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A Software Developer's Guide To Stock Options

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A start-up company offers you a great opportunity—with stock options. It's a great deal, isn't it? Perhaps not. In this short article, you'll learn the least you need to know about your own options.

Software developers are usually savvy about their technology domain, but are less well informed about basic economics. That becomes evident when software developers join a start-up company, expecting to get rich on their stock options. I've found that options - how they work, who benefits, and why - are often widely misunderstood. Here's a short introduction.

An option is a contract. The contract gives one party a right (but not an obligation) to make a specified economic transaction with the other party some time later. There are many forms of options, but the most common are the call, in which the option holder can buy something from the other at an agreed-upon price, and the put, in which he can sell something to the other. The agreed-upon price is the strike price. The period during which the option is valid is its term, which ends on its expiration date. The party on the other side from the holder is the writer of the option.

To induce the writer to write the option (i.e. to enter into the option contract) the holder pays a premium. If the holder decides to exercise the option, he notifies the writer and pays the strike (in addition to the premium already paid) and the writer delivers the item. If the holder does not exercise by the expiration, then the option expires and cannot be exercised; the writer keeps the premium. Sometimes the option can be exercised at any time before expiration (American style), sometimes only at expiration (European style).

Commonly, the optioned item is a security. There are traded options (both puts and calls) for most widely-held public stocks, as well as for other things of economic interest such as commodities contracts or market indices (like the Dow or Nasdaq). Traded options are nearly always in units of 100 shares. But options are just contracts, and can be written with any terms whatever between willing parties.

Often, traded options come in series with differing strikes and expirations; there are advantages and drawbacks to each kind in a series, and options investors will often buy one option in a series while selling (writing) another.

An option is a leveraging device, one whereby you take on higher risk in return for potentially a bigger payoff. Suppose that you that see a call option for XYZ Corp. is available at a strike price of $50, a premium of $5, and an expiration in December. If you buy an option (and pay $500 to the writer — the contract is for 100 shares and the premium is per share) you own the option. If in December XYZ is at $60 you can exercise the option (paying $5,000 - $50 for each of 100 shares), sell the stock you get (for $6,000), and net $1,000, doubling (100% return) your $500 investment. If XYZ is at $55, you can exercise and sell and at least get your $500 back. And if XYZ is still at $50 (or lower) then there's no point to exercising, you're out the premium, and have a total loss.

Contrast this with simply buying 100 shares of XYZ instead of buying the option. You pay $5,000. If in December you sell at $60 you have made $1,000, or 20% on your money. If XYZ is at $55 then you make $500, or 10% on your money. If it is still at $50 you break even. And if XYZ is at $45 then you have lost only 10% of your money, instead of all of it with the option. The use of leverage is only profitable if you are smarter than the market - you expect the stock to go up more than the option market does (calls), or down more (puts).

How does the option market set the premium (i.e. price the risk of the option to the writer)? In public markets, the first answer is supply and demand. People are in there, both buying and writing options all the time, based on their estimation of XYZ's future fortunes. But there's an underlying pricing mechanism that keeps the market premiums on a short leash: statistical pricing. Clearly, the gain to the writer is whether he can get a premium that is larger than the gain of the holder over all the possible futures. There is a well-established way to predict this (the Black-Scholes model), which relies on stock prices being essentially random movements superimposed on general market trends. The more variable a stock's prices historically have been, the more likely a random excursion of that price (before expiration) will make it profitable for the holder to exercise - and a loss for the writer. Price variability is readily computed, and so long as the average variability stays under the premium, in the long run the writer will make money and the buyer will lose. Unless the buyer has inside information of course, which both obviates the statistical approach and also is illegal.

Low Pay, Lots Of Stock. Right?

So much for marketable options. The same applies to employment options, which are always calls. Typically (if you read the fine print) the term of the option is ten years or the occurrance of some event (such as an IPO). The strike price is specified, and is often nominal. And the premium is what you paid for it.

But wait, you say, I didn't have to pay anything for it; the company gave them to me for free! Dream on. Companies provide a package of benefit (salaries, options, benefits etc.) which in total are enough to induce the employee to provide value to the company. Companies are not generous rich uncles. So, if you get a benefit from one part of the package, you can be sure that you have lost it in some other part. Thus, high-option companies typically have miserly benefits and low salaries, lousy working hours, and (via the golden handcuffs) restrict your power to move to a better job. All of that is a cost to you, your premium for receiving those options.

You may consider the package a good deal. I hope it is, but the wisdom of the market and industry is that the only way to make money in options is to write them, i.e. to be the company. The venture capitalists (VCs) think so too (or they wouldn't offer the deal), and they are a hell of a lot more experienced than you are.

I'm not saying that options are wrong for everyone. If you don't need salary or benefits (i.e. are young, single and healthy), haven't had a date in years (long hours don't matter), and you think this job is intrinsically fun, then the premium, while present, may not matter much to you and you'd rather take the flyer on the options. Fair enough.

And there's another reason that options may be a good deal in most startups: the premium may in fact be cheap. That's because the owners (e.g. the VCs) may actually be very generous with options, and not charge as much as the options are objectively worth. Why would they do that? Natural born saints they are not. The reason is that while you get the benefit, the VCs will not pay the price. That is, the VCs write the option today, but the person who is the "other party" will be different when the time comes to exercise. That person will be the then-owners: the public investors, after the IPO. So,by giving you great options today, the VCs can lower their out-of-pocket costs and risk, and somebody else pays for it. To the extent that you get a better deal on your options than their economic worth, you get to piggyback on top of the VC's ethics. You have to decide for yourself how you feel about ripping off the eventual public.

Earlier, we saw how an option with a strike of 50 and a premium of $5 produced a 100% gain when the stock went to 60. But 20% stock price jumps don't happen in startups. Startups go bust, or they go 10X. So consider ABC, a startup, with a $1 strike and a $0.10 premium. That is, you can buy for a dime the right to buy a share for a buck. The stock IPOs at $10. You exercise and sell, and after the premium (and neglecting interest and opportunity cost effects) you have made $9.90.

Compare that with simply buying a share outright, at $1. After the IPO you sell at $10, and net $9. That's almost the same as you would have netted with the option. So why use the option? Two possible reasons: $0.90 extra profit is only $0.90, but that's still $0.90. And if you only had $10 to spend, you could have bought 10 shares at $1 but 100 options at $0.10.

The first reason is valid, if the premium really is $0.10. But in practice, the hidden premiums of poor pay, work pressure, poor benefits, and so on are usually much more, and are often quite a bit more than the price for outright share purchase. After all, VCs are not stupid (no matter what you think of their ethics) and they buy shares — perhaps they know something?

The second reason is certainly valid — if you can use it. However, startups never let you buy all the options (or shares) you want. You are granted 10,000 and that's all you get. So being able to afford to buy more is irrelevant.

Investing Your Future

VCs have a goal of 10x for their investments. — In rare cases the multiple may be 100x or more, not the VC goal of 10x. Clearly, the higher the multiple the more irrelevant the difference between premium and outright purchase. In the case of Out-of-the-Box I'm working hard to avoid dilution (that's another facet of business that software developers typically misunderstand)and either we're dead or a barnburner, so — in my case, at least — I think options' advantages do not outweigh their drawbacks.

I'm also opposed to the way that premiums are usually extracted in startups. Benefits tend to be missing or lousy, which disproportionally penalizes the old farts. I am one, and I object. Hours, work pressure, lack of freedom — all of those make for an inhumane environment. It's better that people simply buy in if they feel the future of the company merits it, with a satisfying and worthwhile job whether they buy in or not.

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