Who Wants to be a Millionaire?!: Demystifying Employee Stock in Tech

So you’ve decided to work at a startup, and you’re still a little confused by all the different components of an offer. Not to worry! Let’s walk through the least understood part of startup offers: employee stock.

Getting equity in a company is an important part of tech startup culture. This is the main reason so many people are packing up and moving out west in this new “gold rush”. Many will trade a lower salary in return for a stake in a startup with the hopes it will become the next Facebook (only roughly the first 1,000 employees at Facebook became millionaires, by the way!). Stock options and restricted stock units (“RSUs”) are the two major forms of equity issued. For rank and file employees, stock options are the most common form of employee equity issued in early-stage startup companies.

What is a Stock Option?

Simply put, a stock option is the right, but not the obligation, to buy a fixed number of shares of stock at a specified price for a specific period of time. Options have an expiration date, you always need to know when they expire.

What is Restricted Stock?

RSUs (or Restricted Stock Units) are shares of Common Stock given to the hire and these stock units are usually subject to vesting (see below) and, often, other restrictions.

Exercising your stock options

Three times when you would likely exercise:

1. When the company experiences a “liquidity event” such as an acquisition or IPO (involuntary) OR
2. You sell the underlying common stock in a secondary sale (voluntary) OR
3. When you leave the company.

Note: There are probably two scenarios where early exercise makes sense:

1. Early in your tenure if you are a very early employee or
2. Once you have a very high degree of confidence your company is going to be a big success and you have some savings you are willing to risk.

Most companies offer you the opportunity to exercise your stock options early (i.e. before they are fully vested). The benefit to exercising your options early is that you start the clock on qualifying for long-term capital gains treatment earlier. The risk is that your company doesn’t succeed and you are never able to sell your stock despite having invested the money to exercise your options.

You will owe no taxes at the time of exercise if you exercise your stock options when their fair market value is equal to their exercise price and you file a form 83(b) election on time. Any future appreciation will be taxed at long-term capital gains rates if you hold your stock for more than one year post exercise and two years post date-of-grant before selling. If you sell in less than one year then you will be taxed at ordinary income rates.

Vesting

Your options must be vested before you exercise them. Vesting usually happens over a four year term (i.e. 25% on one year grant date anniversary, monthly vesting for the next 36 months), and they usually “cliff vest” the first year (i.e. you get nothing if you leave the company before 1 year is up).

Now that we’ve gone over some basic terms concerning employee stock in the startup world, let’s answer 5 frequently asked questions.

1. How Does a Stock Option Work?

A stock option gives the recipient the right to acquire company common stock at a set exercise price established at the time of grant of the option. If the option is granted early in the life cycle of the company, it will likely be at a favorably low exercise price.

A typical grant is as follows: Ben Smith receives options to acquire 10,000 shares in Company ABC at 10 cents per share. The options are earned or “vest” over a 4-year period if Ben continues to be employed by Company X. He has a cliff vesting of one year (meaning he has to be at the company at least one year before any of his options vest, and at the end of that one-year period, he has vested a quarter of her options).

If Ben stays at Company ABC for the full 4 years, he has the right to exercise all of his 10,000 options at the exercise price. The exercise price is set at the time of the grant of the option at its then fair market value. If he wants to exercise his options, he then has to pay the exercise price times the number of shares (10 cents times 40,000, or $4000).  Hopefully, when he exercises his options for 10 cents a share, the value of the shares has gone up significantly.

2. How Many Options Should I Get as a New Employee?

There is no guideline for this as it is always negotiable. A company may have its own internal guidelines by position within the company. What is most important is not the number of options, but what the number represents as a percentage of the fully diluted number of shares outstanding.

For example, if you are awarded 100,000 options, but there are 100 million shares outstanding, that only represents 1/10 of 1% of the company. But if you are awarded 100,000 options and there are only 1 million shares outstanding, then that represents 10% of the company.

3. What Taxes Do I Have to Pay for Stock Options?

There are two types of stock options under the tax code: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). Most employees typically receive the more tax advantaged ISOs. The tax treatment for ISOs is as follows:

• There is no taxable event at the time of the grant of the option.
• There is generally no taxable event at the time of the exercise of the option.
• At the time of the exercise of the option, the spread between the exercise price and the value of the stock will be taken into account for determining whether additional tax is owed under the alternative minimum tax rules.
• At the time the stock acquired from the exercise of the options is sold, that will be a taxable event. If the stock has been held both for more than two years from the date of grant of an ISO and more than a year from the date of exercise, all of the gain will be taxed at the more favorable capital gains rate; otherwise, all of a portion of the gain will be taxed at the ordinary income tax rate.

(Note: NSOs have less favorable tax treatment, and the spread between the exercise price and the value of the stock at the time of exercise will be taxed then at ordinary income rates.)

4. Are There Any Downsides to Stock Options?

The key downsides of stock options are:

• You typically have to pay cash to exercise the options.
• At the time you exercise the option, you may incur a tax depending on your particular alternative minimum tax situation or the type of options you hold.
• When you exercise the stock options, you will receive stock that will not be easily saleable if the company is still privately held or is subject to substantial transfer restrictions.
• The value of the stock could go below the exercise price you have paid for the stock, which is why many option holders wait until a liquidity event to exercise options.

5. How Long Do I Have to Exercise a Stock Option?

The stock option agreement and stock option plan lays out the time periods for when an option has to be exercised. Typically, as long as you remain an employee, you will have 5 to 10 years to exercise the vested portion of the option. But if you are no longer employed by the company, you typically only then have 30-90 days after termination to exercise the vested portion of your option (determined as of the termination date of your employment).