• Skip to content
  • Skip to primary sidebar
  • Skip to footer

The Money Habit

Your Path To Incredibly Early Retirement

  • Start Here
  • How Much Bloggers Make
  • Recommended Tools
  • Blog
    • Best Posts
    • Strategies and Blueprints
    • Invest Money
    • Make Money
    • Save Money
    • Pay Less Taxes
    • Early Retirement
    • Money Mindset
  • Contact
  • Search
  • Best Posts
  • Strategies and Blueprints
    • Money Mindset
  • Make Money
  • Save Money
  • Invest Money
  • Pay Less Taxes
  • Early Retirement
  • What It’s Like To Be Retired
  • Categories
    • Best Posts
    • Make Money
    • Featured
    • Invest Money
    • Money Mindset
    • Save Money

Teardown: How Much Are Your Stock Options Really Worth?

0 Comments -- Reading Time: 10 Min

gold-1369453_1920

 

If you are seeking your fortunes at a tech firm or as senior level management, odds are your offer letter comes with some allocation of stock options. This grant is supposed to buy your loyalty and entice you to stay in the long-term, but paradoxically employees are often given next to no information on how much they are worth. Or worse, they are given rules of thumb passed down from other equally uninformed employees about their value.

In a past life, I spent a bit of time tweaking the stock option plans of several companies. I want to clarify how you can go about understanding the value of your stock options.

 

A Brief History of Stock Options

In the 1950’s, a court ruling reinstating preferable tax treatment to stock options over ordinary income led to a surge in stock option allocations. Hooray! Boards were able to give CEO’s more value at equal cost to them. Because of this, stock allocations became about ⅓ of total CEO compensation in the mid 1950’s. When the stock market stumbled in the 1970’s, stock options saw less popularity because employees would look at those grants at discount them heavily in value.

By the 1980’s, stock options saw a resurgence. Public investors were outraged over what they viewed as overcompensation of CEO’s, and so boards turned to stock options to attract and retain executive talent in a way that was more acceptable to the public. 1980 is where our modern story of stock option bonanza begins, so we’ll follow it from there.

Several things contribute to the eagerness to grant stock options. The primary reason is that, even today, stock options don’t show up as an expense. Yes, you heard that right. This thing you are given that clearly has some potential value is not showing up in the company’s books as an expense.

Why?

In 1972, the Accounting Principles Board (predecessor to FASB) issued APB 25. In it, they said that the expense of providing stock options to employees should be recorded as the difference between the stock’s intrinsic value and the price at which the option could be exercised. Well, since companies are generally issuing options at what they consider fair market value at the current time, the difference in these two numbers is zero.

Anyone who’s had their morning coffee would pause at this moment. If the company tanks in value, the options holders don’t exercise the shares, so they don’t share in the downside. But if the company does well, the employees will exercise their options and see some gain from it. Whose slice of the pie are they eating out of?

The other shareholders.

So there is some value – upside value with no downside –  that these options provide. That is something that the rules don’t account for. But because they don’t account for it, all the companies on the stock market who trade on multiples of EBITDA don’t take a hit on their market values by issuing stock options. And so they issue more of them. It’s free!! To management at least, but not to shareholders.

 

So How Do My Options Work?

For the purposes of this post, we’ll focus on stock options rather than restricted stock units (RSU’s).

Your options are a right to buy shares in the company by paying an agreed upon price per share, called the strike price. The strike price is typically set by completing a 409A valuation with a third party assessor, who helps the company determine what the fair market value of the company is at the time the issue the new options packages.

Vesting

Along with this grant typically comes a vesting schedule. It states how many shares vest, or become purchasable to you at that agreed upon price, per period of time working at the company.

Oftentimes vesting is done on an annual schedule.

If you have a grant of 40,000 shares issued with a vesting schedule of four years, then on the one year anniversary you would be able to purchase 10,000 of those shares at the strike price. By the second year, you would be able to purchase 20,000 shares.

You can choose to actually exercise your options before a sale or other liquidity event.

If you do, you have to pony up the cash. The benefit is that if you hold the stock for a year before a liquidity event, you get capital gains treatment rather than ordinary income treatment on your shares. If you leave the company, you will often have a window to purchase your shares or forfeit them. That window can be as short as two or three months.

Your other option is just to leave those options on the books.

