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This is not financial advice.  Talk to a financial advisor if you need financial advice.

Congratulations!  That job offer you just received included a stock options award.  Welcome to the big time!  Or something…

The question everyone wants to know is what could those stock options be worth.  But it seems like a lot of employees are afraid to ask.   Don’t be afraid.  

I am going to assume that you understand the basics of options.  If not, there are plenty of articles covering option mechanics.  Here is one from Morningstar. There are plenty of others.

If the options are for stock in a publicly traded company, then this is probably a relatively easy question to answer.  They are probably worth $0 when issued – as the strike price will correspond to the current stock price and most of the other relevant information will be publicly available.  

However, if we are talking about a privately held company, then you need to collect some data to ascertain if those options are your path to a life of luxury or just a little extra kicker.  I am a firm believer in finding ways to accumulate wealth that has leverage, and owning part of business is certainly a good way to do this.  But, if we’re talking private companies, then generally it will take some sort of liquidation event (i.e. a sale of the company) to trigger any payout, so all that is baked into my comments below.

Fully Diluted Share Count

First, to evaluate how much those options might be worth someday, you need to understand how many shares are outstanding.  In other words, how much of the company do your options represent?  So, I personally would phrase this question as:  What is the fully diluted share count?

This matters because if a company is worth $150 million and there are 50 million shares, then every share is worth $3 dollars.  Your options would be worth:  Option Count x ($3 – Your Strike Price).

You need the total share count to help you estimate how much a share could be worth at different valuation numbers, for example.

Who Gets Their Money Before Shareholders

Second, you also need to know if anyone is going to get paid out before the shareholders.  There can be a number of mouths to feed before shareholders see any proceeds including the following:

1. Bankers, Lawyers & Any Transaction Fees
2. Working Capital Adjustments
3. Debt
4. Preferred Shares

For simple math, you can probably ignore the expenses related to bankers, lawyers, and other transaction fees.  This is not to say they are going to be small.  But we are doing horseshoes and hand grenades math here.

Same with the working capital adjustment.  This is a purchase price adjustment due to estimating how much money is going to be left in the business by the sellers vs. how much actually gets left behind.  Since the negotiations typically take place several months before the close, an estimate is used and then trued up based on actuals.  But for our purposes let’s ignore it.

Debt.  This is not to be ignored.  If you sell the aforementioned business for $150 million but there is $50 million of debt, then only $100 million is left over for shareholders.  This, as a shareholder, you care deeply about.

Preferred Shares.  This could be a topic of an entire post, but for simplicity, you should understand that there can be different “classes” of shares and each class may have different provisions.  The provisions you care most about is the preference in the proceeds waterfall.  Let’s say in the aforemention business with 50 million shares, that 25 million are Participating Preferreds that get paid out at $2 a share.  And then participate ratably with the other 25 million Common Shares.  So, take your $150 million purchase price and subtract off $50 million of debt.  Then take the remaining $100 million and pay the Participating Preferred their $2 per share ($50 million), leaving $50 million.   Then all shares, both Participating Preferreds and Common Shares, get the rest, so each share is worth $1.

So, as a Common Shareholder, you also care deeply about Preferreds.

Valuation

This one is a bit subjective, but you should have some decent data points.  The strike price on your options should be a reasonable approximation of how much the company thinks the shares are worth today.  Under IRS guidelines, you should not be issuing shares under fair market value.  Now for private companies, that can be highly subjective, but at least you have a starting point. And the fair market value should take into consideration any of the considerations above.  You can take the strike and the total share count and work backwards to get a total equity value and if necessary, add back any debt, to get a total company value.   

Some companies, depending on their culture, may consider some of those data points to be confidential or at least highly sensitive.  If that is the case, then I think it would be an extremely fair request to ask if they could put together a schedule that showed the potential share price at various valuation levels.  They could bake in all the items above, without having to disclose them specifically.  

I am always a little surprised by how many employees do not ask these questions.  But , hopefully that helps you evaluate any stock option awards that you have been offered.  

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I am a closet active investor.

This statement is partly predicated on the fact that most investing decisions, including purchasing index ETFs, contain an element of active decision making.  Unless you are 100% invested in the entire market, even the index ETF selection process involves the selection of asset classes, which is by definition, an active choice.  

“As Rick Ferri, perhaps the most notable expert in the world when it comes to indexing says, “there’s no such thing as passive investing. It’s true. Passive investing in its purest form doesn’t exist. Only lesser degrees of active management exist.”  – The Myth of Passive Investing

In fact, some research suggests asset class selection is potentially the most significant driver of returns.

“More than 90% of the variability in returns for institutional portfolios had to do with the asset allocation decision.” – Four Investing Lessons From David Swensen

Also, I believe that a lot of the research on “passive investing” vs. “active investing” is based on periods of history where the aggregate level of “passive investing” was much lower than it is today.  So it will be interesting to see how those relationships hold up as the amount of “passive investing” increases to a much higher percentage in the research dataset or if that relationship changes and additional opportunities for more active selection decisions present themselves.  Further, we have had a fairly long stretch of broad gains across almost all asset classes, which seems like the perfect environment for less active decisions.  It is possible the environment will change in the future.  I may write more on all that later.

Based on my investing philosophy, I have a portion of my portfolio that is invested mostly in the equity of individual names.  The starting point is based on some of the tenets laid out in Joel Greenblatt’s book, The Little Book That Beats the Market

I have been doing this for over a decade.  And I have created a little bit longer checklist as I have attempted to enhance my investing decision making process.

So, for your enjoyment, here is my investing checklist:

This is not investment advice.  Use at your own risk.  If you do use this checklist, you will likely be publicly shamed based on your under-performance, generating excessive fees and taxes, lack of non-income producing assets in your portfolio, and knowing what EBITDA means. Other legal disclaimers.  Blah, blah, blah.