Everything I Wish I knew About Stock Options 15 Years Ago
Photo by Suzy Hazelwood
Disclaimer: I’m a designer. I’m not an accountant or a lawyer. When it comes to stock options, if you’re not careful you can end up in a mess tax-wise. Be sure to consult with an accountant and a lawyer before considering any of the scenarios below.
Slow your roll…
You just received a job offer from a startup that includes a $120/yr salary and 20k options that vest over 4 years (with a one year cliff). How do you ensure that those options don’t just slip through your fingers?
Before you start browsing brochures for your Scrooge McDuck sized money vault, here are some practical tips that you should consider:
Don’t be like most startup employees
Most startup employees have no idea how stock options work. They blindly sign agreements, have no idea what liquidation strategies are available to them, and often times forfeit all of their options by leaving the company without exercising anything.
Learn the terminology
Here’s a quick primer:
a. Stock Option
It’s called an “option” for a reason. A stock option is not the same thing as “stock”. With stock options, you are not given stock, you’re giving the option to purchase stock once your shares have vested. Once you leave your company, you typically only have 3 months to execute your options, before it disappears.
b. Strike/Grant/Exercise Price
The fixed price you’re allowed to purchase stock at. This price stays the same during the life of your options grant. If the company that you’re working at is growing, the delta between your strike price and the 409A price and market price will continue to grow.
c. 409A Price
Private companies that issue stock options are required to periodically perform an evaluation of the companies value. Technically this should happen after any event that materially affects the value of the company. Typically though this process happens once per year. From this evaluation, a price per share is estimated. The 409A price is typically lower than the market price.
d. Market price
The per share price the market is willing to pay for your companies stock.
e. ISO vs. NSO
There’s quite a bit of nuance here. Instead of listing everything out, I’ll just link to this article. The biggest thing to keep in mind are the tax implications of the type of options you have.
The amount of stock options you’re given. In the scenario above this would be 20,000 options.
g. Issue/Grant Date
The date you were issued your grant.
h. Vesting Schedule
The schedule by which your stock options become exercisable. Having a 4 year vesting schedule with a one year cliff is super common. In our example above, that would mean that 5000 shares would become exercisable after one year at the company and approximately 416 shares would become exercisable to you each month thereafter for the next 3 years.
The period of time before your first chunk of options becomes exercisable. After the cliff, a smaller pool of your options generally start becoming executable on a monthly basis
The point at which you can purchase some portion of your options.
k. Exercise Date
The date you purchase your options.
l. Expiration Window
The date at which your options expire. Typically this is either:
- 3 months after you leave the company
- 10 years after your issue date
- The date you were fired (if that applies)
m. Cap Table
The list of people who already own stock in your company. This may include founders, investors, advisors, other employees who have already exercised their options.
n. Options Pool
Stock options are granted from an options pool. From a company ownership standpoint, an options pool is necessary in order to prevent constant churn or dilution as options are granted and then expire.
o. Liquidation Preferences
Depending on the round and the state of your company when it raises money, liquidation preferences can be added as bargaining chips that can have an impact on your options when it comes to a sale or acquisition. Essentially this means that some investors will be able to get more money for each share they hold, and likely will be able to sell their shares in the event of the sale of your company before you can.
Any time additional shares are added (typically as a result of fund raising rounds) there is going to be dilution of the stock value for all stock owners across the board. Basically this means that (at least temporarily) your individual stocks, or options will be worth less money.
q. Equity Investment Plan Document
This formal document outlines the bylaws of a companies stock option program. You’ll need a copy of this if you ever wish to sell your shares.
r. Option Agreement Document
This legal document outlines everything about your particular stock grant. This document will also be needed if you ever go to sell your shares.
s. Exercise Agreement Document
Once you exercise stock options, it is done through an exercise agreement. You’ll also want to hang onto this document.
t. Right of First Refusal
If you have a contract to sell your private stock to a third party, the company typically has a clause that they can purchase your shares at the same price that the third party. This ensures that the company has control over who is added to their cap table.
Know the Tax Implications
I can only speak from my experience. Again, if you’re considering purchasing options, you’ll want to consult with an accountant and a lawyer.
Long-term vs. short-term capital gains tax
In the U.S. if you purchase options and hang on to them for a year before you resell them, you will pay long-term cap gains taxes which as of 2018 is a flat 15% rate. If you purchase your options and sell them before a year passes, you’ll pay short-term cap gains tax which is effectively your personal tax rate 25-35%.
