How to determine the worth of stock option?

Say I was given an incentive stock option for X number of shares at an exercise price of Y per share. The shares vest over 4 years. How do you determine the worth of this stock option?

A) What is the significance of the number of shares offered? I assume the proportion of my shares compared to the total number of shares is important. Will the CEO tell me how many number of shares other employees are getting or is that as taboo as speaking of salaries?

B) What the significance of the exercise price per share? I assume the difference between the exercise price and the initial public selling price will determine it's worth. How can one possibly predict the initial selling price?

The bottom line is I want to figure out if I can get rich off of this stock option or if I'm getting jipped.

First, IANAL.

Second, I'm going to assume you're talking about Pre-IPO shares here.

In most pre-IPO stock option grants your strike price (the fixed contracted value for which you can purchase the shares at) is usually close enough to zero that it is a rounding error in the overall computations.

Number of shares is completely insignificant, especially at this stage.

The two main things you want to find out (and any upstanding company would share with you) are:
1) What your shares represent as a percentage of the overall stock pool
2) What preferences the investors have in an equity event (sale, IPO, etc.).

Keep in mind too that these things are likely to change with every investment round. So while A-round shares are going to have a lower strike price (typically) and possibly a larger allocation than C-round shares, the C-round terms might be less volatile in regards to what they'll REALLY look like at the end.

Your options will probably come out to be somewhere between .01% and 2% of the overall stock pool. This is common for lower-level employees (and I'm only assuming you're lower-level and new to this based on your question, as most people have learned these deals the hard way by the time they've gotten to more advanced startup positions).

To be generous, let's assume your options are equal to 1% of the company. You would have been granted these options when the company might be deemed to have a value of 10 million dollars (note: you don't have anything that remotely resembles 1% of $10M in value. You have a right to purchase 1% of $10M).

Over time the company grows to be worth $500M. Your options grant you a fixed strike price at the $10M valuation, and now the company has grown in value by $490M. This seems like a good thing at first...

Your investors will almost always have what are referred to as preferred shares, and as their name implies they are going to get special treatment before your "common" shares. The investors might also have liquidation preferences. There is no "standard" here because literally everything can and does happen.

A not-atypical scenario though is that the investors have some terms that give them rights in a sale to get back their initial investment, plus some sort of interest, plus maybe a preferred payout of 2x-10x their investment.

Between the $10M and $500M valuation there was another $30M put into the company, making a $40M investment total. The investors have 3x liquidation rights, meaning that the first $120M of a sale is "theirs", then they have their preferred stock as well.

It's not uncommon to see a situation where a company sells for what seems like a HUGE number, but literally 70 or 90% of that sale amount goes to the investors/preferred share holders, and then the remainder goes to the common share holders in equal proportion.

So, what are your options worth? Who knows... Probably nothing at all unless the company is hugely successful and manages to establish itself as a true player in its industry. Anything less than total success is unlikely to yield an amount to common share holders that is worth anything significant overall.

My advice: options are nice. You're probably getting screwed, but shouldn't be working for the value of the options anyway. Work for a fair salary, consider the options a potential bonus if all the stars align. Anyone trying to tell you different, is lying to themselves or to you.

The real answer is that nobody knows and you have to accept the options, or not, as a matter of faith. For me, I'd consider options to be a potential bonus one day, and nothing like money in the bank.

Even for established forms employees can get burned on options, and with a startup it is even harder to know what'll happen. For example, a NASDAQ-listed firm I did business with years ago gave options to their employees instead of pay rises or bonuses. The stock was doing well at $25 and many people expected it to go to at least $50, so the options at $35 seemed great. One guy even started talking about how his options were going to pay off his mortgage. Of course, the market collapsed and the stock never made it to $35, so the options were all worthless.

Well the valuation of a stock option is fairly simple (i am assuming that your stock option is an employee one) Lets say that your stock option gives you the power to buy the company's share worth $10. However, the market price of the stock is $20. Then your stock option is worth $10. However the complication lies in the expiry date of the option where you have to consider what the value of the stock might be at the expiration date.Check out
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The number of shares by itself is meaningless -- it's just an arbitrary number. What you need to know is the percentage of the total number of shares that your options represent. Similarly, the exercise price per share means nothing, but the implied value of the company (exercise price x total number of shares issued) is meaningful.

You can predict the future valuation of the company by making some guesses about its future earnings, and the price/earnings ratio that it's likely to hit when it floats.