If you happen to be working at the company when the company is acquired, what will often happen is that the company will just wire you the difference between your options price and the sale price per share without you having to pony up the cash.

If a company is 100% acquired by another company, you will likely not have the option to exercise your options and continue to hold the stock. This is because most companies have a drag-along provision wherein if X% of the shareholders vote for a sale, all shareholders must sell their shares. What acquirer would want 2% of the company still out there with former employees? That is why this provision typically exists – to facliltate clean, 100% ownership transactions.

 

How Much Are My Shares Worth?

If your company is publicly traded, the answer to this is easy: you can look up the going share price.

For those issued stock in a private company, you need a few pieces of information to determine what your shares are worth: a valuation of the entire company and the number of shares outstanding.

To get to a valuation of the company, you are typically looking at a multiple of revenue or profits. The range on good software companies, for example, could be anywhere between 3x and 10x revenue. The multiple to affix depends on the growth rate of the company, its gross margin, its profit margin, and several other key factors.

How are you supposed to get this information?

In a private company, you aren’t likely to be able to do it. Fortunately, there are a few ways to get a sense.

 

The Company’s 409A Valuation/Recently Issued Options

Who has all the information we just talked about? The 409A valuation assessor. To create their assessment of the fair market value, an assessor will look at these factors and compare it to public companies with similar characteristics. Second, they will also do their best to compare it to relevant acquisitions done in the market. Third, they may look at what’s called a discounted cash flow analysis of the company, which projects out the company’s profit streams for the next 5+ years and asks what that is work in present value dollars after assigning a market-comparable profit multiple. Finally, they will look at any recent funding rounds done by the company and what price was paid by the new investors.

They weight each analysis – say, 60% public comparables, 20% M&A including recent funding rounds at the company, and 20% discounted cash flow analysis. They arrive at a number. Then, they may apply what’s called an illiquidity discount. Sure, Apple is trading at X times EBITDA, but your company doesn’t have a liquid market for its shares, and so there should be a discount to account for that fact. A typical illiquidity discount might be in the 15%-20% range.

So one way to get a sense for how much your shares are worth is to look at the strike price on the most recently issued shares and gross it back up by the 15-20% illiquidity discount; a buyer of the entire business isn’t going to actually get a 20% liquidity discount, it is often a discount that shows up if an individual investor is trying to sell his minority stake to third party.

If your company tells you its recent 409A valuation was $3.20 a share and you are sitting on 50,000 options at $2 a share, you would gross up the $3.20 by a 20% discount: $4 a share. That means are roughly in the money by 50,000*2=$100,000.

Some caveats:

  • This is based on market multiples today. In highly volatile markets like technology, average multiples can change by more than a turn or two in 12 months.
  • This is based on company performance today. If the company is a high-growth rocket ship, the valuation company probably used premium market multiples. The instant the company slows down, it may find itself commanding a much lower multiple

 

Last Round Valuation

It’s not uncommon to have whispers about a company’s last valuation leaked to the press. Based on my experience, 85% of these articles are accurate in reporting the price of the last round. Your CEO might even just come out and share this information with employees at the next town hall. If he does, it’s valuable information to go on. These are real people putting their money where their mouth is.

The one important thing to realize about using the last round valuation to estimate your options’ worth is that investors are typically buying preferred shares vs the common shares you would own.

The most important difference in having preferred shares is what is called a liquidation preference. This is an extremely common characteristic of preferred shares, though it is not necessarily always there. It means they get their money back first before anything else happens with the other equity holders (read: you).

Say the latest investors bought in at a price of $6 a share. Your company was a tech darling and commanded a huge valuation. But three years later, the company sells for $3 a share when it is acquired by Microsoft. That investor has shares preferred shares, so they can choose to keep their preferred stock and get paid out $6 a share, or they can convert to common and take their pro rata piece of the pie. In this case, they would be stupid to convert and take $3 a share when they could have $6 a share. That has two implications for you, Mr. Employee.

  1. Their shares are worth more than yours. So if they paid $6 a share, it’s not likely that your shares are also worth $6 a share. They have preferences that can take more than their economic share in the downside scenario. How much you discount your shares by depends on how much downside you think is likely.
  2. In that downside scenario, be hyper aware that you may receive much less money than you expect. Let’s rewind the play track. Those investors paid $6 a share but the company sells for $3 a share. They choose to get paid back in full by using their liquidation preference. Where do those extra dollars come from? They come from the common shareholders, which means they come from you. So there you are with your options at a strike price of $2 a share. Say those new investors bought half the company at $6 a share. Your options are literally worthless. They paid double what the company sold for, and they own half the company. They get paid back first before common sees a dime. So you would never exercise your options, because you’d be paying $2 per share of common and getting back $0.

