This page is based on personal experience, and is based on what I know of American tax law. I am not a lawyer, however, and can not claim that this information is currently accurate. Use it at your own risk.

See Also

See also a paper on stock I wrote for fellow employees of a company several years ago. It covers a bit more material, and goes into more depth on some topics.

Terms to know

stock Ownership of part of a firm.
options or ‘non-qualified’ options The right to buy or sell stock at a predetermined price. For example, you might have an option that gives you the right to buy IBM at $100/share, even if it’s selling for $150/share..
strike price The price at which an option lets you buy stock. In the above example, $100 is the strike price of the options.
market price The price at which stock is selling on the open market. In the above example, $150 is the market price of IBM stock.
vesting You rarely receive stock or options all at once. Rather, you receive shares/options as you meet certain milestones. Stock whose milestones you’ve met are considered “vested.”
vesting schedule The schedule over which shares or options vest. Often, a person receives a certain number of shares each quarter or each year. A typical vesting schedule might be, ËYou receive 10,000 shares over 4 years. 2,500 shares vest on your first anniversary, and the remaining 7,500 shares vest in equal monthly amounts for the following three years.Ó
dilution When new shares are issued in a company, it ËdilutesÓ the value of the existing shares. For example, if you own 100 shares of a company with 1,000 outstanding shares, you own 10% of the company. If the company issues an additional 1,000 shares to investors, there are now 2,000 outstanding shares. Your 100 shares are now only 5% of the company. This is called dilution.
registered shares When a company is public, its shares are registered with the SEC. Private companies issue non-registered shares, which often can’t be sold or turned into money.
incentive stock options (ISOs) Options which get special tax treatment: they create no tax event when exercised, but are taxed when the stock is sold. if the stock is held for more than a year, they are taxed at the long-term capital gains rate, rather than the normal income rate.

When exercised, ISOs can subject the owner to the “Alternative Minimum Tax,” which can be substantial.

You can get paid in stock or in options. If you get paid in stock, you actually receive shares of a company’s stock. If you get paid in options, you receive the right to buy the stock later, at a set price. If the stock is selling on the open market for more than the strike price, you can exercise the option, buy the stock for the strike price, and then sell it immediately for the market price, pocketing the difference as profit. The lower the strike price, the more profit you make.

Options are often issued with a strike price equal to or 10% lower than the market value of the stock at the time the options are issued. That means that the maximum profit the option holder can realize is movement in the stock price after the time options are issued.

Cash flow & liquidity

With stock, there are no cash flow concerns. Once you own the stock, you own it. With options, however, you need to come up with the money to exercise the options. This isn’t always easy. If you have 10,000 options with a strike price of $5, it will require $50,000 to exercise those options and buy the underlying stock.

“But why is that a problem?” I hear you ask. “After all, you’d only exercise options if the stock were selling for more than the option strike price. Can’t you then just sell enough of the stock to cover the $50,000?” Ah, if only it were that easy…

Liquidity

You can’t sell stock in a non-public company. So unless your company is publicly traded, the stock you get (either directly or by exercising options) is just pieces of paper, unless the shareholder’s agreement gives you permission to sell it to third parties. Rarely—and never in a venture backed by professional investors—will you be given that ability.

As I write this (8/99), there is also a holding period on shares of stock in non-public companies. The holding period can range from 6 months to 3 years. Even if the company goes public during that time, the holder of pre-public shares can’t sell until their holding period expires. The intent of this is to prevent monkey business in which insiders are allowed to purchase pre-public shares immediately before an IPO and then turn right around and sell them. In fact, there is currently a strong movement in congress to eliminate the holding period.

[Author’s editorial opinion: eliminating the holding period will probably encourage all kinds of game playing and profit-taking. Philosophically a believer in businesses being value-creators, rather than transient-paper-profit creators, I favor keeping the holding period. Yet as someone who may someday be in a position to benefit from its elimination, I find my principles put sorely to the test.]

Tax implications

To make matters worse, taxes can cause a cash flow issue in all of this. Here’s a summary of how the taxes work:

  early tax hit later tax hit
options

When you exercise the options, the difference between the option strike price and the market price of the stock is treated as normal income, taxable at your full tax rate.Your full tax rate can be quite high, once state and federal are both taken into account.

For example, if you exercise 10,000 options to buy XYZ at $5, when the stock is selling for $7, that counts as $20,000 of taxable income even if XYZ is a non-public company.

When you sell the shares you acquired by exercising your options, any up or down movement in the share price since the date of exercise counts as a capital gain or loss. Capital gains/losses are taxed at a much lower rate than ordinary income.

If you later sell your XYZ shares for $9, that counts as a $2 capital gain (the fair market value was $7 when you acquired the shares).

incentive stock options No tax hit when exercised.

Possibly subjects you to the alternative minimum tax (AMT).

When you sell the shares, the difference between the strike price and the share price is taxed. If the shares have been held for less than a year, the normal income tax rate is used. If they have been held more than a year, the capital gains rate is used.
stock

If you are receiving actual stock shares that vest, the moment they vest, the amount vested becomes treated as normal income, taxable at your full tax rate.

