Options, RSUs, and why most equity is worth nothing

Start from the base rate

Most start-ups do not produce a payout for employees. Most employee equity in private companies ends up worth zero, and this is the ordinary outcome rather than the sad exception.

That is not an argument against ever taking equity. It is the reason for one rule: do not accept below-market cash for equity unless you can afford for the equity to be worth nothing. If the grant is a lottery ticket you can afford, take it happily. If it is load-bearing for your rent, it is not compensation.

The four instruments

• Share options (ISOs and NSOs in the US, ESOPs in India and much of Asia). The right to buy shares at a fixed strike price. You pay to convert them.
• Restricted stock units (RSUs). Shares given to you when they vest. No purchase, and at a large public company they are close to cash on a delay.
• Phantom shares and share appreciation rights. A cash payment tracking share value, with no shares involved. Common where issuing real shares is legally awkward.
• Direct shares, occasionally, in very early companies.

The arithmetic

An option’s value today is:

(current share value - strike price) * number of options

10,000 options at a strike of ₹250, when the company’s current fair value per share is ₹250, are worth zero today. They are worth something only if the value rises. People hear “10,000 shares” and imagine a number; the strike is half the equation and is frequently omitted from the conversation.

Vesting is the schedule on which they become yours. Four years with a one-year cliff is the common shape: nothing for twelve months, then a quarter, then monthly or quarterly. Leave at month eleven and you have nothing.

Dilution is the reduction in your percentage every time new shares are issued in a funding round. Your number of shares does not change; the denominator grows. Two more rounds can halve a percentage.

The two clauses that decide the outcome

Liquidation preference. Investors typically get their money back before common shareholders get anything. If a company has raised $50 million with a 1× preference and sells for $60 million, the investors take $50 million and $10 million is divided among everybody else. The press release says the company sold for sixty million dollars. Employees discover their share is small, and they were never told the preference stack.

Ask: ”What is the total liquidation preference, and is any of it participating?”

The post-termination exercise window. In most option plans you have 90 days after leaving to buy your vested options or lose them. If you have 10,000 vested options at a ₹250 strike, exercising costs ₹25,00,000 in cash, and in many countries you owe tax on the paper gain in the same year, for shares you cannot sell. This is how people leave a company having vested four years of equity and walk away with nothing, and it is entirely legal and disclosed in a document nobody read.

Some companies extend the window to seven or ten years. It is worth asking, and the answer tells you a great deal about how the company thinks about the people who leave.

Tax, in outline only

Genuinely differs by country and you should take advice. The shape:

• India: ESOPs are taxed as a perquisite at exercise, on the difference between fair market value and strike, whether or not you can sell. Eligible start-ups have a deferral. This catches people badly.
• United States: incentive stock options can trigger alternative minimum tax at exercise; RSUs are taxed as income at vest.
• Most places: a second tax event on eventual sale.

The pattern to notice is that tax is often due before any money arrives. Plan for that or do not exercise.

The four questions to ask

1. How many shares are outstanding on a fully diluted basis? (Without this you cannot compute a percentage, and a number of shares alone is meaningless.)
2. What is the strike price and the most recent valuation per share?
3. What is the total liquidation preference?
4. How long do I have to exercise after leaving?

A company that will not answer the first has told you the grant cannot be valued, and an unvaluable grant should be treated as worth zero in your comparison. Some well-run private companies decline on confidentiality grounds; you still cannot value it, and the arithmetic does not care about their reasons.

The limitation

Public-company RSUs are the exception to almost everything above: they are close to deferred cash with market risk, and they are straightforward to value. Nearly all the complexity here belongs to private companies, and nearly all the disappointment does too.