Startup stock options: The fundamentals
Startup stock options: The fundamentals
Stock options are a significant component of startup employee’s’ compensation. These financial instruments are complex, fraught with risk and unintended consequences. I’ll be dedicating a few posts on the topic of stock options, specifically as a tool for employee compensation at startups. The first post will cover the basics of these instruments and how one earns - vests - them over time. The second post will address liquidity, or more generally how once can sell startup stock. Finally, my last post will focused on my major concerns with the “typical” stock option package and how startups can reduce some of the financial burden and risk posed by these instruments on their employees.
But first this disclaimer. I am not a lawyer, neither am an accountant. Please consult professional tax accountants and proper legal advice before acting on anything mentioned here.
Stock options: the basics
Employee stock options (ESOs) are a form of compensation that gives employees the right to buy shares of their company's stock at a predetermined price, known as the exercise or strike price, after a certain period. This price is typically set based on the stock's value at the time the options are granted, with the hope that the stock's value will increase over time, making the options more valuable. ESOs are a way to incentivize and retain employees by aligning their interests with the growth and success of the company. Employees stand to gain if the company's stock price rises above the exercise price, as they can buy the stock at the lower price, potentially earning a profit on the shares if they sell them at the higher market price.
Vesting is a crucial part of how ESOs work, as it determines when employees can exercise their options. A common vesting schedule includes a one-year cliff, followed by monthly or quarterly vesting over a total period, often four years. The one-year cliff means that the employee must work for the company for a full year before any options vest and become exercisable. If the employee leaves before the year is up, they forfeit all options. After the cliff, options typically vest on a monthly or quarterly basis, granting employees the right to purchase more shares over time. This structure ensures that employees remain committed to the company for a certain period, contributing to its long-term success before they can reap the full benefits of their stock options.
One caveat to note. Options, much like the name suggests are an option to purchase. Once an employee vests some options, they can then elect to purchase stock at the options strike price.
Let's consider an employee at Unicorno who is granted 1,000 stock options with a strike price of $0.10 each. The vesting schedule is as follows: there's a one-year cliff, after which the options begin to vest monthly over the next three years.
At grant date: The employee is granted 1,000 options at a strike price of $0.10, but cannot exercise any options immediately.
After 1 year (the cliff): The employee vests 25% of the options, which equals 250 options. This means the employee can now exercise these 250 options, buying 250 shares of Unicorno at $0.10 each, regardless of the current market price.
After the cliff, monthly vesting: The remaining 750 options vest evenly over the next 36 months. This means 20.83 options vest each month (750 options / 36 months = 20.83 options per month).
By the end of the first year the employee would have the option to purchase 250 Unicorno shares at the strike price of $0.10 per share. Similarly by the end of the fourth year, the employee would have the opportunity to buy all 1,000 shares at the strike price of $0.10 each, provided they are still employed by Unicorno and choose to exercise their options.
Additionally, stock options typically have an expiration date. This is the final date by which the option holder must exercise their right to buy the company's stock at the predetermined strike price. After this date, the options expire worthless, meaning the holder loses the right to purchase the stock at the strike price, and any intrinsic value the options may have had is forfeited.
The expiration period for stock options can vary significantly, depending on the terms set forth in the stock option agreement. It's common to see expiration periods ranging from 5 to 10 years from the date of grant. The specific duration until expiration is an important part of the option's terms and is decided by the company at the time the options are granted.
409a
Earlier I stated that “the right to buy shares of their company's stock at a predetermined price, known as the exercise or strike price” What sets that price though? Enter 409a.
A 409A valuation is an appraisal of the fair market value (FMV) of a private company's common stock. It determines the price at which employees can purchase shares through their stock options. This valuation is named after Section 409A of the U.S. Internal Revenue Code, which was introduced to regulate the taxation of deferred compensation, including stock options. The purpose of a 409A valuation is to ensure that stock options are issued at a price that reflects the company's true value at the time of issuance, thereby complying with federal tax requirements and avoiding penalties.
409A valuations are typically conducted by independent third-party firms specializing in valuation services. These firms assess various factors about the company, including its financial condition, projected earnings, recent transactions in the company's equity, and market comparables. The outcome is an FMV for the company's common stock, which then sets the strike price for stock options issued to employees until the next valuation is conducted. Private companies are generally required to perform a 409A valuation at least once every 12 months or after a significant event that could affect the company's value, such as a new round of funding, a substantial change in the business model, or a notable shift in the market.