When you sell your shares, you realize a capital gain or loss on any movement in share price from the time that you acquired the shares.

The big "gotcha" type tradeoffs:

If you want compensation that vests over time in a private company, stock may be a poor choice. As each block of stock vests, it constitutes taxable income equal to the fair market value of the stock at the time of vesting (not at the time the contract is written). So if the company is doing really well, the 5,000 shares that vest this quarter could be worth $10/share, giving you $50,000 of taxable income. But since the company is private, you can’t sell the shares to pay the taxes. You have to come up with the cash to pay the taxes some other way.

Options are more palatable, but they introduce a quandry. In a private company, you would like to exercise your options as soon as possible. You will start the liquidity counter ticking early, so your holding period will be over by the time the stock is tradeable. And if your options are not incentive stock options, they will generate a normal income tax rate hit. You also want to take that hit (which happens at exercise time) on as low a stock value as possible, and have most of your gains happen as a capital gain or loss.

But on the other hand, you might not want to exercise your options until the company goes public. The shares you receive from the exercise will be fully liquid, and you can trade them immediately. But your entire gain (market price minus strike price) will be taxed as normal income. That can be a huge incremental tax burden.

Whether to exercise options while a company is still private is a complicated, individual question. The answer depends on your regular tax brackets, your capital gains brackets, how long you think it will be until the stock goes public, and how much money you have to pay taxes on the options exercise.

Other Questions

What if the company never goes public?

Well, then you have to find someone to buy your shares if you want to make any money off them. Sometimes the shareholder’s agreement will let you sell your shares to anyone, while other times it only lets you sell your shares back to the company or to other shareholders.

What happens if more stock is issued to give to new investors?

Your shares get diluted. If you are in a very powerful negotiating position, you may be able to get an anti-dilution provision, which lets you maintain your percentage ownership in the firm even when new shares are issued. If this is your first job out of college, don’t bother asking.

What if the company gets bought out while I own options or stock?

This depends on your agreement and the terms of the sale. An IPO or acquisition can drastically change a company, effectively making it a different place than you signed up to work in originally. If you can swing it, the safest thing to do is to require that your options or shares vest immediately upon a public offering or acquisition.

How much should I ask for?

As much as you can get. A few very, very rough rules of thumb: by the time a company goes public, the VCs and investors will own around 70% and the original owners and employees will own around 30%. What matters is not how many shares you have, but what percentage of the company now and at IPO/acquisition time you own.

If you believe that the company will be worth $100,000,000 someday, and you will own .5% of the company at that point, your share will someday be worth $500,000. If you took a $20,000 pay cut for 5 years in exchange for that equity, you essentially exchanged a guaranteed $100,000 salary for a risky $500,000 in stock. It’s up to you to decide if that tradeoff is worth it.

Think this through! I have seen people take a $30,000/year pay cut in exchange for stock that was worth $60,000 after two years. They effectively traded salary for equity without getting enough stock to compensate them for the risk they took or for the fact that it took two years before they saw the money.

Keep in mind that subsequent funding rounds will dilute you. What matters is the percentage you own when the company goes public or is acquired. The percentage you own today may be less relevant.

They offered 3,000 options. Is that a good deal?

Maybe. It depends what percentage that is of the company. If there are 30,000,000 outstanding shares, you’ve been offered .01% of the equity. If the company is the next AMAZON.COM, you’re set for a lifetime if you’re a careful investor. If the company is Joe’s Garage and Fried Chicken Joint, you might want to reconsider. (See the essay on Equity Distribution to get an idea of what percentages are good percentages.)

Remember: it’s the percentage you own, not the number of shares that matters! If they say they can’t reveal how many shares are outstanding, or won’t tell you what percentage ownership your shares represent, run, don’t walk, in the opposite direction. You are investing your time and reputation with the company. Any aboveboard company would instantly reveal those numbers to a monetary investor. If they won’t reveal them to you, it’s probably because they are making a lousy offer.

Without knowing the percentages, you can not evaluate the value of your options. Period. Companies split their stock immediately before going public, or they reverse-split their stock, to adjust the share price. You may have 30,000 options today, but a pre-IPO reverse split of 1-for-2 will leave you with just 15,000 shares after the IPO. (This happens. It’s rare, but it happens. Two companies whose IPOs I’ve been privvy to had pre-IPO reverse splits. One was 2-for-3, the other was 1-for-2 reverse split.)

Once you know what percent you own, find the value by multiplying the expected company valuation by your percentage ownership at IPO. Remember that the IPO itself dilutes all shareholders. Then multiply the result by 2/3 to find out how much you’ll have once you’ve paid your taxes.

I’ve heard companies say, “The percentage doesn’t matter. After all, regardless of percentage, 3,000 shares when the stock hits $100/share, is $300,000.” True. But how do you know that 3,000 shares today will still be 3,000 shares at IPO? And what would the whole-company valuation have to be to justify a $100 per-share price? That’s why it makes more sense to talk company valuation and percentage ownership at IPO.

Does the company care if they give me stock or options?

They may, but if they do, it is only because of the accounting treatment or administrative overhead of giving out stock. Either way, they are giving you ownership or an option of ownership in the company.

Things to Know about Stock vs. Options

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