Over the years I’ve talked to countless startup employees who feel like they got burned by their long-term incentive compensation, otherwise known as their stock options. Each time, I’ve realized that most people just don’t understand how the equity component of their compensation package works and how it may (or may not) be realized some day. Clearly, the earlier you join a startup, obviously the bigger the risk, but also the greater the potential reward. There tends to also be a big tradeoff for cash to stock at the earliest stages so ensuring you know what your signing up for is imperative.
Below you will find some of the basic elements that you must educate yourself on and understand to approach your illiquid net worth with eyes wide open.
- Stock options are meant to align employees with the ultimate monetization of their company via a strategic exit, investor recapitalization or IPO. It is long-term incentive compensation.
- When a startup employee receives stock options, they are granted at today’s fair market value, meaning they have a cost basis to them that someday will need to be paid before any upside gain is realized. It is an illiquid asset with no real value to you at its current state.
- Stock options are typically represented as Basis Points in a job offer, commonly for senior management or early employees, which ends up outlined on the company’s capitalization table (cap table). For example, 50 BPs/BIPs would be 0.5% in a fully diluted position. It is important to understand the market for your role and stage as part of the holistic job offer (base salary, bonuses, commission, benefits, stock etc.) As companies scale or for specific employees, typically just a number of shares will be represented. See #12 below as dilution will most always play a role, but the absolute number of shares you have typically won’t change.
- Stock options are attached to vesting schedules generally with a cliff. In other words, you don’t get them all at once but over time based on your employment with the company. They usually vest over four years either monthly, quarterly, or annually. A cliff can be in place, meaning you don’t get the full vest until you hit it. This can be 90 days, six months or even a year. For board members or advisors these vesting schedules can be as short as two years.
- Stock options can only be exercised and become yours once they are vested. Most employees, if they remain gainfully employed, don’t exercise them until a liquidity event as there isn’t always a need or opportunity to use cash flow to do so. There are tax benefits listed below to do so, however:
- Many times when a company raises outside capital from institutional investors, even founders will be put on what’s called a ‘founder vesting schedule.’ This is done to protect a new investor from the chance that a founder who they are backing may think about leaving the company. This is typically done via some ratio split of the founders equity holdings.
- If you were to leave a company and you have stock vested, there is a limited time window typically allowed to cut a check (aka buy the shares at the strike price) at that earlier mentioned exercise price – typically 60-90 days.
- It’s worth mentioning that the stock you hold in a private company typically doesn’t have an open market where you can actually redeem the value of the stock. Typically, you’re at the mercy of the startups monetization fate, which is directly tied to leadership, investors and the board of directors of the company.
- If you do end up early exercising the stock options (writing a check to own them and turn your shares into real equity), it’s always best to hold them for one year for long-term capital gains tax. If sold sooner, you’ll pay ordinary income tax on the gain which is not as favorable financially.
- In essence, stock options are worth nothing until a) exercised and you convert them to equity b) the company has a liquidity event. It’s important to track the value of the shares for potential reasons, but you shouldn’t spend the returns until they are truly monetized.
- The horror stories you hear on stock options, no value, or negative value are when employees (current or past) exercise their options and the company ends up less valuable (has a worse valuation) at the time of exit. This is something that York IE coaches entrepreneurs in and why we frown against vanity metrics, over fundraising, inflated valuations etc. It only sets companies up for potential failure even when exit events should all be celebrated and rewarding.
- Your stock option percentage will get diluted every time the company issues new shares – this happens when they create a larger stock option pool or raise more money. Every time a company brings on a new investor, they are selling pieces of the company they’ve built and the clock restarts on upside opportunity for all shareholders.
- The money fundraised must create accretive value while minimizing dilution for all shareholders to win on the inevitable exit. Team members must really believe in their incentives being aligned with leadership to realize the true potential value of their stock options.
- Typically institutional investors have favorable terms written into investments. This can come in the forms of stock classes (preferred vs. common shares) and liquidation preferences (they get their money before you do). The institutional investors tend to limit their downside risk given the large amounts of capital on the line. It’s important you understand this and again have leadership who is fundraising responsibly and looking out for the interests of common shareholders, which is typically what founders and stock option holders are.
- There are exits where the stock preferences are so stacked and negative for the common shareholders where investors make great returns on their capital, but employees are left with nothing or worse yet, with shares under water (worth less than what they were executed at).
- As it relates to Stock Options, there are two types and they have different tax treatment that is nuanced: Non-Qualified Stock Options (NSO) and Incentive Stock Option (ISO) are taxed differently. Most of what we’ve outlined are in regards to ISOs. If you are to this level of depth and seeing different types of stock options, as with all financials, please refer to your tax and financial advisors.
- Many companies as they scale, and public companies more commonly, use Restricted Stock Units (RSUs), which are on a vesting schedule as well, but when they vest they are yours and the value of them is taxed as ordinary income. RSUs have similar mechanics to NSOs. If you hold them without selling on the public market (assuming a public company) you’re smart to hold and wait for one year and get long-term capital gains treatment, assuming there is a gain and stock price has gone up. There is lots of good information across the web on RSUs.
- In the most favorable of situations, companies qualify for Qualified Small Business Tax (QSBS), but this is typically done early at founding or maturity and only pertains to those shareholders who are fully vested, exercised, and own their stock. If they hold the stock for five years or more until an exit happens, they pay no federal capital gains tax. Wow!
- Lastly, it’s critical that employees realize that when they are betting on a startup they aren’t just betting on the company but also on themselves. Be prepared, educated, negotiate well and realize that when your motivation is best aligned (incentives) with company leadership and investors you are most likely to see great success.
We wish you the best and hope to watch you create generational wealth and impact the world. The best and most healthy companies have all shareholders aligned and our mission is to help ensure this happens more and more into the future!
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