What is a Stock Option?

If you’re working at a startup or new to the tech scene, you’ll want to familiarize yourself with equity compensation. It’s common and often expected for tech companies to include equity in the form of company stock as part of an employee’s compensation package. This is especially true for early-stage startups that often grant equity in the form of employee stock options. Stock options are not as straightforward as a paycheck, but they have the potential of a big payday. To understand how, let’s get into the basics.

What is a Stock Option?

An employee stock option is a contract that gives an employee the right to buy a specific number of shares in the company they work for at a fixed price. Mainly, stock options provide the potential to share in the growth of your company’s value. Some of the rules that regulate stock options are imposed by tax and securities laws. Still, many variables in the ways options operate are at the discretion of the company to provide in the grant agreement, which employees will need to formally accept. 

To take full advantage of your stock option equity offering, you should familiarize yourself with your equity grant agreement before you make any decisions or take any action with your stock options. For starters, you’ll want to compare your grant agreement with any offer letters or employment agreements for inconsistencies or ambiguities. 

Generally, your grant agreement will have:

  • the grant date – the specific date the equity is granted to you.
  • The number of options granted.
  • the type of options granted – whether incentive stock options or non-qualified stock options.
  • The exercise price – the price you will pay to buy the options, also known as the strike price.
  • Vesting schedule – employees typically gain rights to their grant of equity incrementally over time.
  • The exercise window – options are only exercisable for a fixed period of time, which is typically 10 years if still employed. 
  • The expiration date – the date an option expires and can no longer be exercised.
  • The effect that termination of employment and a change in the control of the company have on vesting.

To put this all into perspective, imagine this: You are granted 2,000 stock options vesting over four years when the company’s share price is $10 per share. Your exercise price will be $10 per share. Under the vesting schedule, 25% of your options vests per year over the four years (500 options per year). If you stay employed with the company for all four years, all of the stock options become exercisable. Suppose the stock price has increased to $15 per share, the option contract gives you the right to buy the shares at the exercise price of $10. Note that options are only valuable if the price of the stock increases, creating a discount between the market price and your exercise price. If the stock price decreases, it’s best not to exercise them and let the options expire. 

Subsequently, the potential for personal financial gain directly aligns with the company’s stock-price performance. The intention is to motivate employees to work hard to improve corporate value. In other words, as the company succeeds, the employees succeed. 

Non-Qualified Stock Options

Companies can grant two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NQSOs) — NQSOs being the more common vehicle. The most significant difference between ISOs and NQSOs is in the tax treatment, hence the name non-qualified. For this reason, they can be granted to employees, contractors, and consultants. 

Once you exercise the NQSO, you will trigger taxable income. The difference between the exercise price and the market price of the stock, known as the discount or bargain element, will be taxable as W-2 income for the year the options were exercised. If the exercise price at the grant date is lower than the fair market value of the stock, the difference is taxable as W-2 income at the grant. 

Example: Your stock options have an exercise price of $8 per share when the fair market value is $8 per share. You exercise them when the price of your company stock is $15 per share. You have a $7 discount ($15 – $8) and thus $7 per share in ordinary income. If the fair market value of the shares were $10 at grant, you would have an additional $2 per share of ordinary income. 

Generally, when you exercise NQSOs, your employer will withhold taxes — income tax, Social Security, and Medicare — resulting in employees receiving fewer shares in order to pay the taxes. When you sell the shares, whether immediately or after holding onto them, the proceeds will be taxed according to capital gains rules. 

Incentive Stock Options

ISOs qualify for special tax treatment, which makes them favorable. However, they are bound by more rules, making them more complicated than NQSOs. For instance, they can only be granted to employees, and there is a limit of $100,000 on the grant value of ISOs in a given calendar year. If beyond the limit, the difference in value is treated as NQSOs. 

At neither the grant date or the exercise date are ISOs taxable. In fact, if an employee were to hold the shares for two years from the date of grant and one year from the date of exercise, they will only incur the favorable long term capital gains rate on all gains over the exercise price when the shares are sold. 

