Understanding Employee Stock Options - Why the Number Doesn’t Tell the Whole Story

There isn’t a single finance professional who hasn’t heard the question: "But at my previous company, I received 10,000 stock options - why am I getting only 1,000 here?"

It’s a common misunderstanding. When it comes to stock options, the quantity doesn’t matter - the ownership percentage does. You may have received 10,000 options in the past, but if those were out of 20 million shares, that’s only 0.05%. If you’re now getting 1,000 out of 1 million shares, that’s already 0.1% - twice as much equity.

But that’s only the first layer. There’s a deeper one - the rights of the investors. In most startups, investors hold preferred shares while employees receive common shares. Preferred shares come with certain privileges, such as “Double Participation” or “3x Participate” clauses.

Here’s what that means: Imagine a company is sold for $100 million. An employee holding 0.5% of the company might expect a payout of $500,000. However, if investors have double participation rights, they first recover their initial investment (say, $20 million) before any remaining funds are distributed. Then, the remaining $80 million is shared among all shareholders - including those same investors again.

This structure can significantly reduce the employees’ portion. That’s also why, when valuation experts set the exercise price for employee options, it’s typically lower than the share price in the latest investment round - to account for the preferential rights investors hold.

The bottom line: The more favorable the investors’ terms are, the wider the gap becomes between the investors’ share price and the fair market value of employee stock options.

And one last question: Why do companies need to perform option valuations periodically? Stay tuned - we’ll cover that in our next blog post