The Basics of Employee Stock Options
What you need to know to effectively manage your options and maximize their value
Since the first VC-backed startup launched in Silicon Valley, tech companies have been recruiting and retaining employees with stock options. A stock option locks in the price today (i.e., the exercise price) at which you can purchase the company’s stock in the future. Simply put, the value of these options is equal to the difference between the exercise price and the price you can get for those shares when you eventually sell them. For the most successful startups, the “unicorns” that grow the value of their shares manifold over years, that difference can be enormous.
For the companies, it’s effectively a way to print their own currency to compensate employees. Stock options also create a culture of ownership among employees, aligning their interest with the company’s success. For the employees, stock options represent a “wealth creation opportunity,” the chance to take enough money off the table to create a lifetime’s worth of financial security. To the kinds of people that are drawn to the high risk, high reward startup life, that opportunity is worth more than a little extra W2 income they might have received from working at a more mature (but less exciting) company.
Though understanding how stock options work and how to maximize their value is obviously critical, it’s surprisingly hard to do – many employees don’t know the basics of their equity compensation. The first reason for this is that stock option plans and grant agreements are typically written in “legalese” that can be hard to follow. Key terms like vesting, expiration dates, transfer restrictions, etc. can be buried in dense paragraphs of technical jargon in multiple documents. Stock options are also governed by complex securities laws that can restrict who and when you sell the shares underlying your options. Finally, the taxation of employee stock options is both extremely complicated and extremely important to the amount of after-tax dollars you get to keep from an eventual sale of your shares.
In this article, we introduce you to the basics of stock ownership and suggest some things to consider in managing them. Let’s start with a list of the key documents you should make sure to collect and save in a safe place. These documents contain all the terms and restrictions applicable to your options and the shares you receive when you exercise them. Gathering them up when you first receive your options is much easier than trying to track them down years later when you finally are ready to exercise them. They are:
- Stock Option Plan: This document states the general policies, procedures and rules for all of the company’s employee stock options. Frequently the other documents will refer back to definitions or provisions in the Stock Option Plan.
- Stock Option (or Grant) Agreement: This agreement is what actually grants you the stock option and is specific to you. It will lay out the vesting provisions that determine how many of the options you can exercise at each point in time.
- Exercise Notice: This form is typically attached as an exhibit to your Stock Option Agreement. When you’re ready to exercise your option (or part of it), you fill it out and send it to the company along with the exercise price. A few days later, the company delivers your shares, almost always in the form of Common Stock, by updating its cap table software to reflect your ownership.
- Bylaws: The company’s bylaws will often contain transfer restrictions on the shares underlying your options. Because these restrictions may limit who you can sell your shares to and when, it’s important to know what they are from the beginning.
Now that you have the key documents, you will want to read through them to find the following important facts about your options:
- Number of Options: How many shares can you exercise your option for when its fully vested.
- Vesting Schedule: Options are almost always subject to vesting. On the day the option is granted, none of the shares are vested and so the option can’t be exercised. Over time though, the options vest and more and more of them can be exercised.
- Exercise Price: This is the dollar amount you need to pay the company for each share you exercise.
- ISO or NSO: For purposes of the tax rules, options fall into one of two legal categories. They are either Incentive Stock Options (ISOs) or Non-Qualifying Stock Options (NSOs). Whether an option is an ISO or an NSO can dramatically impact the tax treatment of your sale of the shares underlying the option. So much so that it often determines if and when you exercise and when you sell the shares.
- Termination Date: This is the date your option expires. Once it expires, the option can’t be exercised and so becomes worthless. Typically, options expire upon the earlier of a stated date, often ten years from the date of grant, or within some number of days after you cease being an employee of the company.
- Transfer Restrictions: These are the company’s rules about who you can sell your shares to and when. Almost all private companies impose a right of first refusal that enables it to replace any buyer you might find for your shares. Many companies also require you get company approval prior to selling shares. Finally, companies also very frequently have a provision called a “lock-up” prohibiting share sales for the first 180 days after the company goes public.
With the right documents and information in hand, you’re ready to begin managing you stock options. The following are a few things you might want to consider to maximize their value and reduce your risk.
- Track Share Price: Because the value of your option is the delta between the exercise price and what you can sell the underlying shares for, you will want to keep an eye on the market price for the shares. Pricing information can be hard to find for private companies (i.e., those not traded on a public exchange like Nasdaq), but there are a couple of places to look. Whenever your company does a preferred stock financing, a new company value is set and so a new value for its shares. These financings are often announced by companies in their press releases. There are now also a number of online brokers that may be able to give you pricing insights. Finally, you might also visit www.CollectiveLiquidity.com to get a real time offer valuing your shares.
- Minimize Taxes: Because taxes on a stock sale can take between none and nearly half of your sale proceeds, it’s critical that you understand which tax treatment – e.g., long term capital gains, short term capital gains, ordinary income, alternative minimum tax, etc. – will apply before you exercise your options or commit to a sale of the underlying shares. Given the complexity and impact of the rules, deciding on a tax strategy will likely require the services of a tax professional.
- Reduce Your Risk: If you’re like most unicorn employees, your options represent the bulk of your assets and so you have something called “concentration risk.” With all/most of your eggs in one basket, your net worth could tumble significantly if the value of your company declines. This could happen because of a problem at the company or a market crash that drags your company’s value down with it. To reduce this risk, you will want to consider diversifying – i.e., exchanging some of the shares underlying your options for other assets (e.g., other stock, bonds, investment funds, etc.).
- Consider Alternatives to a Sale: Though by far the most frequently used way to monetize your options is to exercise them and sell the shares, taxes and broker fees can take more than half of your sale proceeds. There are, however, alternatives for unicorn shareholders to consider. For example, there are now lenders who will loan money – typically ~20% of the value of your shares - using your shares for collateral. Note though that these loans often charge exorbitant interest rates and cash and stock fees so that the all-in effective interest rate is greater than 20%.
- Finally, you might want to consider Collective Liquidity. Collective enables you to diversify tax-free by exchanging unicorn shares for an interest in our portfolio of leading unicorns. Then, whenever you need cash, you can borrow on a non-recourse basis against your interest in the fund at relatively low rates. You can borrow up to 60% of the value of your shares. As a result, many unicorn employees find they get more immediate after-tax cash from the loan than they get from a stock sale while still maintaining their upside in the fund. Transactions can be initiated immediately and entirely online – it’s liquidity without brokers. To learn more, visit www.CollectiveLiquidity.com.
We hope you have found this introduction to stock options and how to manage them helpful. Please keep in mind that this article addresses just some of the basic stock options concepts. It is obviously beyond the scope of this article to advise the reader on any particular strategy. We highly recommend you consult with your tax, legal and financial advisors before taking any action.