Understanding Stock Options in a Pre-IPO Company: How They Work and What You Need to Know

Being hired at a company with stock options can be an exciting prospect, especially for those looking to align their financial interests with the company's success. However, stock options in a pre-IPO company function differently from those in a publicly-traded company. This article aims to demystify the workings of stock options and provide you with the insights you need to understand your rights and responsibilities.

What Are Stock Options in a Pre-IPO Company?

Stock options in a pre-IPO company offer the opportunity to purchase shares of the company at a predetermined price (strike price) in the future. However, the key difference lies in the fact that you cannot sell these shares on the open market until the company goes public or is acquired by a public company. This can create a complex financial and legal environment, especially when it comes to exercising the options and managing their liquidity.

How Stock Options Work in a Pre-IPO Company

Just like a public company, you will have a vesting period over which you earn the right to exercise your stock options. This period can range from three to four years, during which you gradually gain the ability to exercise a portion of your options. Once vested, you can 'exercise' your options, meaning you can purchase the stock at the designated strike price. However, due to the private nature of the company, you cannot sell the shares immediately after exercising them. Instead, you may need to wait for the company to go public or be acquired to sell the shares.

Vesting Period and Exercising Options

During the vesting period, you are granted the right to exercise a portion of your stock options over a set timeframe. Typically, options vest in equal installments, such as 25% per year for four years. Once fully vested, you can exercise your full options and purchase the stock at the pre-determined strike price. It's important to note that the strike price can be influenced by the company's valuation, and in heavily-funded pre-IPO companies, this price may be relatively high.

Exercise and Expiring Options

Options are usually only exercisable after a specific period of time, known as the vesting period. Until this period is up, you cannot do anything with the options. Once vested, you can exercise the options to purchase the stock. If the company is still not public, you cannot sell the shares on the open market, but you can explore other liquidity solutions such as periodic buybacks by the company or sale on a secondary market, depending on your shareholder agreement.

What Happens When the Company Goes Public?

The most common scenario for unlocking the value of your stock options is when the company goes public or is acquired by a public company. In an IPO, the company's shares become publicly tradable, allowing you to sell your shares and realize the value of your options. Alternatively, if a public company acquires the private company, the stock options may convert into the acquirer's shares, or if the company is acquired by a private equity firm, the shares can be paid out based on the acquisition price.

Key Takeaways

Stock options in pre-IPO companies vest over time, allowing you to exercise and purchase shares at a predetermined price. You cannot sell the shares on the open market until the company goes public or is acquired. The strike price is typically determined by the company's valuation and can be influenced by recent funding rounds. Evaluation of liquidity options and timing for exercising options is crucial.

Understanding the nuances of stock options in a pre-IPO company can help you manage your financial interests more effectively. Always consult with a legal and financial advisor to ensure you make informed decisions that align with your personal and professional goals.