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Stock options 101: A primer for startup employees

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Startup perks

There are plenty of perks when it comes to working at a startup. But while ping-pong tables and casual dress codes may help to make your day-to-day activities more enjoyable, there is one benefit of working at one of the growing number of US tech-focused unicorns that is truly life-changing.

We are of course talking about equity, the opportunity to claim a stake in the financial future of the company that you are working for and potentially own a piece of a multi-million (or billion) dollar startup.

Today, many private tech startups offer some sort of stock option package as part of their compensation. The problem is however that they rarely explain what those options mean to the employee.

That’s why we’ve put together this brief guide to help you take stock of your equity options so that you can make better decisions about your options’ worth and what you should be doing with them.

Key terms explained

Salary, benefits, vacation allowance, these are all terms we know and understand when it comes to employment. But what about equity, options and vesting? The vocabulary that surrounds employee stock options can feel like a foreign language to the uninitiated, which is why there is often so much confusion when it comes to understanding equity options.

You don’t suddenly need to become a financial expert in order to understand your options. But there are a few key terms that can be beneficial to ensuring you get the most out of them.

  • Vesting – This is the process of gaining full legal rights to your stock. You will initially receive your options unvested, that’s jargon for: your company would like you to have options, but only if you keep working there for a while. Unvested options still need to vest (again, just jargon for you actually getting them), a process that takes years.
  • Vesting schedule – You will not receive all of your options upfront, instead they will be subject to a vesting schedule that incrementally awards you options during the course of your employment.
  • Cliff – Vesting schedules typically include a cliff designating the length of time you must work for a company before your options start to vest. The intention of the cliff is to ensure that you commit to the company for a certain period of time in order to receive your options.
  • Exercising – Exercising your options is an industry term for buying the shares that are available to you.
  • Exercise date – This is the calendar day that you decide to exercise your options or buy your shares.
  • Grant date – This is the calendar date on which your employer grants you the option to buy a set number of shares.
  • Expiration date – This is the date at which your offering period ends and your option to buy stock expires.
  • Strike price – Also known as the exercise price, is the predetermined price for which you can buy stock from your employer. This is typically determined using the fair market value of the stock at that point in time.

Your equity explained

Equity or stock options give an employee the ability to buy shares of the company they work for at a certain price within a certain timeframe. There are two common forms of stock options that you might receive as part of a compensation package, these are incentive stock options (ISOs) and non-qualified stock options (NSOs) and the key difference between them are the tax rules that apply to each option.

Non-qualified stock options (NSOs) give you the right to buy a set number of shares at a predetermined price, which is typically the market rate at the date those shares are issued. Usually you will have a deadline by which you can exercise these options, and generally speaking you will have to pay tax on the difference between the exercise price (the price you were promised you would be able to buy the stock for) and the fair market value at the time of selling. The difference will be subject to regular income tax and will also be subject to payroll taxes too.

Incentive stock options (ISOs) also give you the right to buy the options at a predetermined price, which is determined using the company’s current 409A valuation (also known as fair market value). These options are more favorable when it comes to taxation as, if planned for carefully, the recipient pays for any gains at the capital gains rate, not the higher rate normally associated with other forms of income.

If you are unsure what kind of option you hold or that you are being offered, then speak to your employer. Alternatively, your stock option plan should contain a document that explains exactly what kind of options you have and the regulations that apply to them.

Finally, there are restricted stock units (RSUs), which are more commonly allocated by mature companies. With RSUs, employees are effectively awarded a dollar value in shares, which gets taxed as ordinary income when the RSUs vest. Essentially this means that employees are awarded shares rather than paying for them, but the downside is that they are far less efficient as the employee is locked into paying taxes on those stocks at standard income rates.

Understanding what type of equity you have is important because it will have a big impact on how you unlock the value of your equity. No matter if you hold ISOs, NSOs, RSUs or a mixture of both, you will need to carefully plan how you will unlock the potentially life-changing value they hold.

What you should do with your options

The purpose of stock options is to someday make you money, but that will only happen with careful planning, and that planning should begin the day you get your offer letter.

Understanding your options will not only help you to calculate how much they are worth, but also enable you to consider the various tax implications that apply to them. Armed with this knowledge you will be able to put together a plan of action (preferably with the help of a licensed professional) to ensure that you unlock their maximum potential value.

At Secfi we understand that options can be overwhelming, but we’re here to help. We work closely with you, helping you to analyze and understand your options as well as providing financing to help make your company’s success also become yours.

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