Negotiating your offer at a startup

Pay me in equity

When a startup offers any form of equity as part of its compensation package, there is a new set of factors for you to consider as a Millennial in tech. Before accepting any offer, you’ll want to negotiate the terms firmly and fairly. After all, if you’re planning to commit your time to any startup, do yourself a favor and make sure you put the highest valuation on yourself. It’s pretty natural to be anxious about negotiations, whether you’re going through this process for the first time or the tenth. Quite frankly, there’s a lot at stake, and it can be uncomfortable and stressful to ask for things you want or need. Unfortunately, too many young professionals I’ve come across think negotiating could get the job offer revoked, so they’ll accept the offer with little to no discussion. All in all, because startups are leaner than many mature companies, and because they may grow quickly, additional considerations are in your best interest when negotiating a job offer from a startup.

The trade-off: salary vs. equity

From my experience, salaries at startups are often a bit below the market rate compared to an established tech company. It’s common for companies to have flexibility during negotiations, letting you decide whether you prefer a higher salary or more equity. When choosing between the two, it’s important to understand how they differ in the short-term and how they may pay off in the long run. The advantage of cash compensation is simple. You know precisely what you’re getting. It’s a fixed dollar amount that you can count on and plan your life around. Conversely, equity is a bit trickier. For very early-stage startups, the risk is higher, offers vary vastly, and variation among companies will be more significant, particularly when it comes to equity. While you have the potential for a substantial payout if the company succeeds, the main risk inherent with equity compensation is that it’s not guaranteed that you’ll gain from your equity’s appreciation. There are plenty of variables determining whether your equity will pay off in the long run, most of which are not in your control. Nonetheless, choosing between cash and equity is a personal decision based on your unique cash flow needs, belief in the company’s management, career goals, etc.

What happens when a change in control occurs?

Since startup employees earn, or vest, their equity over time, a company may be acquired before employees are fully vested. How a company treats unvested shares when an acquisition occurs affects the risk calculation of joining that particular startup. In other words, your right to earn 100% of the shares gives the equity offer a higher potential upside than the right to earn only a portion of the shares promised to you.

Double Trigger Acceleration

Early-stage employees can negotiate special vesting schedules to protect themselves from losing unvested shares in the event of an acquisition. With Double Trigger Acceleration rights, any unvested equity will immediately vest if an employee is terminated after an acquisition. It’s called a Double Trigger Acceleration because vesting occurs immediately when two triggers have occurred — first, the acquisition and, second, the termination. One rationale for negotiating double trigger accelerations is based on hedging risk. Think about it like this, if you’re taking a significant risk to join a startup, such as sacrificing cash or other compensation for the equity, it’s wise to negotiate for Double Trigger Acceleration to protect your upside if the equity becomes valuable. Another key rationale for this negotiating term is based on aligning incentives. If employees could lose valuable unvested equity by achieving a prompt acquisition, their incentives would not be aligned with the company’s goals. For these reasons, Double Trigger Acceleration rights bring your incentives in alignment with the company’s goals, and often work in your favor.

Single Trigger Acceleration

As the name suggests, Single Trigger Acceleration rights allow for immediate vesting once an acquisition occurs. From my experience, companies can be apprehensive about negotiating for these terms. Their argument is the company might be perceived as an unappealing acquisition target if their talent isn’t incentivized to stay. This is especially the case for technical talent like designers and engineers. On the other hand, the key argument for Single Trigger Accelerations is based on the need, or lack of need, for the employee’s role after an acquisition. For instance, I’ve worked with a VP of People who negotiated for a Single Trigger Acceleration because she was hired with the express purpose of improving the company’s culture and growing the startup to achieve an acquisition. Negotiating the terms in your offer can get a bit tricky. Depending on the startup stage, acceleration terms may or may not be on the table in equity offer negotiations. Be that as it may, the availability of acceleration protection is a factor in assessing the risk of joining a startup. Without these protections, it may be beneficial to negotiate for a higher cash salary or more shares to balance the additional risk.

What happens when you’re fully vested?

