The financial term “derivative“ refers to a security whose value is a function of another security such as a stock or bond. The most common types of derivatives are futures – the obligation to buy a security at a future date at pre-agreed upon price – and options – the right to buy something at a future date at pre-agreed upon price.
In theory, the primary societal purpose of derivates is for businesses to hedge against “exogenous” risks. For example. Southwest Airlines is famously prudent about buying futures on oil to mitigate the effect of fluctuating oil prices on their core business.
In practice, most derivatives are bought and sold by speculators. One of the first speculators was a philosopher names Thales, who Aristotle described in his book Politics (Book 1, Part XI):
There is the anecdote of Thales the Milesian and his financial device, which involves a principle of universal application, but is attributed to him on account of his reputation for wisdom. He was reproached for his poverty, which was supposed to show that philosophy was of no use. According to the story, he knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year; so, having a little money, he gave deposits for the use of all the olive-presses in Chios and Miletus, which he hired at a low price because no one bid against him. When the harvest-time came, and many were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort.
Valuing options was a mystery until 1973 when the Black-Scholes model was invented. The main practical outcome of this model was the idea that the value of an option was determined mostly by the volatility of the underlying security.
One way to understand the important of volatility is to think of options as the opposite of insurance policies. Suppose you are selling insurance on houses in one region that is prone to catastropic events and another that isn’t. Rational insurers would price insurance policies higher in the catastrophe-prone areas.
Startups are inherently very volatile – their price can increase or decrease dramatically in short periods of time. Having an option on a startup is the economic opposite of selling insurance in a catastrophe-prone area.
The US tax system has some rules related to startup options. The first rule is that there is a special class of options called ISO options that can be granted to employees. ISO options are tax exempt until the options are exercised, which allows employees to receive them and not be liable for taxes until they actually realize cash gains. This rule only applies if the options are assigned a strike price equal to or greater than the “fair market value” of the company’s common shares. The fair market value is normally assessed by an outside valuation firm (a so-called 409A valuation) and usually ends up being significantly lower than the last round VC valuation (a rule of thumb for early-stage companies is the strike price will be approximately 20% of the last VC valuation).
When you are granted options in a startup there are a couple of important things to keep in mind:
1) You should know your percentage ownership of the company’s “fully diluted” outstanding shares (number of shares of the company including the option pool).
2) You should understand that if you leave the company, you normally have 90 days to “exercise” the options (purchase the shares you have the right to buy) before you forfeit your options. Normally the company has no obligation to inform you of this possible forfeiture, and in fact the standard practice is to hope the employee forgets and loses the options.
3) You should know the “preferences” on the company. The preferences normally equals the amount of money raised. If the company sells for near or less than that number the common shareholders, and hence the employees (who own options on common shares), will receive little or no money.
The strike price of the options is somewhat important but, if you study options theory, not nearly as important as the volatility of the underlying stock. Financially, what matters most is having a reasonable percentage of options in a company with lots of volatility (and hopefully a stock price that has an upward slope).