Stock options 101: what startup employees need to know

TL;DR: the startup you work in is offering stock options? Understand what are them and what are the opportunities, risks, and tax implications when buying and selling shares of a startup:‍

So the startup you work for is offering you stock options – sweet!

They're not as common in Latin America as they are in the US, but we're getting there. If this is your first time getting the opportunity to buy startup shares, I assume you have a handful of questions. 

Have a seat. We have answers.

Are you a startup founder, on the other side of the table? Share this with your team and learn more about the best practices when offering stock options to your employees.

What are stock options?

You can think of stock options as an invitation to buy shares of a company you work for. Buying shares isn't at all mandatory – but it can be a good opportunity.

Companies offer stock options to employees as an incentive. It's simple Math, really: if a person can benefit from the upside of a business as it grows, they're more likely to contribute to creating value for it. 

And if you're helping build something of value you should also get to make a profit, right? That's the premise.

When a company offers you a stock option grant, it will have its own terms and conditions for how many shares you're allowed to purchase, how long you need to wait before you can start buying them, and how much you'd be paying.

The key thing about stock options is that they have a set price per share, which we call the strike price. What this means is that, whenever you do choose to buy stock, that's how much you'll be paying for it – even if the value has since gone up. It's a pretty sweet deal, kind of like getting a discount coupon automatically added to your shopping cart.

How can I make money with stock options?

Startups are privately held companies, meaning they're not traded in public stock markets. Once you buy shares of a startup, you can't just up and sell them whenever you want to. 

People who own shares of a private company can make profit through something called a liquidity event.

"Liquidity event" is an umbrella term to refer to acquisitions, mergers, initial public offerings (IPOs), tender offers, or other types of actions that allow you to cash out some or all of your investment. You can learn more about each of these terms in our glossary.

Let's paint a picture: in the very best case scenario, stock options can be life-changing. 

When Airbnb was just starting out in 2008, it was a startup like any other. Accepting a job offer from them was a risky career move when compared to established companies, so they offered stock options to convince their first employees to join. Their shares weren't worth much then, and the price per share offered to these first few team members was pennies on the dollar. 

Twelve years later, Airbnb went on to have an Initial Public Offering, and its shares traded for US$ 146 that day. 

Now say an early-stage Airbnb employee received an option grant for 10,000 shares, bought all of it and held onto the stock until the IPO in 2020, 12 years later. If each share's strike price was US$ 1, their US$ 10,000 in shares would have sold for US$ 1,460,000.

That's all to say that making a profit with your stock option would require you to play the long game and wait for an opportunity to sell your shares.

What are the tax implications of stock options?

This will be highly dependent on where you live. Most commonly, stock options will be taxed on the spread upon exercise, meaning the difference between how much you paid for the shares and how much they are worth at the time of purchase. 

When planning to buy shares, take into consideration that you'll likely have to pay not only the purchasing price, but also the taxes over your unmaterialized gains, a.k.a. the profit you'd be making.

It is fairly common for stock options to be taxed at the moment of exercise in Latin America, and for employers to withhold taxes on behalf of employees. 

For a brief overview of taxation across different countries in the world, we highly recommend referring to this guide. It's also important to consult with a tax advisor in your country of residence to understand your specific circumstances.

What are the risks of buying stock options?

As is the case with every startup, you can't really be sure if the company will succeed. Buying stock is risky business in general, and you should consider that before making any purchases.

There are five main risks involved in buying the shares in your stock option:

• You could lose all of the money invested if the startup fails;
• Investment return is not guaranteed and is highly volatile;
• You likely won't be able to cash out your investment for years;
• Selling your shares can be hard since there's no private stock market;
• The tax implications of buying and selling shares can eat into your profit.

To mitigate risks when buying the shares in your stock option, you should:

• Only buy shares if you can afford to lose the entire amount invested without harming your overall financial health;
• Have strong long-term financial planning that does not depend on the materialization of this investment;
• Wait for the company to show signs of success, like raising venture capital or becoming profitable;
• Ask your financial advisor for help understanding tax implications, to optimize for the best tax rates possible.