The tech industry is known for using refresher grants to incentivize employees to stay longer with the company. Essentially, a refresher grant is an incremental grant of additional shares of the company to an employee who has already received an initial equity grant. Quite a few startups will offer equity compensation over a four year vesting period. That being the case, refresher grants come in handy when the company’s goal is to retain all-stars. The new grant will have a new vesting schedule, so you will continue to have an equity-based financial incentive to work in addition to your salary and benefits. In fact, it’s common for companies to use refresher grants on an annual basis, or to top off the equity grants for employees who have shown exceptional performance, or loyalty, or received raises and promotions.

Is company leadership transparent?

Not all startups are created equally. It’s important to ask questions when you get an offer that includes any aspect of equity. In addition to understanding the facts and nuances about the equity offer, the process of discussing the details can help you get a sense of the company’s transparency and responsiveness. Startups are understandably meticulous about sharing financial information, so you may not get full answers to all of your questions. Still, you should at least ask questions related to the 409A valuation, percentage of ownership, vesting, business goals, etc. Here are some questions you should consider asking when evaluating and negotiating your offer at a startup:
  • What percentage of the company do your shares represent?
  • What is the most recent 409A valuation? When was it done, and will it be done again soon?
  • Do you allow early exercise of my options?
  • Am I required to exercise my options within 90 days after I leave or am terminated? Does the company extend the post-termination exercise window of the options of employees that depart?
  • Is there any acceleration of my vesting if the company is acquired? (discussed above)
  • Does the company have any repurchase rights to vested shares?
 

Restricted Stock Units Explained

When tech companies grant employees equity compensation, it is usually in the form of stock options or restricted stock units (RSUs). Although there are pioneers like Spotify, employees generally won’t get the opportunity to choose their preferred equity type. Rather, the equity-type and amount you receive will depend on your role, the size, and stage of your company. Restricted Stock Units (RSUs) are relatively new when compared to their stock option counterpart. They have become a popular means of awarding company equity to employees not just by tech startups but also by much larger and more established public companies. Regardless if you’re an employee at a startup or a blue-chip tech company, you’ll benefit from restricted stock units explained. 

Restricted Stock Units Explained

RSUs holds no value when they are granted to you. They are only a company’s promise to give you shares of the company’s stock or the cash value of the company’s stock on a future date if certain restrictions are met. Unlike stock options, RSUs always have some value to you at the vesting date. Unless, one way or another, the stock price drops to $0. Nonetheless, the key benefit is that RSUs are always worth something and should always result in some form of income for you, even if the stock price drops below the grant date’s price.

For example, your company grants you 125 RSUs. When the shares are delivered to you, the company’s stock price was $150 per share. The value of the grant is then worth $18,750 (125 x $150). If the stock price is $120 when they are delivered to you, the grant value would be worth $15,000. Accordingly, it does not matter what the stock price was on the grant date or any other date except the date of delivery. 

How are RSUs restricted?

In order to receive your RSUs, certain restrictions must be met. For most public tech companies, these restrictions are usually time-based and tied to employment. In other words, you must stay at the company for a certain amount of time to receive your promised RSUs. This time-based restriction is known as a vesting schedule. Graded vesting can occur in increments over the course of the vesting schedule. For instance, new shares can be delivered annually or each month. Alternatively, all the shares can be delivered at once in what is known as cliff vesting. 

How are RSUs taxed?

With RSUs, you are generally subject to ordinary income taxes on their market value when the shares vest and become yours outright. However, there are specialized RSU plans that may allow you to defer the delivery of your shares, giving you more control of ordinary income taxation. In any case, your company may offer you a few ways to elect to pay taxes due at vesting. Some options include deductions from your salary or payment by check. However, the most common is selling a portion of your vested shares and using the proceeds to cover tax liabilities. At that point, you can choose to either hold the remaining shares in your portfolio or sell them right away. 

Why would I sell my RSUs right away?

