Equity vs. Stock Options

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For the past few years I’ve seen the Startup mentality suffer an exponential growth in popularity. But with every new thing that becomes mainstream, there’s bound to be some confusion regarding how the Startup cookie crumbles.

Now don’t get me wrong, I am a firm believer in what a small group of people can build if they have the right mindset and motivation. I see that in every Startup I work with and I bow in owe to every great idea pushed out there by talented and ingenious people.

But it’s a shame to see how the flood of buzz words thrown out there misleads founders and employees alike. So I wanted to share with you a bit of my experience when it comes to how a Startup works. And it seem that two of the most commonly misunderstood terms are Equity and Stock Options.

Let’s start by defining what this buzz words mean. Equity refers to the net difference between a company’s total assets and its liability. Basically, it refers to the amount of money left for the owners if all assets are liquidated and debts are payed. To make this cristal clear, let’s say that I own 10% of Startup X. I can own it if I am one of the founders or if the company considered my work essential to their growth, so they repay my contribution with an Equity percentage besides my monthly income. Let’s say that in 1 year we built an amazing product and the company is acquired by a big corporation for $10 mill. Startup X pays their vendors, their potential loans, and whatever debts they have that are around, let’s say, $1 mill. So the total net equity is $9 mill. And man on man, I own 10% of that, so I just made $900K. Not too shabby for a year’s work, right?!

Now, let’s see what Stock Options are. They are a contract that gives an employee the right, but not the obligation, to buy company Stock at a certain price, once that company goes public. So let’s say that besides my monthly income, Startup Y gives me a Stock Option Pack of 10’000 Shares which I can buy at the strike price of $20 per Share once the company is publicly listed. This sort of contract represents for me a huge leap of faith because I will have to trust that the company will not go bust until they get the chance to become public. An additional kick is the vesting schedule, which highlights how an employee earns their Stock Options over time. The most popular vesting schedule is the “4 year with a one year cliff”. In laymen terms, that means that I get 1/48 of my Share Option Pack every month for 4 years, IF I manage to stay in the company for the one year cliff period. If I leave before one year has passed, I go over the cliff and end up owning nothing. But let’s say that I love it there and I stay for the whole 4 years. Still, to be able to make any money, Startup Y has to go public, which can take years. But let’s keep the positive mindset and say that Startup Y goes public at $50 per share. Wohooo! That’s so amazing! Absolutely incredible news! To get there represents the hard work of a dedicated team, great timing, and a bit of luck. But after the congratulations wave fades, let’s dust off that Stock Option Pack and make some money. I have the option to buy 10’000 Stocks at $20 per stock, which means I need to have $200K laying around. Let’s say that I have a ginormous piggy bank and I can buy the 10’000 Options. Now I can sell them at $50 per Share, even though that is really bad for the company because my sell can draw the stock price down. But let’s say I do sell 10’000 at $50 and I end up with half a mill in my account. Basically, I’ve made $300K in 4 to 10 years, depending on how much time it took Startup Y to get public. Not too bad, right?!

The main difference between Equity and Stock Options is the status of the company. For me, owning Equity provides the feeling of a founder, but it also comes with a lot of responsibility, crazy schedules, and a roller-coaster of emotions. Stock Options on the other hand make you less involved in the day-to-day business decisions, but come with a lot of trust in the executive team. Ultimately, it depends on you, your work ethic, and risk tolerance.

But if you had the possibility to choose, what would you prefer?