employee equity compensation in tech startups
July 15, 2021
May 5, 2021
July 15, 2021
May 5, 2021
If you’re a startup employee with stock options, thinking about your company’s exit can be really exciting — and rightfully so.
If the company’s exit value is high enough, you can sell your shares to make a profit. This is the moment your company’s founders, investors, and colleagues have been waiting for: A chance to reap the benefits of all their hard work. There’s more than one way for a private company to exit. Let’s take a look at four typical scenarios, exploring how each one works and what it means for your stock options.
In an IPO, a company raises money by selling shares in the public markets for the first time. Hence the name: initial public offering (IPO).
Once your company goes public, and is now trading on the public market, shareholders can now trade their shares. Company employees and investors can now unlock the value of the options they were given when the company was private.
The IPO process takes a while to complete. It involves big Wall Street banks, regulatory filings, and a roadshow where company leaders pitch the shares to potential investors.
At the end of the roadshow, bankers and company executives meet to determine how many shares to sell and to whom. They also set a price for the shares based on what new investors are willing to pay. The next day, shares begin trading publicly. The opening price is determined by an auction. Also, because new investors are being brought on to raise additional funds, dilution of the stock is likely.
After the IPO, there’s usually a lock-up period of 90 or 180 days where employees can’t sell their shares. There may be “early releases” from the lock-up, allowing you to cash out a small amount early on.
Startups can also go public via direct listing. How is a direct listing different from an IPO? It mostly has to do with how the shares are priced.
In a traditional IPO, new shares are sold to a group of investors the night before public trading starts. The bankers and the company determine the price of the shares based on orders received during the roadshow. The next day, there’s an auction to price the first public trade.
In a direct listing, no shares are priced before the opening auction—so the pricing process is fully transparent. Essentially, everyone participates in setting the price.
This “democratization” of pricing is why some companies choose a direct listing over an IPO. Direct listings also mean companies pay less money to lawyers and bankers.
Another reason why startups like direct listings: There usually isn’t a lock-up period, which means you can sell your shares immediately.
Spotify did the first notable direct listing in 2018. Palantir Technologies, Roblox, and Coinbase have also gone public via direct listing.
SPACs (special purpose acquisition companies) are another way for startups to go public.
Also known as blank-check companies, SPACs raise funds to acquire private firms and bring them public. The SPAC itself isn’t really a business — it doesn’t sell any products or services. Its only purpose is to find a company to buy.
SPACs have been around since the 1990s, but their popularity exploded in 2020: More than 200 SPACs were launched last year. Big-name SPAC deals include DraftKings and Virgin Galactic.
Here’s a quick rundown of how the process works:
For companies looking to go public, one of the key advantages of a SPAC deal is efficiency. A SPAC transaction can usually be completed faster than an IPO.
Another advantage is the ability to tell investors about financial projections. With a regular IPO or direct listing, startups can only talk about their past financial results.
If you have stock options or equity in a private company that’s part of a SPAC deal, you’ll probably be subject to some kind of conversion. For every share or option you hold in your existing company, you’ll get some number of shares or options in the new, merged company.
No matter what the conversion is, you won’t lose share value — you’ll just have a new number of shares at a different price. For example, if you had 100 shares at $5 each and the conversion is 2:1, you’ll end up with 50 shares at $10 each. Same value, different number of shares.
SPAC deals often come with lock-up periods, typically longer than for a traditional IPO. There may be “early releases” from the lock-up, depending on deal terms, allowing you to cash out a small amount early on.
Whether your company chooses an IPO, direct listing, or SPAC, the result is the same: You’re going public.
If your company is planning to go public, but you haven’t yet exercised your stock options, you should know a couple of things about getting the most out of your options.
First, timing matters — a lot. You can exercise your stock options before your company goes public and pay ~35% in taxes. Or, you can wait until the shares are trading publicly to exercise (a cashless exercise) and pay ~51% taxes once you sell your equity.
This is due to a US tax rule called long-term capital gains. If you own shares for at least 12 months before selling them, you pay less in taxes if and when you sell those stocks at a gain. If you exercise now, you can unlock that tax savings by the time your company goes public and you can finally sell your shares.
Our options exercise tax calculator can help you break down the taxes you owe upon exercising and suggest strategies to reduce taxes upon selling.
Another common exit is an acquisition. In this scenario, your company is bought out by another company. In some cases, your company may be folded into the company that acquired you. In others, your company may continue to exist even though it is now owned by another company. The latter scenario is what happened when Microsoft acquired LinkedIn..
What does an acquisition mean for your stock options? There isn’t one easy answer—it really depends on the negotiated deal terms. The terms under which your options were awarded can also matter, along with how your company’s previous funding rounds were structured.
Companies can buy startups with all cash, all stock, or a combination of both. Uber, for example, acquired Postmates in an all-stock transaction. Facebook purchased Instagram for a combination of cash and stock.
If your company is bought by a private firm, the deal might specify that stock options will be cashed out, which means startup employees get a lump sum check for their value. It’s also possible that options and shares in the acquired company will convert to options and shares in the private purchasing company. If the purchasing company is public, you might get cash or publicly traded stock.
If you have unvested options, you may "inherit" a new vesting schedule.
If your company is acquired, there will be a lot of fine print involved. As there will likely be tax implications for you, it’s wise to stay informed about the details and get professional advice if needed.
Secfi is here to help. Our team of experts is happy to discuss all things equity, including exit scenarios. We offer personalized insights designed to help startup employees make the most of their options and shares. Get started today.