The human-resource director at a Fortune 500 technology company recently told me a story about a candidate to whom an offer had been made. The offer included an option on 1000 shares of stock, but the candidate was not happy. A startup had also made an offer that included an option on 1000 shares of stock, and the candidate told the HR director that if a small company could offer 1000 shares, then a large company should be able to offer more.
This mistake clearly was made by a person with little investment experience. However, valuing hire-on options is not always easy for even a seasoned investor. When evaluating an option or stock grant, there are many factors to consider that involve not only the number of shares and the company, but one's own sense of adventure and risk. The evaluation process becomes even more difficult when a company is privately held. Here are five questions that can help you seek out your next employer:
Question #1. Should I interview early- or later-stage companies?
Selecting a prospective employer is not simply a process of matching your skills and interests against the company's activities and needs. While such a match is important, you also must consider the level of risk that you are willing to assume. An early-stage startup may provide some exciting opportunities and potentially valuable stock options. However, if you recently purchased a house or had a child, then you may want to consider an established company that can provide you with more financial security. If you have enough cash to get through some lean times or a layoff, then financial security may be less of an issue.
You also need to consider your own level of risk aversion. If the prospect of being laid off or missing a paycheck will cause you to lose sleep, then working for an early-stage startup will cause you more stress than you bargained for. If you are not comfortable with risk, or are not in a financial position that allows you to assume some additional risk, then stick with established businesses that have been around for two or more years, and have a stable cash position.
Question #2. How stable is the company?
If a company is public, then look at its most recent annual report, and try to obtain an outside perspective of it. Read research reports on the company's industry, and analysts's reports on the company itself. If its earnings have been below expectations for several quarters in a row, or its cash position has been declining, then any options you receive may be of little or no value for quite some time.
If a company is private, then earnings reports will probably not be available, and the company is not likely to be willing to share such information with you. During the interview process, ask how many people the company has hired in the past year, and is planning to hire in the current year. Follow this up with a question about how they expect to pay for these employees, and what factors may lead to a layoff. This will give you an idea as to how financially stretched the company is. If you hear an answer like, "Our larger staff will allow us to generate enough revenue to finance our growth..." then watch out! A larger staff may increase a company's ability to generate revenue, but also increases its overhead. Additional employees also heighten the likelihood of layoffs during an economic slowdown. A more desirable response is one along the lines of, "We recently entered into an alliance with Company X, and this relationship will bring us more customers because..." It's a good sign if the company is able to finance its additional staff without relying too heavily on the staff itself.
Question #3. How will I make money from my stock options?
If you are interviewing a publicly traded company, then you will make money by purchasing stock at the option's strike price (that is, the price at which the options state that you can purchase the stock), and selling the stock on the open market. In many cases, the strike price will be based on the stock price as of some past date. If the stock has been rising, then your options will have a positive value immediately. If not, then you may end up with a strike price that is above the stock's market value.
If you are interviewing a privately held company, then you will only make money on your options if the company goes public, the company is bought out, or you can find a buyer for your stock. Privately held stock may have transfer restrictions associated with it, so you should check the terms surrounding the option and stock carefully. During your interview, you should ask how the company expects to pay off the shareholders, and why. A later-stage company typically will have a clearer picture than an early-stage startup.
Be sure to verify what the company tells you, if possible. You should look for similar businesses that have recently gone public, been purchased, or received venture-capital funding. If the venture-capital community has taken notice of a particular industry, then a strong company in that industry may be a future initial public offering (IPO) or buyout candidate. Many venture-capital firms have a web site that contains a list of selected portfolio companies.
Question #4. When will I make money from my stock options?
The question of when is equally important as that of how. Most option grants have what is called a "vesting period." When you are granted a stock option, it is unlikely that you will be able to purchase the stock at the strike price immediately. This is the company's "golden ball and chain," as it requires you to stay on for a certain period of time before you can make any real money from your options.
If the company is privately held, then there are additional considerations besides the vesting period. Stock options in an early-stage startup may have no value for several years regardless of whether they have vested. If the company is privately held, then you should ask about its timeframe for going public or being bought out. If a company does not expect to be bought out for some time, then it may be willing to offer bonuses that are tied to its profits. You should not ask about bonuses until the negotiation phase, after the company has decided that it wants to hire you. Keep in mind that startups are often optimistic about their IPO/buyout timeframe, and that harvesting a business usually takes longer than everyone would like.
Question #5. How much will I make from my stock options?
The answer to this question depends on many factors, and can rarely be answered with any degree of accuracy. However, it is possible to compare different offers that include stock options and make an informed decision. It is important to remember that you cannot directly compare options on publicly traded and privately held companies. You must also think about the tax implications that will result from a capital gain due to the exercise of your options.
When considering a company that is publicly traded:
If the company that you are considering is privately held, then the situation becomes more complex. It is important that you check the company's capitalization prior to accepting an offer that includes stock or stock options. You may be asked to sign a nondisclosure agreement prior to the company discussing its capitalization with you. If a company that is making an offer refuses to discuss its capitalization, then you should reconsider whether you want to work for it.
The key issues in evaluating options on a privately held company include:
Answering these questions will help you in your job search and negotiation processes, but each situation will have its own unique characteristics. You should be aware that there is no one "right" way to evaluate a job offer, and that making an optimal decision ultimately rests on your understanding of yourself and your priorities.
DDJ