Stock vesting is one of the most famous ways a startup compensates its early employees and other key stakeholders at the building stage.
However, vesting may sometimes involve complex terms and conditions, which may or may not be understandable to a lot of employees. So, what are the key components of stock vesting in an African startup?
Not so long ago, the prevalent type of executive compensation was cash, in the form of salaries and bonuses. Now, the reverse is the case, with stock options taking a more prominent role in big corporations, especially startups.
They dominate the bulk of top level and early employee compensation, and oftentimes are even a requirement to acquire top talent. Steve Ballmer is the 9th richest person in the world, with a net worth of over $100billion, most of which comprise exercised stock options at Microsoft.
So, we know options can be a very rewarding compensation, especially if the startup reaches sky high valuations or IPOs/exits at a huge price. But, technicality and obscure terms may hinder this, and ruin those years of painstaking hard work in the hopes of a future windfall. In fact, startup employees have left an estimated $4.9 billion on the table by not exercising their pre-IPO stock options. The companies with the greatest number of unexercised stock options at the time of IPO included Snowflake, Airbnb, DoorDash, Unity, and Palantir. What do you need to know about stock vesting so you can secure your future and your hard work in the long term?
Stock options and Startups
Startups are always in the market for top talent, and competitive monetary compensation may not always be enough to attract the best talent, especially as a lot would prefer a fairly stable career in well established industries. Options are a way for startups to remain competitive in the job market and attract top talent. It is also a way to reward early employees and make them stay incentivized to grow the company.
It should be noted that stock options aren’t actual shares. They’re the opportunity to exercise (purchase) a certain amount of company shares at an agreed-upon price, called your grant, strike, or exercise price.
What you need to know
Whether as an employee or employer, it is imperative to understand how to value the equity given/received. Communicating effectively the value of the equity package in clear and concise terms may sometimes be difficult, especially since options are never as straightforward as salary packages.
Some important terms include
- The Premium: The stock option contract premium is the price per share paid by the stock option holder to the seller for the stock option contract.
- Strike price: Your strike price is the price at which you can buy your stock options (also known as exercising). It is the price that a stock option contract can be exercised. As a stock option holder, you use a strike price to lock in the future price of a stock. When you exercise the contract, the stock share will be bought (if you buy a stock call option) or sold (if you buy a stock put option) at the strike price.
- 409A Valuation: The 409A valuation is an assessment of the fair market value of a private company's common stock by a third-party and is based on the company’s valuation. This is also referred to as the fair market value (FMV). The 409A valuation always changes, for example if the company has now been valued higher, the 409A changes for everyone. It’s also possible for the 409A to go down if, for any reason, the company is now valued at a lower amount. This is known as a “down round.” Airbnb had a notable down round during the pandemic.
- In the money: For the call stock option, if the current market price of the stock is above the strike price, you are in the money, i.e. you make money. For the put stock option, if the stock's current market price is below the strike price, you make money.
- Out of the money: When the price of a stock is below the strike price, you are out of the money, i.e. the price of the stock is unfavorable to you. The stock option buyer or investor loses money if he or she is out of the money.
How the contract is typically initiated
When you take up a stock option contract, you are called a holder or a buyer and when you give out a stock option, you are called a writer or a seller.
When you decide to exercise the option, you can buy or sell the stock option contract by paying only the contract premium which is usually quoted for one share. For instance, if the premium of a stock option contract is $1 per share, then the total premium you will have to pay for a single stock option contract is $100 for 100 shares.
Time is an important component of the price of a stock option. The more time there is until the expiry of a stock option contract, the probability of an increase in price in your favor increases, and vice versa. If you buy a one-month call stock option contract that is out of the money, and the price does not move, then it will be less valuable to you.
The nature of stock option plans
Stock options may be
- Fixed Value: these can otherwise be called fixed value stock. Fixed Value Plans. With fixed value plans, employees receive options of a predetermined value every year over the life of the plan. A company’s board may, for example, stipulate that the CEO will receive a $1 million grant annually for the next three years. Or it may tie the value to some percentage of the executive’s cash compensation, enabling the grant to grow as the executive’s salary or salary plus bonus increases. Fixed value plans are popular because they enable companies to carefully control the compensation of employees and the percentage of that compensation derived from option grants. But fixed value plans have a big drawback. Because they set the value of future grants in advance, they may weaken the link between pay and performance.
- Fixed Numbers: Whereas fixed value plans stipulate an annual value for the options granted, fixed number plans stipulate the number of options the employee will receive over the plan period. Under a fixed number plan, it may be stated that an employee would receive 28,000 at-the-money options in each of the three years, regardless of what happened to the stock price. Here, obviously, there is a much stronger link between pay and performance. Since the value of at-the-money options changes with the stock price, an increase in the stock price today increases the value of future option grants. Likewise, a decrease in stock price reduces the value of future option grants. Since fixed number plans do not insulate future pay from stock price changes, they create more powerful incentives than fixed value plans.
- Stock call options : With a stock options contract, you have the right, but not the obligation, to buy the stock for the agreed-upon price by a certain date.
- Stock put options: A stock put option contract gives you the option, but not the obligation, to buy the stock options contract for the agreed-upon price by a certain date. If you believe that the price of a stock will drop significantly, then buying a stock put options contract of that stock can be a good risk averse strategy.
The African ecosystem is still very young, and there are still huge prospects for growth. There are about 7 unicorns in Africa, with a lot more prospective ones that may come.
With Paystack’s exit, there will be a lot more deals of that kind of nature emerging from the continent, which means stock options will become a much more relevant topic.
Even in more developed markets, the issue of stock options still represents a very grey area. However, stock options do not have to be difficult to understand. It is essential to understand the risks and benefits involved in stock options and have a fair understanding of the particular terms and the medium to long term goal of the company, and if your goals perfectly align with them.