How Startups Handle Stock Option Percentages in Offer Letters
Understanding the nuances of stock options in startup offer letters is crucial for prospective employees and investors. This article explores the typical practices of startups when it comes to including stock option percentages and the numbers of shares on offer letters.
Typical Practices and Reasons for Omission
Startups commonly include the number of stock options offered in the offer letter rather than the percentage of total outstanding shares. The rationale behind this practice is multifaceted. First, the percentage of outstanding shares can change over time due to the issuance of new shares or additional grants. Second, providing such information in the offer letter can create unrealistic expectations and pledges that may not hold true in the long term.
Some companies offer additional context about the percentage of shares in separate communications or during discussions on equity. However, this is optional and not universally followed. It's particularly relevant when the percentage is vital for comprehending the overall compensation package.
When Percentages Are Provided
The percentage of shares is typically provided only to individuals who would receive one or more shares. Below this threshold, the number of options is given instead of the percentage. This reflects the reality that small percentages can be difficult to compare and don't provide as much essential information.
While the number of option shares is the standard, astute employees might request the total number of shares. Unfortunately, this request often elicits varied and somewhat perplexing responses from the company. The reason is that the total number of shares and the fully-diluted capitalization can change during the vesting period.
Challenges and Cautionary Tales
Understanding the dynamics of stock options is further complicated by the fact that the total number of issued shares is subject to change as the vesting period progresses. Some employees may attempt to calculate the percentage if all options were vested and purchased, but this is a hypothetical and not a real situation.
Many companies include only the total number of shares or option shares in the offer letter, leaving discussions about capitalization to informal, non-binding side communications. A minority of companies might include a percentage figure, which can lead to misunderstandings and promises that are difficult to fulfill due to the fluctuating nature of these numbers.
To illustrate, consider two engineers receiving offers from a startup. If both are given 1% of the current capitalization, which stands at 10 million shares, the resulting allocations would not be 100,000 and 101,000 shares as one might expect. Careful management of the offer letter can include percentages and capitalization information without making it a binding promise, fostering transparency instead of creating unrealistic expectations.
A sample clause might read: 'Upon and conditioned on your joining the Company and further conditioned on approval by the Company’s Board of Directors, the Company will issue you an option to purchase 60,000 shares exercisable at the fair market value as of the date of grant, as determined by a 409A valuation. This is subject to the vesting terms described below. For reference, the valuation as of July 31, 2019, was $0.13 per share, and the company’s fully diluted capitalization on that date was 10,135,400 shares. These numbers are subject to change at any time before your option grant.'
By maintaining meticulous records, companies can provide the percentage as of any date up to the date of the employment offer without making a binding promise. This approach enhances transparency while managing the risks of unrealistic expectations and misunderstandings.