employee equity compensation in tech startups
October 25, 2021
October 1, 2021
October 25, 2021
October 1, 2021
Even if you understand how stock options work, you might still find yourself making a mistake with serious consequences — like paying too much in taxes, taking on too much personal risk, or even losing your stock options entirely. Your startup may be on the path to go public, but you still want to make sure you’re setting yourself up for success with your stock options.
Good news, we’re here to help. Here are the seven most common mistakes people make around their employee stock options, in rough chronological order:
You’re offered a job with an impressive number of stock options — over the next 4 years, you’ll vest 100,000 shares in the company. You’ll need more information to fully understand what you’re actually earning:
Ideally, the answers to these questions should be contained in your onboarding paperwork. If not, ask your HR rep to point you toward the answers.
Stock options are easy to ignore: After your one-year cliff, they just exist in the background, quietly accumulating in a benefits administration portal somewhere.
For most people, they don’t really think about their stock options until it’s time to leave their company.
However, by ignoring your stock options, you may be inadvertently racking up an alternative minimum tax liability that will be difficult to handle on your own. Let’s take a look at a real-world scenario:
If you decide to exercise your stock options immediately, you’ll pay $25,000 to the company to purchase shares that have a hypothetical fair market value of $50,000.
When it comes time to file your taxes, your accountant will note that you experienced gains (on paper) of $25,000. Given your salary, exercising your stock options will trigger a comparatively small alternative minimum tax bill that year. You pay the AMT, which is still manageably small.
If you decide not to exercise your stock options immediately, you’ll continue to work at the company, and automatically vest shares each month. On your 2-year work anniversary, you decide to quit your job and learn you have 90 days to exercise your stock options or lose them permanently.
In the meantime, your company has raised a fresh round of funding that bumps up the fair market value of your stock options to $5 each.
Now, when you go to exercise your stock options, you’ll pay $50,000 (50,000 shares x $1 strike price per share) on stock that has a hypothetical fair market value of $250,000 (50,000 shares x $5 fair market value).
When it comes time to file your taxes, your accountant will note that you earned a profit — on paper — of $200,000, which triggers a significant AMT tax bill.
Squeezed and without the money to exercise their stock options or pay the resulting taxes, hundreds of thousands of people collectively abandon billions of dollars worth of stock options when they leave their jobs every year.
If you’re earning ISOs or NSOs, you’ll have a limited amount of time to exercise your stock options once you leave your company. The prevailing industry standard is 90 days, but you’ll want to check your stock option paperwork to know for sure.
One thing to note: Even if your startup is one of the few that has voluntarily extended its post-employment stock options exercise window — in some cases by as much as 10 years — ISOs automatically convert to NSOs after 90 days of you leaving the company (NSOs are taxed less favorably than ISOs).
If you fail to exercise your stock options in that window, you’ll forfeit them and lose them forever.
For those who haven’t made a plan for their stock options, they’re usually surprised to learn they have to come up with tens of thousands of dollars — and in some cases, hundreds of thousands of dollars — in just 3 months. If they can’t, they can lose their stock options forever.
If you’ve managed to get in early at a startup and stay there for a decade (but fail to exercise any of your stock options in that decade), you should know that all unexercised stock options automatically expire after 10 years.
It’s rare, but we have helped early employees at unicorns exercise their stock options as they get close to their 10-year work anniversary.
If you neglect to exercise your stock options until it’s nearly too late, you’ll likely face trivial exercise costs but a large AMT bill, as the value of your stock options will have likely grown considerably over the past decade.
The majority of startup employees end up waiting until after an exit — either an IPO or an acquisition — to exercise their stock options, using a same-day transaction called a cashless exercise.
With a cashless exercise, you’ll exercise your shares and immediately sell them, setting aside a portion of the profit to pay for your taxes.
Cashless exercises are simultaneously the easiest option, and the most expensive. Cashless exercises are taxed at the short-term capital gains rate, which can result in hundreds of thousands of dollars in value lost to the IRS.
On paper, cashless exercises make sense — by waiting to exercise until a company exits, you’ll reduce your risk (nobody wants to buy stock options early, only to see the company fail), and you won’t have to put up any cash to exercise your shares.
Instead of a cashless exercise, you may want to consider non-recourse financing from Secfi. With non-recourse financing, Secfi puts up the money you need to exercise your stock options before an exit (starting the clock on the long-term capital gains rate), and gives you enough cash to cover your alternative minimum tax bill (if applicable). If the company fails to exit, Secfi will take on the downside risk.
Depending on your specific situation, you might end up saving more money in taxes with non-recourse financing than a cashless exercise. We’ve built a handy stock options exercise calculator to help you run the numbers yourself, or feel free to reach out to one of our equity advisors to talk about your specific situation.
Your company has grown quickly, and a larger competitor wants to acquire it. So what happens to all of your stock options?
That depends entirely on negotiations between your company and its acquirer.
They could be acquired by another private company, or a public one.You might experience an accelerated vesting schedule, allowing you to exercise all of your remaining stock options at once — under an incredibly short window of opportunity. Your company might offer employees the equivalent of a cashless exercise. You might trade your stock options for an equivalent number of shares in the acquiring company.
You might get a combination of cash and stock, subject to a new vesting schedule or performance targets.
During an acquisition, it’s important to do your research and understand what you need to do to maximize the value of your stock options.
You’ve managed to avoid the most common mistakes people make around stock options: You understood your stock options, made a plan, exercised your stock options early using non-recourse financing, and your company successfully exited. Now what?
It’s tempting to hold off on selling your stock as it continues to climb. And, it’s understandable that you feel a personal connection to your company’s stock — hoping, or believing, that it will always go up.
The general rule of thumb is not to hold more than 10 percent of your net worth in a single stock, and to diversify your net worth across multiple types of investments. Of course, it’s always best to make an informed decision with the help of a licensed financial advisor.
We can point to rare examples like the collapse of Enron or Lehman Brothers, where employees collectively lost billions of dollars due to over-concentration of net worth in their company’s stock.
What happens far more often is that Wall Street enters a bear market that impacts certain companies harder than others, leading to a lot of volatility in individual stocks. Watching your net worth swing wildly from month to month can make it difficult to plan your financial future.
A major partnership falls through, or an unexpected competitor enters the market and begins eating up market share. Worst-case scenario, your company experiences a sharp drop in stock value, and decides to cut your job as part of a mass layoff. Now, you’re out of work and your stock is trading at its 52-week low.
It can be hard knowing you sold only to see that price increase, but it’s a far easier pill to swallow than not selling any and watching its value get wiped out.
No one can foresee the future, but usually the worst choice is not making any choice at all.
Feel free to reach out if you have questions about your unique situation, or check out our stock options exercise calculator to better understand the cost to own your stock options.