Stock Options: Mechanics, Valuation, and Dilution

A stock option grant is a contract giving the recipient the right, but not the obligation, to purchase a specified number of shares at a fixed strike price after satisfying a vesting schedule. Typically, options vest over a four-year period with a one-year cliff (meaning the first 25% vests on the first anniversary, with the remaining 75% vesting monthly over the next 36 months).

Startups hand out options freely, and a large share of them are never turned into stock. Carta’s data on its own cap tables shows more than half of entry-level employees leaving in-the-money options unexercised, and an found roughly a quarter of startup employees saying they simply cannot afford the exercise cost. The reasons are the same three every time: cash you do not have to pay the strike, a tax bill on top of it, and no market to sell into if the company never exits. An option is not compensation until you can fund it.

Before you value a grant at all, get the denominator. A grant of 1,000 options is meaningless on its own: in a startup with 100,000 shares outstanding it is a 1% stake, and in one with 10,000,000 shares it is 0.01% — the same grant letter, a hundredfold difference in what you own. Then assume that percentage shrinks, because it will: every financing round and every expansion of the option pool dilutes you, and nobody sends a notice.

In a private company the fair market value that sets your strike price comes from an independent appraisal under IRC §409A, not the headline valuation in the funding announcement; in a public company it is simply the market price. The gap between those two numbers is the part nobody explains at the offer stage. You receive common stock. Venture investors receive preferred stock, which carries a liquidation preference — the contractual right to be paid back first out of any sale — and often a dividend ahead of yours. Your common shares are what is left after the preferred stack is satisfied, which is why a company can sell for a headline number that sounds like a success and pay common holders nothing at all.