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Stock options can be an 'opportunity for significant wealth creation,' says CFO: What you need to know

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Key Points
  • Over half, 55%, of U.S. stock options go unexercised because employees either don't have the cash or can't afford the financial risk involved in exercising them, according to EquityBee.
  • Employee stock options are contracts which give you the right to buy a set number of shares of the company's stock at a specific price over a finite period of time.
  • "If they substantially grow in value, they're an awesome way to create wealth," says FlexJobs CFO David Hehman.

If you're hunting for jobs in the start-up world, you may be excited to receive a job offer that includes stock options. What's not to like? If you do great work, and the company succeeds, your options could one day be very valuable.

"This is an opportunity for significant wealth creation for an employee," says David Hehman, chief financial officer at FlexJobs. "If this is part of your compensation package, you're going to want to put some analysis behind it."

That's an area where many employees are unfortunately falling short. Among employers who received stock options, more than a third (36%), say their employer didn't explain the rules around options clearly, according to a recent study released by EquityBee. According to the firm's data, 55% of U.S. stock options go unexercised because employees either don't have the cash or can't afford the financial risk involved in exercising them.

You'd be wise to scrutinize any equity option offer you may receive from potential employers and negotiate any offer that doesn't offer good terms, experts say. Here's how.

What are stock options?

Employee stock options are contracts which give you the right to buy a set number of shares of the company's stock at a specific price over a finite period of time. You don't have an obligation to do it, though: That's why it's called an "option."

For early employees at firms that end up being successful, the arrangement can be a win-win. Employers can dangle a carrot in front of early employees to keep them engaged in their work, and don't have to part with as much cash up front. Employees who stick things out have the potential to make a big profit if the company goes public or is acquired and their shares become more valuable than what they agreed to purchase them for.

Any equity offer will come with a contract stipulating the rules for buying and selling them. "No two plans are written the same," says Sam Huszczo, a certified financial planner and founder of SGH Wealth Management in Southfield, Michigan. "A lot of times, someone is so excited to land a new role or get a new title, and they're so excited to reach that goal that they don't really care what their stock option contract really says."

Key points of a stock option contract

Here are the key points to look for in your contract and to ask your potential employer about.

Number of shares: You'll be granted the option to purchase a set number of shares. Let's say you're offered 100,000.

Strike price: This is the price at which you are allowed to purchase shares. If the strike price is $0.10 per share, you could exercise all of your options for $10,000. Ideally, you want this price to be lower than what the latest round of investors paid per share, says Hehman.

"If your exercise price is 10 cents and the last time they sold shares, it was for a dollar, that's what we call 'in the money,'" he says. "Sometimes there's not much of a difference. The IRS wants these close to fair market value. But you could walk into a nice situation where the last round of funding was at a significantly higher price."

Vesting period: Your options will "vest," that is become available for you to exercise, over a specified period of time. Under a typical setup, you'll have a 4-year vesting period, which means you don't have the right to buy all of your shares until you've worked at the firm for four years.

This scenario often comes with a 1-year "cliff" — meaning you'll have to stay at least a year to have access to any of your options. After you've cleared the cliff, options are made available to you incrementally.

How to negotiate for better terms

Beyond the basics, understanding options arrangements can get tricky, especially if you're not considering what may happen if you leave the company — voluntarily or not.

"All too many times, people don't look at the agreement until they're ready to leave, and they find out they weren't efficient in utilizing the benefit while they were at the company," says Huszczo. "If you're going to get a high amount of equity compensation, you gotta do a little homework."

If you don't, you could find yourself in a situation where you have the option to buy shares but can't afford them.

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"If your exercise price is $10 per share, and you have 10,000 options, you're going to have to come up with $100,000 to exercise those," says Hehman.  "If you're terminated, you historically had 90 days to exercise those options, and it may have been impossible to come up with $100,000. Ideally, if the company is progressive, they're going to give you a much longer window — up to 10 years."

You'd be smart to ask what window you have to exercise upon termination, or if your vesting period could be accelerated in the case of a layoff or acquisition, Hehman says. These points may or may not be negotiable.

If you're hoping to stay for the long haul, you may want to build in a bonus for yourself on the back, end, Hehman adds. "You could always negotiate a bonus. 'If I stay for the full four years, will you give me a bonus equal to the exercise price times the number of shares?'" he says. "That would allow you to buy all the shares. Maybe you say that if you're terminated without cause, you get the bonus and they vest you."

Consider the potential risks and rewards

If dealing with the finer print of a financial contract isn't your cup of tea, it may be worth it to consult a professional, says Hehman. "If you have access to one, a lawyer, tax advisor, or financial advisor are all going to be great resources," he says.

But beyond understanding the particulars of the package, you'll still have to consider the potential risks and rewards to your financial situation should you accept an offer with a significant portion of your compensation tied up in stock options.

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Try to put a number on the potential value of your options, suggests Renata Dionello, chief people officer at ZipRecruiter. Ask how many shares of company stock are outstanding and divide your allotment into the total to determine how much of the company you'd own. Take your percentage of the latest round of funding the company has received to get an idea of what your shares could be worth now, she says.

Use measuring sticks, such as the market size of comparable companies in your prospective firm's industry, to get an idea of what your shares could be worth were the company to expand into the firm that its financial leaders envision.

Even if it's a big number, that's not enough reason to accept an offer, she says. "You're putting all of your human capital behind one company. It's essentially betting on one stock," she says. "You have to evaluate the company the same way you would any other investment, making sure you feel good about its position in the market, how they stack up against competitors, and the management. When our company was private, it wasn't unusual for candidates to request to talk with the CFO."

Remember, even if you're getting an attractive options package, you likely won't see any of the money if the company fails or never goes public. That's a very real possibility that you have to consider, says Hehman. "Most start-ups don't work, so you shouldn't count on it," he says. "Don't think of options as core compensation. Think of them as a bonus.

"If they substantially grow in value, they're an awesome way to create wealth."

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