 When considering whether to sell your RSUs, it’s best to think about:

  • How much you’ll be taxed
  • Your cash flow needs
  • How you think the stock will perform in the future
  • How diverse you want your portfolio to be

When you sell your shares, you may be subject to capital gains tax on any appreciation over the stock price on the vesting date. In other words, capital gains is the difference between the stock price when the shares vests and when they are sold. The length of time you hold the shares usually determines whether you will pay short-term or the more favorable long-term capital gains tax. Keep in mind, if you sell the shares immediately after vesting, you likely won’t experience any gains and may not be hit with the additional capital gains tax. 

Although it is important, taxes shouldn’t be the determining factor when considering selling your shares. There are also concentration risks inherent when dealing with RSUs and other types of equity compensation. Any concentrated stock holding is risky. Still, when it’s your own company’s stock, you are exposed to an escalated level of risk if the company falls on hard times, especially during an economic downturn. 

Like everything else financially related, decisions around equity compensation shouldn’t be made in isolation. They should align with your overall financial plan. 

Selling Company Stock To Raise Cash

 Believe it or not, selling stocks require a strategy that is just as important and detailed as buying them. There are a few scenarios where selling your company stock to raise cash makes sense. It generally has little to do with market activity and a lot to do with your personal circumstances as a Millennial in tech.

As history proves, successful investing isn’t a matter of timing the market. It’s more about responding to changes in your life and your portfolio. For reasons beyond your control, you may find yourself in a position where you suddenly need to come up with cash. In an ideal world, you would have a cash reserve in a high yield savings account to meet urgent or unexpected expenses. 

Alternatively, the proceeds from selling shares of your company’s stock, acquired through equity compensation, can be a useful source of income as well. However, you must proceed with caution when selling company stock to raise cash.

If you’re considering selling your company shares, there are a few concepts and tax consequences you must know. To guide your decision making around this topic, I’ve put together some main points you should consider. 

Identify the best shares to sell

When you hold company shares you’ve received at varying prices and moments in time, it’s advantageous to clearly identify which shares are best to sell. This strategy is an investment accounting approach known as Specific Share Identification, where an investor’s objective is to optimize their tax treatment when selling company stock to raise cash. 

For instance, let’s say you’re awarded RSUs, and receive 1,000 shares that will vest over four years. Each year, the price per share, also known as your cost basis, is increased by $5. In this scenario, you’ll receive 250 shares at $10 per share in year one. In year two, you’ll receive 250 more shares for $15 per share. In years three and four, you’ll receive 250 shares, but at $20 and $25 per share, respectively.

As you can see, these shares will vest at different prices, and if you decide to hold them rather than selling immediately, they will have different holding periods. If an employee were to sell a portion of their company stock to raise cash, there would be different tax implications for each group of shares. Considering this, make sure to get clarification on how to indicate specific shares to sell through your brokerage firm (E-Trade, Vanguard, Fidelity, etc.).

Understand capital gains taxation

Capital gains are profits from the sale of a capital asset, such as shares of company stock. Notably, when you sell company stock, you will generate a capital gain or capital loss. The calculation is simple — it is the difference between the sales price and your cost basis. Once you’ve decided to sell your company stock to raise cash, the challenge becomes minimizing taxes on the income received. 

If you hold company stock for more than one year after exercising stock options, purchasing shares through an ESPP, or vesting of RSUs, it will qualify for long-term capital gains rates. If you hold the shares for less than a year, it will result in short-term capital gains rates.

The difference between the two is relatively simple. Short term rates are taxed as ordinary income, as high as 37%, while long term rates are capped at 20%. Because of this favorable tax treatment, you are incentivized to sell shares that will result in long-term capital gains as opposed to the alternative.

Know your holding period for ISOs and ESPPs

Capital gains taxation especially plays a role when dealing with ISOs and ESPPs. Holding company stock purchased in an ESPP for more than two years from the enrollment date and one year from the purchase date will lead to favorable tax treatment on the sale. In a like manner, holding shares exercised via ISOs for more than two years from the grant date and one year from the exercise date will lead to lower tax rates. 

On the other hand, selling the shares too quickly will result in a disqualifying disposition and will have different consequences for ESPPs and ISOs. To drive my initial point home further, this is another reason to carefully identify the shares you want to sell. 

