This article is part of the series “What startup equity compensation means for developers”
In the previous part, we've looked into the economic value of your options—how you should value them, and how dilution works.
In this post, I'm going to show you what happens when the start-up you hold options of, gets sold, and how you can realize your economic value in that scenario. Let's dive in!
That depends highly on the deal between the buyer and the company. If the price is high enough, then your vested options and exercised stocks will be liquidated.
That means that you'll receive its price for each exercised stock based on the acquisition cost decided in the deal. For each vested option (not exercised), you'll receive the difference between the exercise price and its acquisition price.
There are, of course, alternative outcomes that could happen: buyer, instead of liquidating your position, could replace your stocks with its own (with an appropriate ratio), and they can decide to continue or discontinue the unvested part of your stock option plan.
Such a replacement is also an excellent economic compensation because soon (after the acquisition is over), you can liquidate them yourself. The bonus is that the acquirer will likely go up in price if it's a public company, or go up in valuation (if private) because it has acquired your start-up. And that increases the economic value of the new stocks/options you have received.
Let's go through a simple example: 3 years from now, you have vested most of your options (75%), and you have exercised all of them at the exercise price of 10 cents per share.
Also, because you're a loyal employee, you had gotten another 4-year stock option grant one year ago, and it's vested (25%) now—you haven't exercised that yet.
Also, you have already advanced in your role to an Engineering Manager position.
Your grant #1 (from 3 years ago):
- Exercise price: 10 cents per share.
- Vested options: 150 * 75% = 112 options.
- Exercised options: 112 stocks for 10 cents each.
- Unexercised options: 0 options.
- Unvested options: 150 * 25% = 38 options.
Your grant #2 (from 1 year ago):
- Exercise price: 10 dollars per share.
- Vested options: 100 * 25% = 25 options.
- Exercised options: 0 stocks.
- Unexercised options: 25 options.
- Unvested options: 100 * 75% = 75 options.
And now, let’s say that another tech giant is negotiating a deal with your start-up for acquisition. Here are the details of the agreement:
- Start-up valuation (post-money): 20M.
- Agreed acquisition price: 25M.
- Total shares: 22.500 shares.
- Price per share: ~1111 dollars/share.
And the deal specifies that all exercised shares will be liquidated directly at the acquisition price per share. All the vested (unexercised) options will be liquidated at the difference between the exercise and acquisition prices.
Additionally, for all the management roles and above (luckily, includes your Engineering Manager position), unvested option grants will be converted into the economically equivalent acquirer’s option grants.
Let’s see what you can get here with such a deal:
- Liquidated stocks: 112 * (~1111,11 - 0,10) = ~124.433
- Liquidated vested options: 25 * (~1111,11 - 10) = ~27.527
That’s a total of 151.960 dollars gained by you.
Of course, for the past three years, you’ve been investing about 20K/year in your “lost opportunity cost.” So let’s see what your return on that investment was:
- Investment: 3 years * 20K/year = 60K
- Payout: ~152K.
- Return on Investment (ROI): ((152K - 60K) / 152K) / 3 years = 20% return per year.
20% yearly return. That’s not bad at all!
Of course, the devil is always in the details. First of all, taxes: the tax system may significantly cut this big payout. In some countries, this will be a capital gain (15-25%), and in some, it’ll be full-blown income tax within one of the highest tax brackets (35-45%). If you can, it’s recommended to hold your stock option grant with a corporation (that you own personally, or together as a couple), in most countries that will reduce the tax burden of realizing these gains considerably.
Another detail is that the deal above is excellent. Not all deals are great. If the start-up wasn’t doing too well, it could’ve been bought for the price lower than the valuation. Also, the acquirer could cancel vested and unvested options entirely—this will allow them to pay a higher price for a company. Thus, it is better for investors and for employees who have already exercised a lot of options.
So, to reduce the risk of losing your vested options, it’s best to exercise them earlier rather than later. Holding actual stock beats holding onto options in the scenario of acquisitions. Of course, this is a good strategy for options with exercise prices near zero (such as 10 cents), but it may not be such a good idea for options with a higher exercise price (such as 10 dollars).
The idea is that you’re competing against two possible bad outcomes:
1) losing your vested options due to an acquisition;
2) having your exercised shares go underwater because the market price (after IPO) or acquisition price is lower than your exercise price.
That’s why it’s a great idea to exercise as soon as you can when the exercise price is low, and “wait and see” when the exercise price is significantly higher.
Alright, that was it from the perspective of an acquisition. What happens if your company doesn’t exit via being sold, and instead goes public? You can read it in the next part.