Stock Options

William Wong Feb 2018

stocks

How to Argue for and Against Them

Offer packages are becoming increasingly complex in today's War for Talent. Many corporations are utilizing equity based compensation as a carrot to woo, motivate and retain their employees. This article will arm you with the knowledge of these equity incentive instruments so you may guide your candidate into making the correct choice - your offer.

ESPPs

RSUs

Stock Options

They come in the form of Stock Options (ISOs and NSOs), Restricted Stocks, Restricted Stock Units (RSU), Phantom Stock, Stock Appreciation Rights (SARs) and Employee Stock Purchase Plans (ESPP). We will cover three of the most popular choices you'll encounter in comp packages and how they compare to one another.

Want to bag yourself a lambo and 50 summer homes? If you've answered a resounding "YES!", then stock options are the way to go. This is the weapon of choice for startups.

Introduction

They come in play for the following reasons:

Startups are often tight on cash and can't compete with the big boys in the salary department. To combat this, they lure folks in with stocks to make up the gap between wage offered and market rate.

They help retain employees - people aren't going to jump ship until they're vested (hopefully). This buys corporations more time and patience thru the rough patches that startups inevitably face.

Stocks can motivate employees because, hey, who wouldn't work harder knowing they have skin in the game. Startups typically march with a united front because of this equity play.

Stock Options represent the right to purchase a company's stock at some future date, but at a price established now. Stock Options are the riskiest of all equity based compensation instruments but they produce the greatest returns.

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A Peek Inside

Stock Options can be broken down into 4 major components. A brief explanation will be provided for each as well as an example for further clarification. There is also a 5th section on the risk associated with this type of equity based compensation.

[1] Strike Price

This is the established price that you will be able to purchase the stock in the future. In most cases, this price is determined by the fair market value (FMV) of the company's common stock on that day. The board will most likely rely on a 409A valuation when determining the common stock's FMV. The earlier you join the startup (think 15th employee vs 500th employee), the higher risk you take of uncertainty - but you'll be rewarded with a smaller strike price and a greater return once the stock moons.

If your company granted you 100k in stocks at $0.01 and the current price of the stock is at $20, it would have only cost you $1,000 to purchase the stock (100k* $0.01) but now it's worth $2M (1,000 * $20).

[2] Vesting Period

Companies require a waiting period before you can exercise your stock options. These are typically spread across multiple years at a certain percentage.

A company may grant you a stock option of 100k shares, but only allow you to exercise 25% at the end of each year. After 4 years, you will be vested 100%. If you decide to leave the company before you are fully vested (say after 2 years), then you will only be able to purchase 50k shares (50% of 100k shares).

[3] Expiration Dates

If the stock options are not exercised within a set period of time, they will expire. A typical period may look like this: 10 years after date of grant or 3 months after last date of employment (whichever comes first).

Your stock option has an early expiration period of 3 month after the last date of employment. If you decide to leave this startup (by choice or involuntary termination), you will have 3 months to exercise your stock options or else they will disappear. At this point you have 3 choices 1) pay the exercise price + tax bill, 2) sell it on the secondary market or 3) walk away and lose the vested value.
Your stocks were granted 10 years ago and now you must exercise it, sell it on the secondary market, or walk away.

[4] Tax Implications

Taxes occur when you exercise your stock option AND when you sell your stock. 1) When you exercise your stock options, the difference between the Fair Market Value of your stock and your strike price is taxed as ordinary income.. 2) If you decide to hold on to your stock and sell at a later date, that gain/loss will also be taxed. If you sold within a year, it will be counted as ordinary income. If you sold after a year, then it will be considered capital gain/loss.

Utilizing the scenario above, your stock option grants you 100k shares at $0.01 shares. You decide to exercise this option and purchase the 100k stocks for $1,000. The current FMV at exercise is $20/share, which gives you a total of $2M. The gain realized is $1,999,000 (FMV - strike price). At a hypothetical tax rate of 37%, your taxes due are $739,999.63. Total cost of the stocks = $740,000.63 ($1k for stock purchase, 739,999.63 for taxes). Net take home is $1,259,999.37 ($2M - $740,000.63).

While stock options provide an excellent opportunity to strike it rich, it has a potentially very harmful nature.

[5] Risks

Liquidity! The above scenario looks like a great deal. It only costs you $1k to purchase 100k in stocks and even with a tax liability of $740k, you’re still making a profit of $1.3M. But what if there isn’t a market to sell your stocks because the startup hasn’t gone IPO. The typical tenure of a startup employee is 3-4 years and as companies stay private longer, chances are you will leave the company after your shares have vested but before an IPO. In this scenario, do you risk paying 740k in taxes for monopoly money that may never amount to anything? There may be a secondary market for you to unload these shares but it only exists for popular startups.

Forced Loyalty! Companies typically have an expiration date of 1-3 months after you leave the company to exercise your stock options. This creates a scenario where people are unwillingly staying at a startup because they don't have the cash flow or guts to stomach the taxes from exercising their stock options. Remember, startups typically pay a lower salary by luring you with stock options. If they leave and walk away from the stock options, then all the years they’ve worked at the startup was in vain.

The Green-Eye Monster! You are taxed twice with stock options - once when it is exercised and once again when you sell the stock. You may end up with a huge tax bill If you continue to hold the stock and it plummets in value. Many people experienced this painful reality during the DOTCOM crash. In this article a Cisco Engineer purchased 100k of shares with a FMV between 60-70/share and a strike price of 10 cents a share. This created $2.5 million in taxes. If he had sold the stocks immediately after he exercised his stock options, he would have made a profit of $4.5M (7M sale of stocks - 2.5M taxes). However he did not. The market crashed and Cisco’s stocks fell to $17.98 a share, which means even if he sold all his stocks, he would only yield $1.8M and still owe the IRS $700k.

[!] How to argue Against them

If you are battling against a startup w/ stock options, remind them of the risks above. But more importantly, do your own research on this startup to find and exploit the cracks. Your angles will differ depending on the stage of the startup, funding, size, industry, leadership team and uniqueness.

Years in Business: Statistics show the failure rate of companies after 5 years was over 50%. This increases to 70% after 10 years. Could this company fall into this category? If they have been around for a long time, figure out why. Have they missed their time to market?

Key Players: Who are the Founders and what are their track record? Inc. reported Founders of a previously successful company have a 30% chance of succeeding in their next venture. This number lowers to 20% if they failed. First-Time entrepreneurs have an 18% chance. 23% of startups fail because they don't have the right team.

Employee Stats: How many employees do they have? What percentage of them have been with the company for more than 3 years? For less than 1 year? Are any Founding members or first 50 employees still around?

Funding: What round are they at? How much money have they raised? If they have raised too much money too soon, it could an over priced valuation. I've dealt with many companies that could not secure B or C series because of this. 29% of startups fail because they ran out of cash.

Valuation: Knowing the Strike Price of the company every quarter or fiscal halves will tell you their growth trajectory. A stagnation could be a sign of failure.

Market Need: Is their product/service solving a problem? Are they unique in their offerings? The biggest reason why startups fail (42%) is because of no market need.

If the above does not sway them, then appeal to their sensibility. The biggest issue with startups is the opportunity cost you incur. By not having the cash up front (high salary option, ESPP, RSUs), you are missing out on other investment opportunities that will provide you with a much safer return (think Real Estate and Index Funds).