What’s so special about the long term capital gains rate, you ask? Rather than being taxed as ordinary income, which is your tax bracket for the current year, long term capital gains are taxed at a rate of 0%-20%. This favorable tax treatment presents a massive opportunity for tax savings.

The AMT Trap

Not so fast. Since when have you known Uncle Sam (no pun intended) to pass up some free lunch? Although the discount escaped taxation at exercise under regular taxes, they must be recognized under the Alternative Minimum Tax (AMT) rules. Without getting into the weeds of the AMT calculation, it’s important to note that AMT can present a tax planning issue if the AMT is applied to theoretical gains, but the company’s stock price then tanks, leaving you with a big tax bill on income that has evaporated.

Balancing all the issues involved in stock option taxation can be quite intricate. The first and most important step is to develop a financial plan that uses your stock options to advance your life goals. This prevents you from exercising too early and making hasty decisions based on your company’s stock price and short-term performance.

Deciding Between Salary and Equity

There was a pretty enlightening trend on Twitter a few days ago, where folks in tech were sharing and comparing their compensation. For me, it cemented the idea that compensation in the tech industry is highly situational. What an employer may offer in base salary, equity, bonuses, and other benefits, largely depend on the role being filled, and where the company and employee are located. There is no one size fits all. To say the least, company strategies for compensation can be far from simple. Considering this, most tech companies offer equity as part of the compensation package, but employees rarely understand the value or how it fits into their financial plan. If faced with the opportunity to negotiate a better offer, how do you decide between salary and equity?

Salary vs. Equity: What’s The Difference

The advantage of being paid a base salary is that its a fixed amount of income that you can expect and plan your future around. Alternatively, in the context of compensation and investment, equity represents ownership in the company in the form of stock. Generally, the return on equity is often linked to company growth and performance. The purpose of equity compensation from an employer’s perspective is threefold: to attract and retain talent, align incentives, and reduce cash spending. 

  • Attract and retain talent. When a company demonstrates or has good predictability to manifest financial success, employees are incentivized to work for the company in hopes of their equity being worth a substantial amount of money in the future. 
  • Align incentives. Startups are usually strapped for cash, but even companies that can afford to pay higher salaries may prefer to give employees equity. The idea is that employees will work harder to achieve financial success for the company and increase the future value of their equity. In this way, equity can align employee incentives with company interests. 
  • Reduce cash spending. By awarding equity, a company can often pay less in salary compensation to employees now, with the hope of rewarding them with equity later. The cash savings can then be allocated toward other investments or operating expenses.

Types of Equity Compensation

Both private and public companies offer equity compensation for myriad reasons. Equity compensation can be granted in many forms, each with unique characteristics, benefits, challenges, and importantly varying tax implications. These characteristics will impact your overall financial plan, so you’ll want to identify your specific equity compensation type to understand its benefits and potential challenges.

From my experience, most Pre-IPO startups offer equity in the form of incentive stock options and non-qualified stock options. On the other hand, most Post-IPO and mature companies grant equity in the form of Restricted Stock Units (RSUs) and Employee Stock Purchase Plans (ESPPs). Recently, I’ve seen a few companies offer cash as an alternative, RSUs, at-the-money stock options, and out-of-the-money stock options — and gives the employee the choice to select what best fits their needs. 

For instance, let’s say you have a low-risk tolerance, and you’re starting a family or planning a wedding, the cash alternative would likely be the best choice. But if you’re in a financial position to take on more risk, taking the RSUs or even a mix of RSUs and stock options is likely the best strategy. Though I haven’t seen it in many plans, it’s a fantastic opportunity to further align your equity with your financial plan, and I sure hope it becomes widely adopted.

With that said, if you’re deciding between salary and equity here are some things to keep in mind:

Can you maintain your lifestyle on a lower salary?