Watch out for wash sales

A wash sale occurs when you sell a stock for a loss, and you also purchase a substantially identical stock within 30 days before or after the sale. You might be thinking, “why would I ever sell my stock for a loss?” Without getting into the weeds of tax planning, the IRS allows you to use capital losses to offset capital gains, resulting in a lower capital gains tax. In the investment world, this is called tax-lost harvesting.

Under wash sale rules, the loss and holding period are carried over to the new replacement shares. For example, let’s say you sold shares of company stock for a loss. Any RSU vesting, ESPP purchases, or option exercises can trigger the wash sale rules if they occur within 30 days of the sale. That is to say, your cost basis from the shares that were sold will be added to the cost basis of the new shares, resulting in a higher cost basis. 

Know your company’s post-termination rules for stock options 

For the most part, employees typically have 90 days to make a decision and exercise their vested stock options when they leave a company. If you can’t get together the necessary cash and plan for the tax implications for the exercise, you’re likely out of luck. All those vested stock options representing years of hard work will expire, and be rendered useless.

Some companies view this is as a serious burden that many Millennials in the startup world face when they leave a company. Thankfully, there are leaders like Pinterest, Coinbase, and Asana, who have extended post-termination exercise (PTE) windows that reflect their culture and gratitude to employees. 

P.s. I found a list of over 150 companies, all of which have extended PTE windows far more than the standard 90 days. I’ve only shared it in my weekly newsletter with The Equity Shop community 😜

Get with the program!

Types of Employee Equity Compensation Plans

The various ways equity can be granted to employees as compensation are notoriously complex. Please don’t take it lightly when I say it takes some know-how to develop a pragmatic approach to managing equity compensation. For starters, there are a few common types of employee equity compensation plans: stock options, restricted stock and restricted stock units (RSUs), and employee stock purchase plans. Each type of equity compensation vehicle has unique characteristics. With this in mind, it’s essential to identify your equity compensation type so you can understand the potential challenges and take advantage of the benefits. 

You must know the rules before you play the game. Understanding the structure of equity compensation does not guarantee you a fortune. Still, it will help you make better decisions for your personal life, and avoid some common and costly mistakes. So let’s jump right into it. 

Employee Stock Purchase Plans (ESPPs)

Some people may argue that ESPPs are a more attractive benefit than stock options. It’s me. I’m some people. I’ll be honest, of all the types of employee equity compensation, ESPPs are my favorite. Why? Because it allows you to purchase company stock easily and on favorable terms. Particularly, ESPPs enables employees to buy company stock at a discount from the market price. The most significant discount the IRS allows is 15%. That doesn’t beat Saks 5th Ave discount I had back in the day, but hey, it’s definitely something worth talking about. 

Anyway, so you can better understand the features of ESPPs, let’s dive into their life cycle: 

  • Offering period – the period during which your rights to purchase company stock are available. You will need to establish your after-tax payroll contributions to participate.
  • Offering date – the first day of the offering period, and usually follows the enrollment deadline. For tax purposes, this is the date of the grant. It will determine how long you held onto the stock before selling. It’s also called your holding period. 
  • Purchase period – generally, when an offering period is longer than six months, there will be interim purchase periods within an offering period. For example, a 12 month offering period can have two 6 month purchase periods.
  • Purchase date – your accumulated payroll contributions will buy shares of company stock at the discount price at the end of the purchase period.
  • Lookback feature – allows flexibility in the purchase price.

How It Works

Let’s say you have $1,000 deducted from your paychecks to invest at the end of every purchase period. The price at the beginning of the period was $10 and increased to $15 by the purchase date. Because of the lookback feature, your purchase price will be the 15% discount from the market price at either the beginning or the end of the purchase period — whichever is less. In theory, employees could buy and sell company stock at a built-in profit of at least 17.6%. Talk about easy money 🤑

The icing on the cake: If you hold on to your shares for two years from the grant date and one year purchase date before selling, it is known as a qualifying disposition, and a portion of your gains will be taxed at the favorable long-term capital gains rate. 