ISO vs. NSO
With ISO options you wait to pay the taxes on the sale of your stock until April 15th of the following year. When you sell NSO options, you pay the taxes immediately upon purchase.
AMT tax rate
This is a tricky bugger to figure out and plan for. 🙂 Basically, if you exercise your options and hold on to them for a year (in order to qualify for long-term capital gains tax) come April 15 you’ll still need to report the purchase of your options and likely pay AMT taxes on them. Talk to your accountant. They should be able to help estimate this for you.
Warning: If the delta between your strike price and the current 409A price is large, the AMT taxes that you’ll be required to pay (prior to selling your stock and recouping any of the money you spent to purchase your stock) may be high (depending a number of variables, like your household income level). You’re absolutely going to want to factor this into your decision to exercise and hold stock.
Get the big picture
Mapping everything out will help you get a better picture of what sort of return you could see from your options.
I created a sheet to help you plan out your liquidation options:
If you’d like to use this sheet, just go to “File” and select “Make a copy” within this Google Sheet.
Finally, since the company you work for is not a publicly traded company, how do you go about actually selling your private stock? You actually have quite a few options.
1) Forward/accelerated vesting
First, going into a new role it’s helpful to be aware of the option of forward vesting shares. If you’ve got the cash, and the company is open to it, this is your best option, as it avoids all tax hassles down the road.
Here’s how it works:
Taking our example above. Let’s say you’re in the process of joining a new company. They’ve extend a grant of 20,000 options at a strike price of $0.10/share. Chances are the 409A price is also at or near $0.10/share as well.
With forward vesting you purchase all of your options ahead of time. Since there is no delta between your strike price and the 409A price, you don’t pay any taxes. So in this scenario, you’d still have a 4 year vesting schedule with a 1 year cliff. You’d pay $1500 up front, but once you pass your cliff, you start vesting stock instead of options.
There’s a decent chance that the company you’re joining has never heard of this. They may need to consult their lawyer.
But what happens if you leave the company before all of your stock has vested you might be wondering? Not to worry. There is a clause in the agreement that the company can purchase back any unvested stock from the employee at the price the employee paid if the employee leaves the company before they are fully vested.
It requires a little bit of extra paperwork on the company, but can be a win, win situation (assuming you have the cash up front to pre-purchase all of your options).
2) Your company goes public
This is an easy one. Typically there will be a window of time post IPO where you cannot liquidate any of your shares, but after that you can sell your stock at any time at the current market value.
3) Your company is acquired
This is another easy scenario. But again, be mindful of liquidation preferences. Chances are that if you received employee stock options that you have common stock which receives it’s distribution last, and often at multiples less than preferred stock.
4) Sell to someone already on the cap table
If your company isn’t planning on going for an IPO and there’s no sign that they are planning on selling in the near future, a next best step is to reach out to them to see if anyone on the existing cap table is interested in picking up some additional shares. This is in their best interest because it means that no new investors are added to the cap table. It’s in your best interest because it saves you from having to hunt for someone else to buy your stock, and prevents you from having to pay a commission fee.
5) Piggy back off primary rounds
If your company is raising money, it’s almost guaranteed that some people in the company are taking some money off the table. If you can get in on that, this is an easy was to liquidate some of your holdings.
6) Secondary rounds
It’s becoming more and more common for privately held companies to do secondary rounds where employees and early investors have the option of cashing out.
7) Buying yourself 103 days
If you have ISO stock, one handy trick you might try and leverage is to purchase your stock on January 1st. Since you don’t owe taxes until April 15 of the following year, this buys you 3+ months the following year to find a buyer for your stock, thus qualifying you for long-term capital gains tax AND preventing you from having to pay taxes before a sale.
Note: I’ve not actually tried this. You’ll have to let me know if you ever do.
8) Private stock marketplaces
If you work for an exciting startup—one that investors are eager to get a piece of—there are multiple private stock marketplaces where you can list your stock:
Just be aware that just because you list your stock doesn’t mean that you will sell it. There is also typically a commission fee that you’ll pay when you sell your shares (5% is typical but you may pay more or less depending on how popular the company is that you work for).
9) Extending your window
Finally it’s worth noting that if you’re leaving your company on good terms and you don’t have the resources to purchase your vested shares (and pay the corresponding taxes) you should definitely check with your company to see if they’ll extend your expiration window. This is becoming increasing popular. More and more tech companies are extending their expiration window out as much as 10 years.
Just know that by law, 3 months after you leave your company your ISO stock options will convert into NSO options.
I hope that was helpful
If you have any thoughts or feedback I’d love to hear it. You can email me at firstname.lastname@example.org.
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