Do the Math on the Stock Option Cost to Purchase Equity

One of the common tenets of the startup community is the importance of equity to align interests and share in the value created. There are a number of different ways to provide equity with stock options, restricted stock units, and profit interests. Stock options are still popular but one aspect of them that isn’t well understood is the concept of the strike price and how that plays into exercising the options to buy the equity.

The strike price corresponds with the value of the company at the time the equity was issued. So, if the company is worth $1 million, and there are 1 million shares of stock, each share of stock is worth $1. Thus, joining a startup with these characteristics and receiving stock options for 1% of the business would represent 10,000 shares at a strike price of $1 per share. Once the options are vested, to get the equity would require the employee to pay $10,000 to the company and now the employee would own the 10,000 shares (whereas before they had the right to buy the shares at that specified price but didn’t own anything else).

If the company is acquired, immediately exercising the options and then receiving the acquisition value for the equity is an easy decision (assuming it’s above the strike price). Things get much more difficult when deciding to leave a company as option agreements almost always require exercising the options within 1-3 months of departure, otherwise the options are forfeited. Now, it’s a case of paying cash for some equity that is illiquid (assuming the company hasn’t gone public) and might not ever be worth much.

Bigger strike prices combined with bigger option packages can be great for potentially having a nice chunk of a valuable startup, but they can also require paying a large amount of cash to turn the options into equity. Do the math on the stock option purchase cost when joining a startup.

What else? What are some other thoughts on stock options and the cost to purchase the equity?