Restricted Stock and Restricted Stock Units (RSUs)

Restricted and RSUs represent minimal market risks, relatively speaking. Unlike stock options, which can lose all practical value, restricted stock and RSUs are always worth something, even if the stock price drops dramatically. The stock is “restricted” because it is usually subject to a vesting schedule, which is based on length of employment or performance goals. While the vesting rules are similar for RSUs, no actual stock is granted. RSUs are simply a promise to issue a specific number of shares when employees meet vesting requirements.

With restricted stock and RSUs, employees are taxed at the time the shares vest and become yours wholly. The market value of your shares will be taxable income. Subsequently, your company will likely withhold taxes at vesting. They generally elect to do so by holding onto some shares to cover the taxes. Some companies also have the flexibility to withhold taxes using salary deductions or payment by check.

Section 83(b) Election

Alternatively, the 83(b) election permits employees to pay taxes at grant, rather than at vesting. This is especially beneficial if you have good reason to believe that the stock price will be significantly higher on the vesting date than it is on the grant date. If the price at vesting is higher, the taxes you pay on the lower grant price through the 83(b) election will be less than the taxes you would have paid at vesting.

One caveat: The 83(b) election can only be used with restricted stock, not RSUs.

Employee Stock Options

A popular type of employee equity compensation plans among Silicon Valley and startups is stock options. Fundamentally, a stock option is a contractual agreement that gives employees the right to purchase a stated number of shares of the company at a fixed price. Typically, it’s required for employees to work at the company for a specified length of time before you are allowed to exercise your right to buy any of the stock options. This is known as the vesting period. Any employee who terminates employment will forfeit all unvested stock options. 

Beware: employee stock options will expire if they are not exercised. 

Employees usually have ten years from the grant date to exercise stock options, if still employed with the company. Since the purchase price is often the company’s stock price on the grant date, stock options become valuable only if the stock price increases. Ultimately, this creates a discount between the market price and your lower exercise or purchase price. Nonetheless, any value in stock options is entirely theoretical until you exercise them. This is what people mean when they say you’re only rich on paper. 

And this folks, is your introduction to the most common types of employee equity compensation plans.

P.S. If you find these blog posts helpful, subscribe to our weekly newsletter, The Equity Shop, where we’ll keep you in-the-know about all things personal finance and equity compensation.

The Impact of Stock Options on Cash Flow

Turning stock option contracts into real money takes some know-how. I’ll be the first to admit, managing your stock options involves a long list of financial goals, opportunities, and even constraints. Be that as it may, understanding how the fundamentals of stock options mesh with other aspects of financial planning is paramount to achieving your goals. I’ve written about the basics of stock options, including the ins and outs of taxation — but for this post, I want to highlight the not-so-apparent impact of stock options on cash flow. 

Stock Options Are An Expense

As you might recall, stock options have the potential to be a wealth-building tool due to the growth of the underlying company stock. This ongoing buildup of equity proves to be a viable resource to meet both short and long term financial goals. On the other hand, stock options don’t come without a price. When you exercise the right to buy your employee stock options, you must pay the exercise price via a cash exercise or cashless exercise. 

Knowing your options may seem easy in theory, but evaluating which strategy to employ significantly depend on your unique circumstances. Not only can the math behind the scenes of a cash or cashless exercise get tricky, but the decision to exercise stock options also have an impact on cash flow, and how many shares you will own after the exercise is complete. 

As Millennials, a considerable portion of your net worth is likely associated with your equity compensation, so you owe it to yourself to assess and act on the strategy that yields the most value as it pertains to your goals. 

Option 1: Cash Exercise

If your goal is to own as many shares as possible, a cash exercise may be the best choice. Compared to a cashless exercise, a cash exercise is quite simple:

  1. You purchase shares of company stock using the agreed-upon exercise price per share. 
  2. The total price you pay is the exercise price per share multiplied by the number of shares you want to exercise. 
  3. Send your company or your custodian (the financial institution where your stock is held) the cash amount equal to the total price of the options exercised. It is also common to write a check.

