The tech bubble in the late 1990s helped us all learn a lot of things about startups, both exciting and stressful. People who were successful made millions and billions but yes there were people who lost a lot of money as well. History teaches us many things and its impressive on how much perspectives you can get just looking back and learning so much from time.
The Silicon Valley boom still exists and a lot of people are excited about startups and doing great things. An attractive way for startups to get talent has been to offer a piece of the pie. Hence the idea is to take on a larger risk for a larger return. The conventional way of providing a piece of the pie (a percentage share in the company) has been through Options. Its a phenomenal idea, since it gives a person the right, but not the obligation to buy or sell a stock at a price. To give you an example, Company X may offer me 100 options at $1. Now I have the right to sell them if I want or just let them expire away. Let's say if the price of those options goes to $2, then by exercising these options I have the right to make the difference $2-$1= $1 which is still a 100% gain for just an offer that I was given. Again, I not obligated to execute on it, let's say if the price went down to $0.50.
Startups commonly provide these options to their employees to have a share of the return or the risk. These options usually have vesting schedules. So lets say you are granted 1000 options that vest in four years, it could be broken down to the first 25% that you receive at your one year cliff and the rest 75% could be equally distributed monthly going forward for the next 3 years.
Now when you receive your grant, you could get a deal like 1000 options at $1 as a exercise/strike price. This basically means you have an option to buy 1000 stocks in the company at $1 by paying money for it or using the cashless option if the value went higher so that you can pocket the difference. Another important point which a lot of people do not read through on the contract is when does their options expire. It is one of the first things you should look for, because if they expire then the contract technically is no longer valid and you really have nothing. Options could be provided an expiration of anywhere from 5 - 10 years. Please make sure you read the fine print!
When companies are private you could exercise your options once they vest by putting in $1000 out of pocket, but its not very lucrative for people as who knows what that 1000 stocks now would result in. Again, you were provided an option to buy and you exercised it and hence you have 1000 stocks. If the company is private, it might not mean a lot for you since trading would be hard due to lack of liquidity as its not a public market.
The way I have seen people more commonly use it, is hold on to the options before companies go public on the stock exchange which is also referred to as an Initial Public Offering (IPO). Now what happens is lets say if you work at an exciting company and the company goes public on the stock exchange at $2 a share, given that you have an option to buy shares at $1, there is already a 100% return on your money. So what people then end up doing is they exercise their options and make the difference.
There are two most common type of options that are offered - Non-Qualified Stock Options (NSO) and Qualified Incentive Stock Options (ISO). ISOs are mainly offered to employees whereas NSOs are offered mainly for consultant and advisor roles. The other reason is how the taxation works for these. I won't get into the specific details with regards to taxes as I would rather recommend discussing this with a tax advisor when in this situation.
An important point that I mentioned above was expiration, the terms of expiration could change depending on the situation and hence you must look through the contract very carefully. Very commonly, the options could expire in roughly 3 months of your termination. They could potentially expire in a different timeline on a death or a disability event and hence knowing what the rules of the game are is very important. If you miss out exercising those options, you essentially lose on that contract and hence potentially the money that you could have earned out of it.
In the instance of a private company, you could exercise your options prior to exit if you believe its a good investment as you would need to pool in that cash to exercise your right. When the company is public and you have options, the decision becomes a little easier if lets say the price of the option is lower than what the company is trading at, because then you can just pocket the difference and leave. With the private company, since you can't really sell the stocks, you might have to just wait more longer to when the company goes public.
I will wrap this up with the famous quote from Mr. Jobs - "Stay Hungry Stay Foolish". There is so much to learn about these markets and the various investment vehicles that its incredible to see how you can make your money work for you!
(Disclosure: Please review the Disclaimer section prior to any investments.)