Although they’re not mutually exclusive, equity compensation often goes hand-in-hand with a below-market salary. It’s critical to know your minimum number. If you can reshuffle your priorities and costs, so your reduced salary doesn’t make a significant difference in your lifestyle and ultimately your goals, then you’ve mediated much of the pay cut. It’s worth noting that cutting down might be a bit more challenging to do if you live in a high-cost city like New York City or San Francisco, where living expenses can put a dent in your income. 

What does your four-year career plan look like?

Awards of equity compensation are almost always subject to a vesting schedule. Vesting simply means that an employee is required to wait a specific amount of time before gaining full rights to the shares in the equity grant. The most common vesting schedule I’ve seen is four years, on a monthly basis, with a one year cliff. In essence, this means that 25% of stock vests each year for the first four years of that employees’ time at the startup, in monthly or sometimes quarterly increments. Generally, if an employee resigns or is terminated immediately, they get no equity. If they stay for years, they’ll get most or all of it. In any event, be sure to keep your career plans in mind when deciding between salary and equity. 

How strongly do you believe in the company and its mission?

The main risk associated with equity compensation is that there is no guarantee that you’ll gain from your equity’s appreciation in value. Many variables can influence whether your equity stake will actually pay off. Is it worth it to sacrifice a portion of your salary for the potential at winning big in the future? You’ll have to put your VC hat on because the answer will come down to how optimistic you are in the company’s future. 

Negotiating Your Offer

Everyone wants to walk away from the negotiation table with the feeling like they’ve won. When deciding between salary and equity, the key is to win at the right things. After you’ve done your research, take some time to determine what matters to you.

For startups, cash is the most precious resource, and founders may welcome individual requests to trade salary for more equity. Assuming you are offered a market rate salary and equity, and your employer is willing to make some trade-offs, you will need a framework to help you judge how much equity makes sense.

Your strategy will depend on the stage of the company you plan to join.

For early-stage startups, you’ll want to find out the company’s current valuation as well as the amount of shares outstanding. If you divide the company’s valuation by the number of shares outstanding, you will derive at the price per share. You can then divide the amount of salary you’re willing to sacrifice by the price per share to determine the number of stock options you should receive.

For example, imagine you’re offered $100k to join a promising early-stage startup and choose to forgo $10,000 of your salary for more equity. Assuming the company can raise at a $5 million valuation and there are 1 million outstanding shares, the company can raise money at $5 per share, and you can receive 2,000 additional shares for your willingness to sacrifice $10,000 of your salary. 

For mid-stage Pre-IPO startups, the trade-off should be based on the number of shares an employee could purchase at the current stock option price. Let’s say an employee wanted to forgo $10,000 of salary for the opportunity to buy more shares, and the current option price was $2 — the company will likely advocate granting an additional 5,000 shares. 

As I mentioned beforehand, tax ramifications of equity can be far more complicated than salary earnings. Equity compensation can be quite convoluted — but with the appropriate resources and a viable strategy in place, you may be able to leverage your equity within your financial plan to meet your goals sooner than you know.

IPO, Direct Listing, and Your Employee Shares

These days startup companies are staying private longer as they are consistently raising more substantial amounts of capital through private funding. For the sustainable and enduring companies that choose alternative financing options, therein lies the public market. The public market, people like you and I, hold companies to a higher standard of accountability — for financial discipline, disclosure, meeting company goals, strategic direction, and even social responsibilities. While many companies choose to enter the public market through the traditional IPO process, some prefer the direct listing route. But what do IPOs and direct listings have to do with your employee shares? Everything.

Direct listings seem to be an emerging trend to enter the public markets as opposed to the traditional IPO process. If you haven’t heard the news as yet, Asana, a software startup focused on project management, is one of those few companies that opted for a direct listing. In doing so, Asana will be the 3rd recent company to choose this alternative route after Spotify and Slack.

As a startup employee with hopes of a successful exit, whether your company decides to do an IPO or direct listing makes a difference in your employee shares. Before we dive into the how, let’s first get into the basics of IPOs and direct listings and why they matter.