Considering this process, a cash exercise is an out-of-pocket cost, where funds will need to be readily available. Depending on the number of options exercised and the exercise price, you can end up with out-of-pocket costs into the hundreds of thousands of dollars. Needless to say, financial planning is critical here.

Unfortunately, many startup employees may not have that type of cash laying around, making the cash exercise somewhat obsolete. In turn, this often causes employees to be priced out of the stock options, electing for a cashless exercise. And if you need me to say it, yes, it’s a bad idea to take out loans to cover the costs of the shares. 

If you’re lucky and forward-thinking, you’ll likely take the initiative to devise a plan to accumulate the amount of cash needed to exercise your stock options.

Here are some things to know before you perform a cash exercise:

  • A cash exercise maximizes the number of shares you will own after the transaction, thus effecting your portfolio. 
  • The shares you own may lead to a more concentration position.
  • A cash exercise requires liquidity for the up-front cost of shares.
  • If you have ISOs, a cash exercise may trigger the Alternative Minimum Tax.

Option 2: Cashless Exercise

A cashless exercise is frequently the default option if you don’t have the actual funds to pay for the shares. Primarily, with this alternative, you are exercising and selling the shares simultaneously. In doing so, you are covering the costs of exercising the shares with the proceeds of the sale. 

Here are some focal points of a cashless exercise:

  1. You purchase shares of company stock using the agreed-upon exercise price per share. 
  2. The total price you pay is the exercise price per share multiplied by the number of shares you wish to exercise. 
  3. Instead of paying in cash, you’ll immediately exercise and sell some of your shares. You’ll also exercise and hold some of your shares.
  4. The amount you exercise and sell will depend on the total cost to exercise the shares.

Under these circumstances, you can design cashless exercises to cover the costs of purchasing the shares, the tax liability you incur when exercising the shares, or both. 

Develop a Plan

Planning strategies for stock compensation begin with a “financial plan first” mindset. Always keep in mind that your stock option strategy must integrate with every other part of your financial picture, specifically your cash flow, investing plan, and tax strategy. Decisions about your equity compensation can only be optimized through the lens of your current circumstances and hopes for the future. Get proximate with your true desires, and the role stock options can play in building your wealth to achieve your life goals. After all, if you don’t plan for it, who will? 

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?

Year-End Planning For Stock Compensation

As tempting as it may be to take your foot off the gas pedal and enjoy the holiday season, year-end is a key time for financial and tax planning. For Millennials in tech, year-end planning for stock compensation should focus on both the big picture and the details. If you haven’t taken the time to update your plan, this should be a good reminder. Even if you have been proactive with updating your financial plan, it is still an excellent time to strategize and game plan for the upcoming year. Taking a few moments to plan smarter can help you take advantage of wealth-building opportunities and get you closer to accomplishing your goals.

Create a Year-End Stock Compensation Checklist

To build meaningful wealth is to be intentional with your time and resources. Believe me when I say that it will never happen incidentally. So, as part of your year-end planning for stock compensation, here are a few things you’ll want to take a look at:

  • holdings and grants of stock options, restricted stock/RSUs, and other company stock
  • exercises, vestings, and ESPP purchases in the current year
  • scheduled vestings for the upcoming year in addition to salary contributions assigned to ESPP purchases
  • expiration dates for any outstanding stock options and deadlines for option exercises
  • trading windows, blackouts, company ownership guidelines, and post-vest holding period requirements/opportunities
  • brokerage firm statements
  • expected new grants in the year ahead
  • any estimated salary withholding adjustments needed for the year ahead in the Form W-4

Know Your Inventory

Begin with the end in mind. With a keen focus on your life and financial goals, you can design your equity compensation strategy to support and achieve those goals. Start by taking inventory of your holdings, including RSUs, ESPPs, ISOs, NQSOs, and company stock holdings in taxable and retirement accounts. Identify your holdings and the cost basis of owned shares, and you can quickly identify which shares to sell to fund your goals. Not to mention, maintaining your inventory will also help manage the tax impact, avoid losing shares to expiration, and reduce the risk that is associated with holding company stock.

