Startup Stock Options 101: A comprehensive guide to start equity including a detailed Equity Checklist.
So you were granted or offered equity at a startup, now what?
When working for a private venture backed company, equity is an important part of your compensation package. The beauty of equity is that it aligns everyone’s interests because if the company successfully exits via either IPO or M&A, the investors, the founders, and the employees all benefit. One issue with equity is the lack of understanding and education among employees. For example, many are unsure how to value their options, don’t realize they can negotiate for more equity, or feel pressure to purchase the options just because they can. While stock options in a private company can be a great creator of wealth, they should not be exercised or purchased without some due diligence. Some people view equity as nothing better than a lottery ticket, or a throwaway add-on to their compensation. While in some cases it can be either of those extremes, it is important to know what to look for in your equity package and how to understand what your equity is worth.
This article will try and be a concise guide to equity ownership in a private company, including an equity checklist depending on where you are at in your startup journey.
What is a Stock Option?
A stock option is a benefit provided by the company to employees and other advisors etc, that allows the optionee (person granted options) to purchase shares of the company's stock for a pre-set price, called the strike price.
The purchasing of these shares is called exercising. Upon exercise, stock options are taxed based on the difference between the strike price and the current 409a price (also called Fair Market Value or FMV).
Typically employees will have to earn their right to exercise their options by working at the company for a set period of time, this is called vesting. In most cases, 1/4 of the options will vest after the 1st year of employment and the remaining 3/4 vest over the next 3 years. Finally, options have an expiration date, meaning they must be exercised before this date otherwise the option will expire worthless. Typically the expiration date is 10 years after the date the options are granted, but it can be changed if the optionee becomes no longer employed at the company.
Types of Stock Options
Incentive Stock Options (ISOs)
Most startup stock options are ISOs. Since ISOs have favorable tax treatment, they can only be granted to current employees and can only be exercised for 90 days after an employee stops working at the company. Additionally, ISO optionees can only vest $100,000 worth of ISOs in each calendar year. If the expiration date is extended beyond 90 days or if any options are vested over the $100,000 limit the options will become NSOs.
When exercised, ISOs are subject to Alternative Minimum Tax. Upon sale, ISOs are taxed based on the difference between the final sale price and the strike price (exercising does not step up the cost basis).
Non-Qualified Stock Options (NSOs or NQSOs)
As opposed to ISOs, NSOs can be granted to non-employees (advisors, contractors etc.) and their expiration date can be extended up to 10 years beyond the grant date.
When exercised, NSOs are subject to ordinary income tax. Upon sale, NSOs are taxed based on the difference between the sales price and the 409a price when exercised (exercising steps up the cost basis).
Restricted Stock Units (RSUs)
While not technically "stock options" another popular form of employee equity compensation is RSUs. RSUs are more typical in public companies and late stage private companies. Unlike options, RSUs do not have an strike price. When vested, employees will simply receive shares. Read on for more differences between RSUs and Stock Options.
How to value Stock Options
Startup stock options and shares don't truly realize any value until they become liquid. Liquidity occurs when private company shares are converted to either public company stock or cash via an IPO, M&A, or pre-IPO sale. Once a stockholder has either cash or a public stock in hand, the value is obvious, but prior to liquidity the value of startup stock is less clear.
When granted, your strike price will be the same as the current Fair Market Value of the shares. This means they are worth exactly what they cost (based on the FMV). As you work at the company, the value of the stock will ideally grow. If the FMV becomes higher than your strike price, the options are considered "in the money", meaning they are worth more than what they will cost to exercise (based on the FMV). In the unfortunate scenario where the company does not perform well and the FMV becomes lower than your strike price, the options are considered "underwater". The FMV is used by the IRS to determine the value of stock options and as previously mentioned is used to determine the "taxable income" that you pay taxes on when you exercise (in quotes because it is not liquid, tangible income).
Is the FMV a good representation of how much your stock options are worth?
Yes, and no. Yes, because it is a legitimate value for the stock that was determined by an independent 409a valuation provider. No, because the potential value is suppressed by these 409a evaluators because the stock is illiquid. Think of the FMV as a floor value for the stock, or a very conservative measure of the current value of the shares. A more aggressive valuation of your startup equity would use the price paid by investors for the last round of preferred stock. The most appropriate value of common stock is somewhere between the 409a price and the preferred price.
Projecting option value going forward
Finding out what your options are worth right now is an important exercise, but the true value in stock lies in the potential value once liquid (post IPO or M&A). A baseline way of thinking is that Venture Capital investors typically require at least a 2x on their investment, meaning they want to at least double their money. This means a good projection of value would be 2 times the last round preferred price. Projecting out into the future isn't perfect and certainly does not work out 100% of the time, but this provides a valuable data point when considering what your equity may be worth.
