Stock options are an extremely attractive way to attract, motivate, and retain startup employees. Thousands of employees at Google, Microsoft, Facebook, WhatsApp, and other companies have become millionaires through stock options, and stock options are an important element of compensation for Silicon Valley technology companies as well as many other companies. This article discusses eight of the most frequently asked questions about employee stock options in startups.
How Does a Stock Option Work?
A stock option gives the recipient the right to acquire company common stock at a set exercise price established at the time of grant of the option. If the option is granted early in the life cycle of the company, it will likely be at a favorably low exercise price.
A typical grant is as follows: Sue Smith receives options to acquire 10,000 shares in Company X at 10 cents per share. The options are earned or “vest” over a 4-year period if Sue continues to be employed by Company X. She has a cliff vesting of one year (meaning she has to be at the company at least one year before any of her options vest, and at the end of that one-year period, she has vested a quarter of her options).
If Sue stays at Company X for the full 4 years, she has the right to exercise all of her 10,000 options at the exercise price. The exercise price is set at the time of the grant of the option at its then fair market value. If she wants to exercise her options, she then has to pay the exercise price times the number of shares (10 cents times 40,000, or $4000). Hopefully, when she exercises her options for 10 cents a share, the value of the shares has gone up significantly.
How Many Options Should I Get as a New Employee?
There is no formula as to how many options a company will grant to a prospective employee. It’s all negotiable, although a company may have its own internal guidelines by position within the company. And what is important is not the number of options, but what the number represents as a percentage of the fully diluted number of shares outstanding. For example, if you are awarded 100,000 options, but there are 100 million shares outstanding, that only represents 1/10 of 1% of the company. But if you are awarded 100,000 options and there are only 1 million shares outstanding, then that represents 10% of the company.
What Tax Do I Have to Pay for Stock Options?
There are two types of stock options under the tax code: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). Most employees typically receive the more tax advantaged ISOs. The tax treatment for ISOs is as follows:
- There is no taxable event at the time of the grant of the option.
- There is generally no taxable event at the time of the exercise of the option.
- At the time of the exercise of the option, the spread between the exercise price and the value of the stock will be taken into account for determining whether additional tax is owed under the alternative minimum tax rules.
- At the time the stock acquired from the exercise of the options is sold, that will be a taxable event. If the stock has been held both for more than two years from the date of grant of an ISO and more than a year from the date of exercise, all of the gain will be taxed at the more favorable capital gains rate; otherwise, all of a portion of the gain will be taxed at the ordinary income tax rate.
NSOs have less favorable tax treatment, and the spread between the exercise price and the value of the stock at the time of exercise will be taxed then at ordinary income rates.
How Long Do I Have to Exercise a Stock Option?
The stock option agreement and stock option plan lays out the time periods for when an option has to be exercised. Typically, as long as you remain an employee, you will have 5 to 10 years to exercise the vested portion of the option. But if you are no longer employed by the company, you typically only then have 30-90 days after termination to exercise the vested portion of your option (determined as of the termination date of your employment).
Are There Any Downsides to Stock Options?
The key downsides of stock options are:
- You typically have to pay cash to exercise the options.
- At the time you exercise the option, you may incur a tax depending on your particular alternative minimum tax situation or the type of options you hold.
- When you exercise the stock options, you will receive stock that will not be easily saleable if the company is still privately held or is subject to substantial transfer restrictions.
- The value of the stock could go below the exercise price you have paid for the stock, which is why many option holders wait until a liquidity event to exercise options.
How Does the Capital Structure of the Company Affect the Value of Stock Options?
Stock options are typically granted for the right to purchase common stock in the company. If the company has preferred stock, the liquidation preference of that preferred stock has to be paid off first before the common stock gets anything on sale of the company. Similarly, if the company has debt, that has to be typically paid off first before the common stockholders receive anything on a sale. So if the company has a lot of preferred stock and debt outstanding, the value of the common stock may be adversely affected.
Can I Transfer My Stock Options or Stock?
Most stock option agreements and plans restrict or prohibit the employee from transferring his or her options or stock. The specific restrictions are contained in the stock option agreement or the stock option plan of the company.
What Can I Negotiate to Get Better Terms for My Stock Options?
Most companies won’t negotiate the terms of a grant of stock options. Sometimes exceptions are made for senior employees. Here are items sometimes requested by prospective employees:
- Monthly vesting instead of cliff vesting
- A longer period than 30-90 days to exercise options after termination of employment
- Accelerated vesting of a portion of the stock options on termination of employment without cause
- Accelerated vesting of a portion of the stock options on sale of the company
- A shorter vesting period than the typical four years
- Grant of additional bonus options on achieving various milestones or performance goals
Author’s note: Many thanks to Jason Flaherty, a partner in the Compensation and Benefits Group at Orrick Herrington & Sutcliffe in San Francisco, for his review of this article.
Copyright © by Richard D. Harroch. All Rights Reserved.