The taxman cometh
This is where the story starts getting complex. We saw how 409a valuations are the manner in which the strike price for options are derived. However, 409a also come in play at the time of exercising stop options. Remember that 409a must be conducted at least once per year, hence the valuation (FMV) of Unicono will change over time.
Consider the chart below that illustrates the change of Unicorno’s valuation over 4 years. The company’s 409a went from $0.10 per share in year 1 to $24 in year 4. A true unicorn if I’ve ever seen one!
When thee employee exercises stock options, the tax implications are significantly influenced by the difference between the exercise (or strike) price of the options and the fair market value (FMV) of the stock at the time of exercise, as determined by a 409A valuation. If the exercise price is lower than the FMV, the difference is considered taxable income under U.S. tax law. This is particularly relevant for non-qualified stock options (NSOs), which are taxed as ordinary income to the employee at the time of exercise.
Let’s go back to our employee with 1000 Unicorno options. At the end of year 1 our employee has the option to buy shares at a strike price of $0.10, while the current 409A valuation of the company's stock is $5.00 per share. If the employee decides to exercise their options at this time:
Exercise (Strike) Price: $0.10 per share
Current FMV (409A Valuation): $5.00 per share
By exercising the option to buy a share at $0.10, while its current FMV is $5.00, the employee realizes a benefit (often referred to as the "bargain element") of $4.90 per share ($5.00 FMV - $0.10 strike price = $4.90). This $4.90 is considered taxable income and, for NSOs, would be taxed at the employee's ordinary income tax rate. If the employee exercises options for 250 shares, the taxable income generated from the exercise would be $1,225 ($4.90 * 250 shares).
The tax liability arises because the IRS views the difference between the strike price and the FMV as compensation income, similar to a salary or bonus, which is subject to income tax. For incentive stock options (ISOs), the situation differs in that the bargain element is not subject to ordinary income tax at the time of exercise. However, it may be subject to the Alternative Minimum Tax (AMT), a parallel tax system designed to ensure that taxpayers with substantial income do not avoid significant tax liabilities through deductions and exclusions.
Here’s the irony of it all though. Our employee will part ways with $250 (exercise cost) + (income tax * $1,225) to own her Unicono shares. Keep in mind these shares are almost certainly illiquid - the employee cannot sell them to realize her gains. The IRS taxed our employee - with real money - against paper gains and yet she cannot realize that profit. Oftentimes that point of realizing these paper-gains could be years out. Our employee paid money now in the hope that she can make a profit at some TBD point in time….
Remember I said to consult a tax attorney..
The (dreaded) 90 day window
There’s more to this tale: the 90-day window.
The 90-day window to exercise stock options upon departure from a company is a standard policy found in many employee stock option plans. This clause requires departing employees to exercise their vested stock options within 90 days of leaving the company, or else forfeit those options back to the company. This policy has significant implications for employees and their stock options, influencing decisions around job changes and financial planning.
Here's how it typically works. if the employee decides to leave the company, whether by resignation, termination, or retirement, they face a critical decision. They must exercise their vested options within 90 days of their departure date to acquire the shares. If they do not exercise their options within this timeframe, they lose the right to purchase the shares, and those options are returned to the company's stock option pool.
Remember how we just illustrated the potential tax implications of exercising stock options? As a departing employee you now have to make a major decision. Should you exercise your options, which might require a significant cash out lay, or should you walk away? The irony, or tyranny of it all, is the more successful the company is, the harder it is to make that decision. Employees can therefore remain stuck with their employers unable to leave b/c they are held hostage to very lucrative stop options.
Even if you elect to stay with your current employer, you face yet another obstacle. Your options will expire, typically by year 10. As that expiration window approaches you have a similar decision to make: to buy or leave on the table.
Damned if you stay and damned if you leave.
We’ve no covered the basics of stock options: what are they and how they work. We also went through the manners in which employees vest and exercise options, including the potential tax implications of vesting and how 409a influences that. Next wee I will go though the manners in which employees can sell their shares. Private company stock is not as liquid as that of public companies, but there are liquidity options. We’ll go through those and their implications next week.