In this series of articles we will be discussing and demystifying a few concepts commonly encountered within the startup scene and sharing what I have learnt over the years so you can better understand what implications they may have for your career and financial future. Whether you are a recent hire in your first startup adventure or more established in your career and looking to brush up on some concepts that you never quite understood, this article series is for you. Today we will explain what a "cap table" is and more importantly what it means to be granted "stock options". While these concepts may seem a little daunting at first, they're important to understand as they may significantly impact your financial future and career decisions. Let's break them down in simple terms.
What is a Cap Table?
A Cap Table (short for capitalization table) is essentially a spreadsheet that shows who owns what in a company. Think of it as the ownership blueprint of a startup business. The Cap Table tracks:
- Who the shareholders are
- How many shares each person owns
- What percentage of the company each person owns
- The value of those shares
Cap tables are dynamic, living documents that change whenever there's a new investment round, when employees exercise stock options, or when ownership changes hands for any reason.
Isn't that the Founders Bag, why Should I Care About the Cap Table?
As a new employee, or a more experienced startup employee more focused on delivering day to day value, the cap table might seem like something only founders and investors need to worry about. However, understanding your company's cap table can give you some valuable insights:
- You'll see how ownership is distributed between founders, investors, and employees
- You can understand how dilution works when new investment comes in
- You'll better grasp where your own stock options fit into the bigger picture
Stock Options sound good, but what does this really mean?
Oftentimes stock options are included as part of a startup employees compensation package. Typically, founders will offer stock options in lieu of part of their salary, usually to save costs and incentivise employees to work harder to drive successful outcomes by giving them a sense of ownership over the business.
Critically however, stock options aren't actual shares—they're the right to buy shares of the company at a predetermined price (called the "strike price" or "exercise price") at a future date. This price is typically set at the fair market value of the company's stock when the options are granted.
The basic idea is simple: if the company grows and the value of its shares increases above your strike price, you can "exercise" your options (buy the shares at your lower strike price) and own something valuable.
Key Stock Option Terms to Know
Vesting: Options typically don't become yours all at once. Instead, they "vest" over time according to a vesting schedule. A common arrangement is "4-year vesting with a 1-year cliff," meaning:
- You get nothing for the first year (the "cliff")
- After one year, you get 25% of your options
- The remaining 75% vests gradually (often monthly) over the next three years
Cliff: The initial period before any of your options vest.
Exercise: The act of purchasing shares at your strike price.
Strike Price: The predetermined price at which you can buy shares.
ISO vs. NSO: The two main types of stock options with different tax implications:
- Incentive Stock Options (ISOs) can receive preferential tax treatment
- Non-Qualified Stock Options (NSOs) are taxed as ordinary income
Expiration: Stock options don't last forever. Typically, you'll have a limited window (often 90 days) to exercise your vested options if you leave the company.
How Stock Options Create Value
Let's use a simple example to illustrate how stock options work:
- You join a startup and receive options to purchase 10,000 shares at a strike price of $1 per share.
- Over the next few years, the company grows significantly.
- You remain with company through the vesting period and by the time your options are fully vested, the company's shares are worth $10 each.
- You exercise your options, paying $10,000 ($1 × 10,000 shares) to buy shares now worth $100,000.
- You've gained $90,000 in equity value (on paper at least).
Remember that this value remains "on paper" until there's a "liquidity event" like an acquisition or an IPO that allows you to sell your shares.
Questions to Ask About Your Stock Options
When discussing stock options with your employer, consider asking:
- How many shares am I being offered?
- What percentage of the company do these shares represent?
- What is the current strike price?
- What is the vesting schedule?
- What happens to my options if I leave the company?
- What happens to my options if the company is acquired?
- When was the last time the company was valued, and what was that valuation?
Potential Pitfalls to Be Aware Of
Stock options come with some important considerations:
Dilution: When a company raises more money, it typically issues new shares, which means existing shareholders own a smaller percentage of the company. Your 1% today might become 0.8% after the next funding round.
Tax Implications: Exercising options can trigger tax obligations, sometimes significant ones. Consultation with a tax professional is highly recommended before exercising options.
Illiquidity: Unlike public company stock, you generally can't sell startup shares until there's an exit event. Your wealth may be "locked up" for years or never be realised unless that liquidity event occurs.
Company Performance: If the company fails or is sold for less than expected, your options might end up being worth less than the strike price.
Final Thoughts
Stock options can be a valuable part of your compensation package, potentially worth much more than your salary if the company succeeds. However, they represent a risky investment—they could become extremely valuable or worth nothing at all.
As a new employee, take time to understand your specific grant, the company's cap table, and the terms of your options. The startup game can be hard so consider them a potential bonus rather than guaranteed money, and make sure your base compensation meets your needs.
Remember that stock options are meant to align your interests with the company's success—they reward you for helping build something valuable. By understanding how they work, you can make more informed decisions about your financial future and your career.