Subsequently, consider the likely length of time of employment with the company. The expected longevity helps determine the value of the equity offering. Review your employer stock award notices to determine potential outcomes in the event you decide to jump ship. For instance, the impact for stock options could range from forfeiture of all vested and unvested grants upon separation to retention of all grants to the original expiration date. For restricted stock and RSUs, the impact may range from forfeiture of unvested grants to continued vesting per the original schedule.

How Much Company Stock Is Too Much?

There truly is no one answer. Some financial experts recommend that no more than 10% of your portfolio should be invested in your company stock, while others may have a contrarian perspective and elect for a concentration strategy rather than diversify. 

Storytime: I once got into an “internet discussion” with someone who believed it is best to invest with your heart because it pays off. They noted that if you believe in your company enough to maintain your entire position, it contributes to something greater than your financial stability — your throughput. You innately work with more diligence because your financial freedom is aligned to company growth. While I don’t wholly disagree, I think an individual’s circumstance undoubtedly plays a role. If you’re a young 20-something with little responsibility (relatively speaking), earning a decent income from a tech pioneer, then sure, maybe a concentration strategy is a good idea for the short-term. But if you’re looking to build sustainable wealth, or perhaps planning for retirement, education, or any irrefutable goal, then diversification is likely the best path.

Here’s the bottom line: owning company stock may allow you to share in the financial success of your company. But it also carries the risk that their financial problems will become your financial problems. In the event your company falters, not only might your investments tumble, but you might also find yourself out of work concurrently. Be smart about the degree to which you’re willing to tie your finances to a single company, even if it’s likely to be the next rocket ship.

The Timing of Taxes & Income Shifting

Keep a schedule of vested and unvested shares and their expiration dates. Request your company’s open selling windows so you can exercise “in the money” options before expiration, if feasible. Unlike stock options, which trigger taxes when exercised, RSUs and restricted stock generally give you no control over the timing of your taxes. As a result, taxation occurs when the shares vest.

However, there are two exceptions to this general rule:

  1. Choosing to be taxed at grant, as opposed to at vesting, by making a Section 83(b) election.
  2. Having a particular type of restricted stock unit that lets you defer delivery of the shares.

When the shares vest, you own the stock outright and have taxable W-2 income, along with your other compensation income during the year. In that case, it might be a good idea to time and shift other income around this restricted stock/RSU income to avoid getting bumped up to a higher income tax rate, or triggering the Medicare surtax.

At any time when you are considering exercising stock options or selling stock at year-end, you want to understand your tax rates, trigger points, and any shortfall in withholding. In general, you want to:

  • Keep your annual income under the thresholds for higher tax rates.
  • Recognize income at times when your annual income and tax rates may be lower.

Since you can control the timing of stock sales and option exercises, and you know when restricted stock and RSUs will vest, multi-year planning is especially valuable as it pertains to equity compensation. Primarily, in your year-end planning for stock compensation, you are looking to identify methods to shift income between years so that you are paying less in taxes over your lifetime. Money you don’t have to pay in taxes is money you can invest or spend, responsibly of course.

It’s All About You

Although it’s an important consideration, taxes should never be the only reason for exercising options or selling vested shares — or waiting to do so at year-end. Consider your investment objectives and expectations for stock price performance, but more importantly, your personal goals. How can you use equity compensation to UX design your financial life? If money were not an issue, what would you want your life to look like? What do you want to be? Whether it involves embarking on a business venture or settling down to start a family, the combination of your goals and well-designed equity compensation strategy have the power to change your life.

Introduction to Stock Purchase Plans

In the world of tech, it’s common—and frequently expected—that startups offer their employees’ company stock as part of their compensation package. If you’re a Millennial in tech, and your company offers an employee stock purchase plan, then take note because you’re sitting on an opportunity of wealth. Your employee stock purchase plan, or ESPP, might be one of the best benefits in your compensation package. Personally, it’s one of my favorites. If your employer offers an ESPP and you are not participating, you may be leaving thousands of dollars on the table. To maximize your ESPP’s value, it is critical to know some key dates and terms and understand the plan’s mechanics. Enter: an introduction to stock purchase plans.

