This article is part 2 of our series on the basics of startup stock options. Here’s part 1 and part 3. Follow us on Twitter @cartainc for more educational content.
Part 2: Strike prices and dilution
When a company offers you stock options, the hope is you’ll be able to sell them for more than you paid for them. If you’ve ever wondered what determines these prices and how to figure out how much your options could be worth, we’ve got you covered. Here, we’ll cover:
1. Strike prices (the price you pay to purchase shares)
2. How stock options gain value over time
3. Stock dilution (how the number of shares issued affects how much of the company you own)
Stock option strike prices
Remember: stock options are the right to buy a set number of company shares at a fixed price, typically called a strike price, grant price, or exercise price. In this example, your stock option strike price is $1 per share.
To come up with that $1 price, Meetly (our example company) had to determine its fair market value (FMV). For private companies, FMV is essentially what the price would be if the stock were traded publicly on the open market. Your stock option strike price is usually equal to the FMV of the company’s stock on the day the option is granted.
It’s easy for public companies to determine their strike price: all they have to do is look at what the stock is currently trading at. That’s the price that people are willing to pay on the open market. If Facebook, for example, is trading at $180 per share, their FMV is $180 that day.
If we try to look up Meetly on an online brokerage platform, we won’t find anything—and not just because we made the company up. Like all startups, Meetly is a private company, and the stock can’t be traded publicly until an IPO or other public listing of the company’s stock on an exchange.
To determine the fair market value of their common stock, private companies usually use an independent 409A valuation provider like Carta. This can help protect them from costly audits and their employees from significant penalties.
How stock options gain value
“At-the-money” stock options
In the graph above, the blue line represents your strike price. The strike price doesn’t change at all over time because it’s a fixed price. The yellow line is Meetly’s stock price (or FMV). Right now, those prices are the same. If you decide to exercise your options and buy your shares, you would have to pay $1 to get $1 in return. In this situation, your options are considered “at-the-money.”
“In-the-money” stock options
When the stock’s value increases, the difference between the FMV and your strike price is called “the spread.” This is the underlying value of the stock. When the spread is positive, your options are considered “in-the-money.”
If you buy at a strike price of $1 and sell when Meetly’s FMV is $5, your spread is $4 (per share).
Underwater stock options
Unfortunately, things don’t always go well for startups.
If Meetly’s FMV goes down to $0.75, your spread becomes negative, and your options are “underwater.” Since you would have to pay $1 to get $.75 in return, you decide not to exercise your options. (Meetly could choose to reprice the options, or replace the worthless options with new ones at a different strike price.)
Stock dilution
Stock dilution is when a company issues additional shares and subsequently reduces how much of the company you (and the other shareholders) own. It usually happens when a company raises money.
When you received your options from Meetly, they had 5,000 shares outstanding. In other words, they’ve issued 5,000 shares in total to all of their shareholders.
This means your 100 shares represent 2% ownership of the company:
100 / 5,000 = 2%.
One year later, Meetly decides to raise another round of financing. It creates 2,000 new shares to issue to the new investors.
While you still own 100 shares, the new shares cause your ownership percentage to drop. Your 100 shares divided by the new total (7,000) equals 1.4%. The effect the increased amount of shares outstanding has on your ownership percentage is called stock dilution.
Now let’s look at what your shares were/are worth before and after the new investors came in.
Before the new financing round, Meetly was valued at $100 million, so your 2% stake was worth $2 million. After the new fundraising, Meetly’s stock value increases to $120 million.
In the above example, your 1.67% of $120 million is still equal to $2 million. Even though your ownership percentage was diluted, the value of your options stayed the same. You essentially own a smaller piece of a bigger pie.
Here’s a quick recap of what we covered:
- We defined strike price. This is a fixed price you pay to buy one share of stock.
- We discussed the economic value of your options, which is basically the spread between your strike price and the FMV of the company’s common stock.
- We explained dilution, or how your ownership percentage can change if the company issues more stock to other shareholders.
These are the three things you should consider when determining the value of your option grants. We’ll cover exercising options and the tax implications in part three.
Read “Equity 101: Part 3”
Read “Equity 101: Part 1”
Special thanks to Alex Farman for writing the first version of this article.
DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.
