Image Credit: Wikimedia Commons

Stock Options (Part I): Employee Perspective

The buzz around sudden wealth creation at tech startups through stock options ignores the realities for the overwhelming majority of tech employees. Rarely are the benefits as great or as widespread as the rosy stories that comprise the industry narrative.

Here is how the reality diverges from the storybook tales:

1. Like many things in life, the options process is a founded firmly on information asymmetry. From an employee’s perspective, when negotiating employment terms, it’s far easier to understand and appear knowledgeable about pretty much every other area — salary, title, responsibility, reporting structure, job conditions, vacation, etc. Comprehending, let alone trying to improve, the options grant component of this piece of the compensation puzzle requires an understanding of the cap table as well as context both within the company and across the industry.
2. Option prices are set at fair market value. So, if you’re joining a startup that just received funding at a high valuation, the math is tough. Just accepted an offer at a Silicon Valley unicorn? Congratulations. Now ask yourself how likely the company’s value is to double, or triple (or grow tenfold) from the recent funding round. What kind of return would be necessary to make the return on the stock option component of your compensation package truly meaningful?
3. In the best case scenario of exercising in-the-money options, the tax consequences can be immediate and significant. If you are lucky enough to work at a company whose share price has appreciated significantly, bear in mind that the IRS will get a piece of your good fortune as well, taxing the difference between strike price (i.e. the amount you pay to exercise your options) and market value as ordinary income (in the case of non-qualified stock options). Not so fun side note: this money is due when you exercise your options. Realistically, unless you have deep pockets, don’t expect to own all of the underlying shares after exercising your options — you may need a stock sale to fund the total cost to exercise. And this is only if the shares can be traded (i.e. your startup achieved a liquidity event through IPO or acquisition by a public company).
4. Exercising options for shares that are illiquid can be both expensive and really risky. Let’s say you’re contemplating a move from a successful startup, and have in-the-money, vested options. It’s highly likely that you have a maximum of 90 days after your departure to purchase your shares. As mentioned in #3 above, prepare to pay the strike price and tax bill at the time of exercise. If you have the wherewithal to pull this off, you are now a stockholder in a private company for which there is no market in which to sell your shares. Prepare to hold tight. And wait.

My advice for an employee: go in with your eyes open.

Options are great as they allow you to participate in the success of the company; they can be very rewarding and are a key component of compensation, particularly for a startup where the salary may be lower. At the same time, be realistic: the fair market value of the shares and company when you join matters, tax consequences will diminish any future gains, and, unless you have deep pockets, it may not be feasible to exercise your options and own your shares (in the case of a publicly traded company) or exercise your shares at all (in the case of a company which has not achieved a liquidity event).

On the flip side, I would also stress that employers can do a better job not just of educating employees, but also structuring options plans for better outcomes. My next blog post will focus on some of these considerations.

Make sure to check out our other the blog posts, and follow Gain Compliance on LinkedIn, Facebook and Twitter.