2016-08-03

I decided to write about startup stock option expiration dates, given the ongoing discussion around the topic.


We like to believe, and are told by founders and hiring managers that we're being given a block of options to purchase shares in the company. We evaluate this grant, given the commonly presented "key terms" of strike price, company valuation, ownership %, etc., to have some value $X [1].

But what we're not explained is that we're actually given a block of options with expiration date of D (where D is most commonly length of tenure + 90 days). What I hadn't realized before is that this D really makes a difference in the value of an option.

Ask any trader about the value of an option, and they'll explain to you that short dated options are the cheapest, and option contracts (ex: puts, calls) become more expensive as the expiration dates become longer. Longer expiration dates directly translate to a higher intrinsic value of those options.

So going back to the option grant given to the startup employee, we can see that the expiration date clause on those options is actually a "key term" that is rarely, if ever, a point of contention. People negotiate for a larger number of options all the time (often trading salary for more options), but when's the last time someone tried to negotiate and trade the number of options for a longer expiration? That would actually be trading some amount of value for another amount of value, but it's never done.

But this is something you could do if you wanted to open a position on say, $AAPL, using options. You'd intently consider both the strike and the expiration date for an $AAPL option, and look at how much each would cost. A longer expiration contract with the same strike price will always cost more. Some hedge fund managers have very long dated (3+ years), out of money (ex: the strike price is higher than the current price) call options on Oil. Those contracts would be much cheaper if they'd expire in 3 months, not 3+ years.

So when we say "we've earned those options" (and thus they shouldn't be taken away by the 90 day exercise window), it's not entirely accurate. We've actually "earned those options with expiration D" (and other terms). Holding strike price constant, option grants with "equivalent value" with different expiration dates would mean that the longer the expiration date, the fewer options you should get.

Of course, figuring out the value of a longer expiration date would be incredibly difficult. I certainly have no idea how to price this, especially given that the value of the underlying asset (the company) is already a bit of a black box in the first place. But this is something worth being aware of, so that we can understand that there is real value at stake in the ongoing expiration date discussion.

Remembering the Intent

BUT -- we shouldn't forget that if the founders' intent truly is to "give Z% of the company to an employee in a tax efficient manner" (like they say in all their conversations), and if "the value of the option grant as computed by the value of the underlying option contract" is not a concern, then the founders will not actually be "giving up" any value by lengthening option expiration since that value was inadvertently created and was never intended to be claimed by the founders/company in the first place.

In this case, a founder who wishes to be consistent with herself and her own narrative should adopt a long expiration option contract to make the reality of the situation as close to the narrative as possible, given the legal limitations. If the narrative's purpose was marketing spin to subtly over promise something to make the sale, then carry on. If the founder just wasn't aware of what's at stake and why this matters, I hope that the recent flurry of articles has made them aware of the need to become educated on the subject.


[1] I tell friends to consider their option grant as $X == $0 to simplify things and protect themselves from being mislead, but all options do have some nonzero value.