Read on for a more in-depth look at employee stock options.
Important things to know before accepting your offer.
When comparing or considering job offers at private companies, you should still cover the obvious elements like salary, bonus, vacation days, healthcare, etc. It is also important not to forget about the equity!
If things go right for the company, it is possible your equity will be worth more than any other compensation you receive. You cannot count on it as a guarantee, but assuming you join a promising company and vest your options, your equity will likely be an important part of your compensation package. If you don’t at least consider the equity laid out in your offer, you may regret not negotiating for more in the future. While you can always get granted more stock later on in your employment, if the company does well, you are better off getting as much equity as possible during your initial grant when the Fair Market Value of 409a price of the common stock is at its lowest.
The important things to know before accepting your grant are:
- What type of equity are you being granted?
- How many options or units are you being granted?
- What is your strike price? (NOTE: only ISOs and NSOs have an exercise price, RSUs do not)
- What does the vesting schedule look like?
The type of equity you have impacts your taxation and expiration as mentioned above. The number of options or units you are granted is important because this is the eventual number of shares you could potentially own in the company. The number of options/units/shares is one of the two most important pieces of information needed to understand how much equity you are being granted. The other is the current Fair Market Value (FMV) or 409a price. If you are granted options, this will also be your strike price!
Simply take the number of options or RSUs granted and multiply it by the current FMV; this will give you an idea of how much your equity is worth today (when granted). For options, this is also how much it will cost to exercise all of your shares.
The last important thing to understand when granted/offered equity is your vesting schedule. This will dictate when you earn the right to purchase your equity. As previously mentioned, you will typically vest 100% of your equity after working for 4 years, but will not vest any until 1 full year of employment (typically 25% will vest on your 1-year work anniversary). This is important because while you may have been offered a certain number of options, you must work for usually 4 years before you fully vest or earn all that equity. This is especially important when realizing that “for tech companies, talent retention is even more volatile, the average employee tenure being estimated at around 3 years” (per HPPY).
We built an equity value calculator that can gauge whether your equity grant is fair or not. Give it a try!
Important things to know before you exercise.
The concrete information to know before exercising is simple:
1) How many options have you vested? (and can you early-exercise un-vested options?)
2) What is the current Fair Market Value of the common stock? (and how does that affect your taxes?).
Knowing how many options you have vested will let you calculate the cost of the exercise (simply multiply total vested options times your strike price). If you can early-exercise, this could allow you to exercise un-vested options and can help save significantly on taxes (just make sure to file an 83b!). Once you know how much your exercise will cost, it is then important to understand your potential tax liability. In order to know how much you may owe in taxes, you will need to know the current 409a price or FMV of the common stock. If your company has an equity portal it can often be easily found there, otherwise you may need to reach out to the company.
If you have ISOs you will potentially owe AMT this coming April, check out ESO's AMT Calculator.
If you have NSOs you will owe income tax when you exercise, the amount is withheld by your company, and can be found either in your equity portal or by asking someone at your company (usually controller, stock plan admin, etc).
Do I believe in the company?
Beyond the bare minimum, concrete pieces of information mentioned above, you should ask yourself a few other questions before exercising. The first important question to ask is “Do I believe in the future of the company?” Most of the time, you are exercising because you have left the company, so the first step here is "Why did you leave?" If you simply left because of a better or different opportunity, but still believe in the company: Great! However, if you left because the company was doing poorly or were laid off, it is worth considering whether the stock options that you have the right to exercise are a worthy investment. If you are exercising to lock in taxes, it likely means you are very bullish on the company’s future growth (and you have done your homework). If you work at a large company, one way to check on the health of the company is to request Rule 701 financials (read more on Rule 701). If your company isn’t large enough to require Rule 701 disclosures, but you are unsure how they are doing, ask around! You and your coworkers are possibly the best resources for making an educated decision.
Is it the right time to exercise?
The next important question to ask is whether it is the right time to exercise. If you have left the company then yes, it is (although it may be worth considering an NSO extension). If you are still at the company, your motivation to exercise is solely based on taxes. A couple of reasons why you may exercise before leaving include: the FMV is still the same as your strike price (aka no taxes), you want to start the clock on long-term capital gains, you believe the company will grow significantly and wish to lock in your taxes beforehand.
Read more on when to exercise stock options to determine if the time is right.
Can I afford to exercise? (ESO Fund can pay for your exercise)
So now you have determined that you believe in the company and it is the right time to exercise. The final question is can you afford to exercise?
This is a matter of 1) do you have the cash necessary and 2) can you afford to lock up that capital. Whether you can afford to exercise in full, can only afford a portion, or can’t afford to exercise at all; it makes sense to explore financing from the ESO Fund to cover your stock option exercise. If interested, please fill out the form below! There is no risk or fee in seeing what we can offer.