*The following post covers Stock Option Economics from Carta's presentation “Equity 101 for Startup Employees.” The remaining sections are covered in the rest of this 3-part blog post. You can follow us on Twitter (@cartainc) for updates on upcoming events.*

###### Part 2: Stock Option Economics

Stock Option Economics is about how much your options are worth and how you should think about their value.

We cover three topics in this section. First, we’ll explain strike price of employee equity, or the cost for you to buy one share of stock. This is also called an exercise price. Next, we’ll detail how your stock options actually gain value over time and what factors determine that. And lastly, we’ll touch on something called dilution. This is what happens when companies start to grow and raise more money.

The strike price on your option grant is what you pay to buy one share of stock. Like we discussed in Part 1 of this post, a stock option is the right to buy a set number of shares at a fixed price. That fixed price is called the strike price. In Kerri’s case, the strike price is $1 per share, which means to buy one share she needs to pay one dollar.

To come up with that $1 price Meetly had to determine what’s called a Fair Market Value (FMV). FMV is essentially what the price would be if the stock was traded publicly on the open market. The strike price is almost always equal to the FMV of the stock on the day the option is granted. So how do companies come up with a Fair Market Value?

For a public company, it’s easy to figure out the FMV: pull out your phone, open up any online brokerage platform, and look at what the stock is currently trading at. That’s the fair price that people are willing to pay on the open market. Facebook, for example, was recently trading at $190 per share, so their FMV was $190 that day.

If we try to look up Kerri’s company (Meetly) on an online brokerage platform, we won't find anything. Like all startups, Meetly is a private company and the stock can’t be traded publicly until an IPO.

To determine a Fair Market Value, private companies engage a 409A valuation provider to value the company's common stock. Carta completes 409A valuations in our platform. If companies fall out of compliance with the IRS, or if their option grants are priced below the exercise price, there are tax consequences that fall on the employee (not the employer).

Now that we’ve covered the strike price and FMV of stock options, let’s describe how stock options gain value.

The above graph has two lines. The blue line is Kerri’s strike price. The strike price doesn’t change at all over time because it’s a fixed price. The yellow line is Meetly’s stock price (or FMV). Right now those prices are the same. If Kerri decided to exercise her options and buy her shares, she would have to pay $1 to get $1 in return. This is called “at-the-money.”

Every company shareholder hopes the value of the stock will go up. When the price goes up, the difference between the FMV and Kerri’s strike price is called "the spread", and is the underlying value of the stock. When the spread is positive the options are considered to be “in-the-money.”

In this case, Meetly’s FMV has risen to $5 per share. If Kerri decides to buy and sell at a strike price of $1, she will make $4 on the spread.

But things don’t always go well for startups. What happens if Meetly’s FMV goes down to $0.75?

The spread is now negative, and Kerri’s options are “underwater.” She would have to pay $1 to get $.75 in return, so she decides not to exercise her employee equity.

The final topic we'll cover that relates to the value of your stock options is dilution.

Let’s start with Kerri’s ownership percentage in Meetly. When she received her options, her 100 shares represented 2% ownership of the company. The company has 5,000 shares outstanding in total, and 100 divided by 5,000 equals 2%.

One year later, Meetly has grown and decides it needs more money. They bring in new investors and raise another round of financing. Before Meetly can issue stock to the new investors they need to create more shares. The 2,000 new shares are issued to the new investors.

Kerri still owns 100 shares, but her ownership percentage has dropped from 2%. Her 100 shares divided by the new total (7,000) is equal to 1.4%. The effect of the increase in the amount of shares outstanding on employee equity is called dilution.

Now let’s look at what Kerri's shares are actually worth, before and after the new investors came in.

We’ve added a column on the right to show the dollar value of ownership. Before the new financing round, Meetly was valued at $100 million, so Kerri’s 2% stake was worth $2 million. After the $20 million round, Meetly's value increases to $120 million. Kerri and all the other existing shareholders care about the value of their holdings after the financing.

In the above example, Kerri's 1.4% of $120 million is still equal to $2 million. Even though her ownership percentage was diluted, the value of her options stayed the same. She essentially owns a smaller piece of a bigger pie.

Below is a recap of what we covered:

We defined strike price (or exercise price). This is a fixed price and it’s how much you pay to buy one share of stock.

We discussed the economic value of your options, which is basically the spread between your strike price and the FMV.

We explained dilution, or how new investment can affect your ownership percentage.

These are three things startup employees should consider when determining the value of your option grants. We'll cover exercising options and the tax implications you should consider in part three.

Read “Equity 101: Part 1”

Read “Equity 101: Part 3”