Initial Public Offerings (IPO)

When companies elect the IPO process, new shares are created, and there’s a ton that goes on behind the scene en route to the first trading day in the public market. For instance, in a traditional IPO, one or more investment banks serve as underwriters — financial experts who quarterback many aspects of the offering. Their role ranges from filing S-1 paperwork with the SEC to setting up roadshows, to garner interest from the investment community and raise capital. Believe it or not, but the investment banks also set the IPO price, buy shares from the company to sell to various institutional investors in their distribution network, who will then sell the shares to individual investors in the public market. In a sense, they provide a safeguard if the demand for the stock is weaker than expected.

Why do investment banks do all of this, you ask? Because they earn a percentage of how much the company raises from institutional investors during the IPO process. Go figure. Generally, on opening day, investors will keep an eye on the stock’s opening and closing price and compare it to the IPO price. Typically, it’s a good sign if the opening stock price is above the IPO price, but not too much higher as this could signal money left on the table due to a low IPO price target. In other words, the company could have sold the shares to investment banks at a higher price, resulting in raising more capital.

Direct Listings: An Alternative to IPO’s

As with most systems and industries, the legacy IPO process is also ripe for innovation. A direct listing is exactly as the name annotates: direct. Rather than creating new shares, employees and investors sell their existing shares directly to the public. Selling existing shares prevents the value of your employee shares from diluting when entering the public market. Unlike IPOs, direct listings have no intermediary underwriters or roadshows, and no setting a price range on the company’s stock — hence making the process faster and less costly. 

This cost-efficient advantage comes at a cost to you and your employee shares because there is no support or guarantee of the share sale and potentially minimizes the number of long-term investors. The availability of shares is dependent upon early investors, such as yourself, while the price is purely dependent upon public market demand. As a result, there could be market swings and more volatility associated with the stock price.  

The Lock-Up Period

Lastly, a significant impact of IPOs, direct listings, and your employee shares is in the lock-up period. In a traditional IPO, existing company shareholders agree to a period, usually 180 days from the date of the IPO pricing, where they are restricted from selling or hedging their shares. Although the SEC does not require lock-up periods, investment banks usually ask for this restriction because it allows for a set period for the company’s shares to trade and establishes a track record during the six-month window.  

The direct listing process does not have a lock-up period. Since no new shares are issued, transactions will only occur if existing shareholders are seeking liquidity and choose to sell some or all of their shares. 

The Demanding Public Markets

IPOs are unpredictable. Sometimes things work out the way we’d hoped and sometimes they don’t. As an investment advisor, I can tell you that the public markets will look for evidence of a strong, healthy, thriving startup — and superb growth and profitability are some of the best indicators of this.

It can be easy to become enthusiastic or even anxious about the possibility of your company successfully going through an IPO or direct listing. Not only may a successful entrance into the public market lead to increased liquidity for your employee shares, but an appreciation of the stock price might also lead to the generation of considerable wealth. The biggest mistakes I see made with equity compensation are getting caught up in the emotions of a liquidity event like an IPO or direct listing, and misunderstanding the technicalities to optimize stock decisions. 

You Are The YOU Expert

As much credit as I like to give myself for establishing a niche and becoming an expert on equity compensation, you are the YOU expert. If you manage to amass a significant amount of wealth from the equity in your employer’s company, what would you do? Better yet, how would that make you feel? Would you do anything differently with your time? You may not have the answers now, but the best part is that you don’t have to figure it out on your own. That’s where a trusted financial planner comes into play, someone you can be vulnerable with — who you can share your goals, dreams, and ideas with.

Because of the unpredictability of life and the complexity of financial markets, it is imperative to work with an advisor who will help you to achieve your financial and life goals. Financial life planning is less about returns on investments, as it is about your values, priorities, circumstances, and aspirations — and designing your unique version of independence. You see, building a foundation is all in the intrinsic details. Be that as it may, personal values will drive behavior and help guide the decisions that we make. So I ask, when you achieve the financial freedom you’re working so hard towards, what are you going to do with it?