

Temi vests 1/4 of the options each year, or 1/48 each month

Cliff: There’s a small caveat though. There is usually a probationary period where stock options are frozen. Here’s an analogy. Each year, you unlock your performance bonus by working and then sticking around until bonuses are paid out. If you leave before bonuses are paid (in most companies), you don’t get the bonus. Stock option Cliffs work in a similar way. Prior to the date of the Cliff (usually 1 year after you are granted the options), if you leave, all of those options can be taken back by the company.

So if Temi has a 1-year cliff and decides to leave TechCo on November 18, 2022, Temi would walk away with zero options. However, if Temi leaves TechCo on January 15, 2023, Temi would have unlocked the 1,000 options that have vested. After January 1, 2023, Temi vests all of the rest of the stock options as described in the section on vesting schedule above (83 options which is 1/48 of 4,000 will vest each month).

Temi does not vest any equity in 2022 due to the 1-year cliff

Companies have a Cliff to protect themselves from situations that destroy company value. For instance, where a new operator does a terrible job and then leaves after 6 months, or where the operator needs to be fired early into their tenure, or the operator decides to hop across multiple startups to accumulate equity and spread their risk at the expense of the companies.

There are cases where an operator joins a startup, does phenomenally well, but still has valid reasons to leave after 10 months. In these situations, a 1 year cliff can be viewed as unfair. As a result, some progressive companies are starting to change the cliff to 6 months, 3 months or removing them entirely.

Exercising (or buying) options: Because Temi has vested and now owns the 4,000 options, we would think that Temi owns TechCo shares. But that’s incorrect, as mentioned at the start of this article. Stock options are exactly that — an option to buy stock. Exercising stock options is the process of buying the options, and in doing so, converting them into stock/shares. Once Temi has passed the cliff and vested stock options, Temi can choose to exercise them. This means Temi pays for those options with cash e.g via a wire transfer, and in return TechCo issues Temi with a certificate indicating that Temi now owns shares in TechCo.

Let’s imagine Temi has vested 1,417 options by June 1, 2023 and decides to exercise those options. Temi would wire $1,204 (or 1,417 x $0.85) and TechCo would issue a certificate indicating that Temi owns 1,417 shares. All of this typically happens on a platform like Carta.

Exercise window: When Temi leaves TechCo, there is a time frame during which Temi can exercise any vested stock options. Afterwards, any options that Temi has not yet exercised will expire. This period, called the exercise window, is typically 90 days. So if Temi leaves in July 2026 after vesting all 4,000 options, but only exercises 1,417 stock options, then by October 2026 Temi would forfeit the other 2,583. If the company does really well, Temi would regret letting the options expire. Whereas if the company fails, Temi would regret paying to exercise any options at all.

Many operators find themselves unable to afford the cost of exercising their options, which could easily range from thousands to hundreds of thousands of dollars. If Temi approaches the end of the exercise window and doesn’t have the money to exercise the stock options, or doesn’t want to risk paying out of pocket, there are companies like ESO Fund or Equitybee that can provide Temi with a loan to exercise the options. In exchange, they take a slice (usually a big one) when Temi sells those options in the future.

Some progressive companies have begun instituting two practices, namely:

Longer exercise windows: Moving to 6 month, 1 year or longer exercise windows to give departing operators more time to fund the options purchase.

Cashless exercise: The startup provides what amounts to a loan to the operator to exercise the options, which gets repaid when the operator sells those options.

Most startups still do not offer either of these, which puts many operators in a difficult place when they leave. This is something we need to collectively change in the African startup scene (and then globally).

Will all of this audio money ever materialize?

This is the million dollar question. Literally.

Maybe yes, maybe no! Mostly no, but often yes.

Stock options at most startups are worthless, because most startups fail to achieve a future state that creates any material upside for operators.

However, at startups that do well and experience a liquidity event where equity gets converted to cash in the bank, the outcomes can be life changing for operators who own stock options. For simplicity, let’s focus on three most common liquidity events that would likely be relevant for African operators:

• Secondary market sale (“Secondaries”): Operators at TechCo can sell their stock options to new or existing investors in private transactions similar to Stripe’s $1B secondary sale in 2021. This can be a sale orchestrated by TechCo’s executive team or through a broker like Forge Global or EquityZen.
• Acquisition: Similar to Stripe’s acquisition of Paystack, TechCo could get acquired by another company, which *could* provide Temi with the ability to liquidate some or all of the stock options. Temi could get all cash, all stock in the acquiring company, or a mix of both.
• Initial Public Offering (“IPO”): TechCo could list on a stock market like Airbnb did in 2020, and after some period of time (called the lock-up period), Temi can freely sell shares to other buyers on the stock market.

Each of these liquidity events involves a complicated process and typically only becomes available after a startup has been operating for several years.

How good can it get? And how bad can it get?

In the absolute best case scenario, Temi could have joined a series A company that goes on to have a successful IPO at a $10B+ valuation (with a share price of $160).

Temi’s 4,000 options could be worth $636,600. Temi could also have been a more senior operator with 40,000 options worth $6,366,000, or an executive with 300,000 options worth $47,745,000.

The table below shows different scenarios for Temi based on the number of options and share price of TechCo, assuming the same $0.85 strike price.

Temi’s equity value as a function of options granted and share price

In the absolute worst case scenario, TechCo could fail to raise future funding or shut down. Temi’s equity could be worth zero.

So what should you do with this information

Stock options are just one of many factors to evaluate when considering joining a startup, but they are very misunderstood.

This is intended to help address the information asymmetry that exists today, and equip operators to walk into startups with more clarity about the opportunities and risks tied to equity, so that you can ask the right questions.

I am truly excited to see more operators help build and scale successful startups, while also achieving great outcomes for themselves.

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