How startups use stock options to attract and retain high-quality people.
To my surprise, a lot of people that I interview at Acquia don’t understand stock options or have never heard of it. This blog post explains what stock options are about. It is a very technical topic but for the sake of this post, I am going to keep it really simple and make some over-simplifications.
In essence, a stock option is a right given to an employee to purchase stock at some point in the future at a set price.
When a company is founded, the founders own 100% of the company. When they raise money from investors, they give them a share of the company's stock in exchange for money. In addition to that, most institutional investors will require that you establish an "option pool" which usually accounts for 10% to 20% of the company. So if you sold 30% of your company to an investor for 2 million dollars, and you set aside 10% for the option pool, the founders still own 60% of the stock and have 2 million dollars to work with.
Having an option pool is very common for a venture backed startup, and fairly uncommon for most small companies. At Acquia, which is a venture backed company, we give our full-time employees stock options on top of a competitive salary. These options come from our option pool.
If you are an employee of a startup, stock options are a big deal as you are going to receive stock options as part of your compensation. It is a big deal because it means you have the option to be a shareholder and to share in the gains. It's a big part of the startup culture, and an important reason why top engineers prefer venture backed startups.
So what exactly does that mean for you as an employee?
When you join a startup as an employee, in addition to your salary, you might be granted 10,000 stock options at a strike price of $1 per share. Those options are taken from the stock option pool that is set aside especially for employees. In our example above, all employees together can own up to 10% of the company.
When the company is founded, the stock is basically worthless. The founders, the employees and the investors will want to steadily increase the value of the company, and by extension, the value of the company's stock.
At the time of an exit, the stock is hopefully worth $100 per share or more. So if you were granted 10,000 options at a strike price of $1 per share, you can buy 10,000 shares for $10,000. However, at that point, the shares are immediately worth $1,000,000 as over the years, the stock price has increased to $100 per share. In other words, the 10,000 shares that you got when you joined, can make you a $990,000 profit on top of your salary.
Granted, the value of the company might not always go up, or it might not go up that fast, but it certainly could. Hundreds of Google employees became millionaires overnight when Google went public. Hundreds of Google employees left to join Facebook — not because they get a better salary but to get some of Facebook's pre-IPO stock options. When a startup is growing and successful, the price will go up over time. At the same time, if the company fails, the employee equity will be worthless.
The reason startups use stock options is because it allows them to attract and retain high-quality people at reasonable salaries. You can choose to go work for a startup for $85,000 per year in salary and 10,000 stock options granted over 4 years, or you can choose to work for a company for $90,000 in salary and get no stock options at all.
Do you want to take the reduced salary and some risk and swing for the fences, or you do you prefer predictability without the potential for a big upside?
My first job out of college I worked for a venture backed startup that granted me two rounds of stock options — both grants were rendered worthless as the company didn't survive the bubble in 2001. Even so, I never regretted the choice to go work for this startup. I still got paid a fair salary, I learned a lot and just loved the start-up culture that we had created.
I firmly believe there is an entrepreneur tucked away in many of the best people. For those people, the daily satisfaction of working with high-quality colleagues in a fast-growing company, and the ability to share in the company's success as a shareholder, is worth a lot more than a bigger salary and predictability. I knew that was true for me when I was 21, and I know it is still true now that I'm 31.