ESPP 101: The Nuts and The Bolts

You know the saying, “there’s no such thing as a free lunch?” That doesn’t apply here because your ESPP is essentially free money. For this reason, most tech companies will use it to attract, reward, and incentivize their best talent. At it’s simplest, an employee stock purchase plan offers a way for tech employees to purchase company stock seamlessly and on favorable terms. Primarily, they allow participants regular, ongoing purchases of company stock through accumulated after-tax payroll deductions.

Moreover, participants can purchase company stock at a discount from the stock market price available to the general public. This discount is the free money I was referring to a moment ago. I’ve reviewed plenty of compensation packages for the Millennials in tech we serve as clients and have seen discounts ranging from 5% and 15%.

A Deal Too Good To Be True

What makes an employee stock purchase plan so appealing is the potential for both a discounted price and a lookback provision. As the name implies, the lookback feature allows employees to purchase shares based on the price at the beginning or end of the offering period, whenever share prices are lower. 

For instance, let’s say the stock price is $100 per share at the start of the offering period. Your purchase price is $85 per share with the 15% discount. 

  • If the stock price goes to $200 per share, you’ll earn a hefty 135% ($200-$85/$85).
  • Even if the stock price stays at $100, you’ll earn a 17.65% return from the discount ($100-$85/$85).
  • Even if the stock price drops to $50 at the end of the offering period, your discount gives you a favorable purchase price of $42.50, as a result of the lookback feature.

As far as Uncle Sam is concerned, the money deducted from your paycheck will be taxed like the rest of your salary. However, for Millennials in tech who can delay instant gratification, you’ll be rewarded with preferential tax treatment from the IRS. Correspondingly, if you are willing to hold the shares for at least two years from date of grant and one year from the purchase date, any tax liability is deferred until the shares are sold. Like my mom used to tell me growing up, “patience is a virtue.”

A noteworthy reminder: if your company pays dividends to its shareholders, the deal gets even better. You’ll receive a check for the dividend amount each quarter for the stock you hold. If your company has a dividend reinvestment program, you have yet another opportunity to take advantage of dollar-cost averaging to buy even more shares of company stock.

Key Dates In Your ESPP

Now that we’ve touched on the mechanics, let’s get familiar with key dates, events, and terms associated with most ESPP’s. It’s helpful to think of these key dates as a timeline of the typical stock purchase plan’s life cycle. 

Enrollment date: Known as the grant date is usually the first day of the offering period. The grant date is vital in ESPPs that are qualified plans, and it starts the clock for tax purposes. 

Enrollment or offering period: During this period, payroll deductions are accumulated to purchase company stock. Most ESPP’s have offering periods that last anywhere from 6 months to 24 months. 

Purchase period: Purchase period: Some tech companies use the terms “offering period” and “purchase period” interchangeably when the time frames are identical. Alternatively, when companies establish an offering period of longer than six months, there are usually interim purchase periods. Your company will purchase your shares at the end of the two six-month periods within the 12-month offering period. For example, a single offering period could be from January 1 to December 31. In this scenario, the first purchase period might start on January 1 and end on June 30. The second purchase period might start on July 1 and end on December 31.

Purchase date: Payroll deductions accumulated during the offering period will be used to purchase shares of company stock at the discount price on the purchase date. The purchase date is pre-determined and is usually the last business day of the offering or purchase period.

Reaping The Benefits

Investing in any individual stock is relatively risky: we all can acknowledge that. The most significant risk by far is not having a strategy or game plan to manage your shares as they begin to accumulate. Markets go up, and markets go down. It’s inevitable. In fact, this volatility is what causes an efficient market to demand higher returns for those who can keep faith. With risk comes reward, and hanging on for the long term is more often than not, rewarding. It’s unlikely to become wealthy overnight by participating in a stock purchase plan. Nevertheless, over time, the gains can be attractive. All the more reason for Millennials in tech to develop a holistic approach to stock compensation. If you’re not sure how or where to start, we’d be more than happy to help!