When should I buy/sell the shares in my stock options?

That's one of the hardest questions to answer. As a matter of fact, 48% of employees are afraid they'll make a mistake when buying or selling their equity.

While there's no one-size-fits-all answer for when you should buy or sell your shares, there are a few things you can be on the lookout for to determine when's the best time to do it.

All stock option grants have expiration dates, so make sure to be mindful of yours when planning to buy your shares. It's pretty standard for the expiration date to be 10 years from the date of grant, so you don't necessarily have to be in any rush. Always check what your specific terms and conditions are.

If you heard your company is raising a new funding round at a higher valuation, you may want to consider exercising before the round is closed. This will help you optimize your taxation treatment in a lot of countries, because it will shrink the gap between how much you're paying for the shares versus what they're worth. Your accountant or tax advisor can help you get more context on this for wherever you are in the world.

For most countries, you'll want to hold on to any shares you buy for at least a year before selling them. This time window may change from country to country, but the intention here is to qualify you for long-term capital gains. Ask your advisors what the threshold is for where you live.

If you're given an opportunity to sell your shares, ask yourself: do I believe that the company will continue to grow and become even more valuable? If the answer is yes, hold on to your shares for a little longer. You may get the impulse to sell them at the first opportunity, but that's not always the wisest decision. Remember the Airbnb example? Employees had an opportunity to sell their shares in 2016 through a tender offer– for a much lower value than their IPO in 2020.

How can I buy the shares in my stock option grant?

The act of buying shares in an option grant is called an exercise. How you can exercise your options will depend on how you received them. 

If you received them through an equity management platform, your company will have the ability to enable online exercises, meaning you can just add your payment information and make a purchase like any other e-commerce transaction.

If you received it the old-fashioned way, through a physical signed document, you'll have to talk to your company to figure out the course of action. Most commonly, they'll instruct you to write a check or make a wire transfer.

How do I know how much my shares are worth?

Because startups are privately held, you can't just check the price per share on a stock exchange market. 

Startups refer to two main sources of truth to determine the value of their shares:

• The valuation investors agreed on when the company raised its latest funding round;
• Third-party valuation service providers, which are mandatory in some countries.

The value of a share is commonly referred to as the fair market value (FMV), and it is a method of calculating how much your stock would be worth if it were publicly traded today.

If you want to know what the fair market value is for shares you have bought or are considering buying, you can ask someone in the company – any founder should be able to tell you.

How does the value of my shares change over time?

The north star metric for how much your shares will change in value overtime is the post-money valuation of the startup after each funding round, which is a fancy way of saying how much the company is worth after receiving each new investment.

The more profitable a company is, the more leverage it should have when negotiating investment terms with venture capitalists. Following the expected route of growth year over year, the more capital a startup raises, the more valuable it becomes. 

What happens to my stock options if I leave the company?

When you leave a company, you will immediately stop vesting shares, and you will trigger what's called a post-termination exercise period. You will have limited time to exercise whatever options you have vested before they're canceled, and if you haven't vested any, tough luck.

Seeing as most option grants don't start vesting until you've been with the company for at least one year, you should take that into consideration before you pack your things and go.

Most commonly, you'll see a 90-day post-termination exercise window, but you should double-check your own option grant for your specific timeframe. 

What happens to my stock options if I pass away while still employed?

Death would trigger what we call accelerated vesting. That means your beneficiary would have the ability to exercise the total of shares offered in your option, and/or would inherit the shares you have already purchased.

Instead of the 90 days standard common for terminations, companies are a lot more sensible when it comes to situations like this. They typically extend the exercise window so that the family and friends of the deceased can have time to grief, and to plan how best to manage the estate.

We've seen exercise windows ranging from 1 year to 5 years in this type of situation, and there's really no common standard for it. Make sure to check your own option grant to see what the terms are for you.