This is the most disappointing thing about options when it comes to employees. How are you to know how much liquidation preference there is in the company? How are you to judge how much the company is worth without knowing what its revenue and EBITDA are? This is all sensitive information kept behind privacy screens in the finance office. I agree with you. You can’t.

 

Conclusion

My personal view on stock options is that you don’t exercise them unless you have information that suggests that they are worth at least 2-2.5x what it would cost you to exercise them.

You don’t control the fate of the company and how long it will take before they sell and you actually see liquidity. So you want to feel truly in the money before locking up cash in these options and leaving them out there for who knows how many years.

The best scenario is just to be employed at the time of a sale, in which case all this will be made transparent and money will arrive in your bank account without you having to pony up cash (most times they will just calculate how much you would have made and send you the difference).

However, because of this lack of transparency, I place much less value in stock options unless the company is publicly traded. The exception is if you are C-level employee who has access to all this information. But as a developer or mid-level manager in a privately owned company? Make sure you see your way to 2-2.5x value before you exercise.  

Of course, this is just one point of view and I encourage you to consult a lawyer about the details. Other folks who work in the space, feel free to weigh in.

 

 

Enjoyed This Post?
Join 15,000+ readers and get new posts every Tuesday and Thursday that will help you earn, save, or grow your money by thousands of dollars. Plus, get access to The Money Habit's FREE Library which includes The Quick Start Guide to Early Retirement.
No spam. We respect your privacy.

Share with a friend:

  • Click to share on Facebook (Opens in new window)
  • Click to share on Twitter (Opens in new window)

Related

Reader Interactions

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Primary Sidebar

  • Popular Posts
  • Classic Reads

How Much Can You Actually Make Blogging?

Two Metrics You Must Track To Achieve Extreme Wealth

2017 Income Report: How I Made $62,326 Blogging 5 Hours A Week

All About Index Fund Investing: How To Generate 8-10% Returns

Above Average Net Worth – By Age

ABP: The Secret to Not Wanting Fancy Things

Teardown: The Only Two Ways To Make Your Money Grow

All About Index Fund Investing: How To Generate 8-10% Returns

You Can Pay Zero Income Tax In Retirement – Legally

Snapshot vs Stable State: Why Your Retirement Budget is Overinflated

Welcome to The Money Habit

As a retiree at 28, I've discovered that early retirement doesn't require you to be a genius or have an incredibly unique skill set. It can be achieved without you becoming an emotionless robot. Showing up every day is what counts. Incremental improvement - a Money Habit - trumps everything else. This blog will teach you how to get there.

Want To Retire Earlier?
Keep building your own Money Habit. Get new posts every Tuesday and Thursday that will help you earn, save, and grow your money by thousands of dollars.

Blog Categories


Best Posts

Save Money

Make Money

Invest Money

Money Mindset

Early Retirement

Strategies & Blueprints

What It’s Like To Be Retired

My Favorite Tools

Free Net Worth and Expense Tracker


Main Brokerage Account


Best Blog Hosting



Footer

The Money Habit

Written by someone who retired at 28, The Money Habit is a personal finance site that focuses on investing, saving, and earning strategies to help you achieve financial security. 15 minutes a week to extreme, early wealth.

Affiliate Links

Some posts may include affiliate links, which share a commission with the blog at no additional cost to you. We only recommend products we believe in; if they have an affiliate program, we add it, and if they don’t we share and recommend them anyway. Being a good human being > promoting crappy products.

Categories

  • Best Posts
  • Early Retirement
  • Featured
  • Invest Money
  • Make Money
  • Money Mindset
  • Pay Less Taxes

  • Early Retirement
  • Other
  • Save Money
  • Strategies and Blueprints
  • What It's Like To Be Retired

Disclaimer

Posts represent my opinions and experiences and are for educational purposes only. I am not a financial advisor and these posts do not represent formal financial advice.

Privacy Policy

We take privacy very seriously at The Money Habit. From one  normal person to another, we get that no one wants their information handed out willy nilly. So check out our privacy policy over here.

Copyright © 2021 The Money Habit