In the past two decades startups have become one of the dominant forms of doing business. They have accounted for about 40% of jobs created during that time—and that even takes into account startup closures.
And with that, comes a new question for employees: How to deal with stock options?
According to a Kauffman Foundation longitudinal survey of startups launched in 2004, about 7% offer their workers this less traditional form of compensation. And it’s not just startups. The Foundation’s 2007 Survey of Business Owners found that 6.4% of all firms offered profit sharing or stock options.
Employers like stock options because giving employees the opportunity to own a piece of the company may make them feel invested in it and help keep them around. Plus, for startups trying to hold onto cash, options don’t require an upfront outlay.
But once you have options, what do you do with them? It’s an option, after all, that requires employees to shell out money to actually get the stock. Given how many startups go bust, how should one decide whether to make that investment?
First, let’s get the terms straight. When granted stock options, you are being given the right to buy shares of your company at an agreed-upon, usually discounted price called the “exercise price” within a certain time frame, usually 10 years, at which point that right to purchase expires. Usually, the options will also “vest” over a period. For instance, for every year you stay with the company, you’ll get the right to a quarter of your options, and by the fourth year, you’ll be able to purchase all of them. You “exercise” your options when you buy the stock underlying them.
“[An option] gives you the right to purchase the stock at the exercise price, but not the obligation,” says Chris Chen, a wealth strategist at Insight Financial Strategists, in Waltham, Massachusetts. “If the company goes bust, which for startups is a relatively common occurrence, then you don’t have to buy anything. If the company has a successful exit, either because they are purchased by another company or go public, then the stock has a lot of value and you can exercise it. And that’s the dream of all entrepreneurs.”
But if you leave a company before it either goes bust or has a successful exit, your calculation takes place in more of a vacuum. What are the odds that paying up now will land you a windfall later? Consider these factors.
1. Are there any non-compete-type provisions in your options plan?
If there is a non-compete—i.e., a provision that prevents you from working for a competitor for some set length of time—for the stock plan, separate from your employer agreement, and you have good reason to believe you’ll violate it, the company would get your stock, so exercising your options is probably a moot point.
2. Can you afford it?
Determine what portion of your shares have vested and what it would cost to exercise them. Then calculate your taxes on what’s called the “bargain element ” — the difference between the exercise price and the market price on the date you exercise your options. (More on calculating that below.) Is that sum—the cost to exercise and the amount in taxes—money that you not only have (and can access without penalty) but that wouldn’t be too painful to spend?
3. Are the company’s prospects good?
Evaluate this as you would other investments. Does the company have paying or, even better, profitable clients? Is the client base diversified so the company’s fortunes aren’t tied to any single revenue source? Does the team work well together and deliver on schedule? Is there market buzz? Is the company meeting its benchmarks?
If the answer to these questions is yes, that bodes well for a good exit. But also estimate the wait for a potential initial public offering or sale. “If they’re a few years away, then there’s a much greater risk that it will never happen and [your shares] will be diluted,” says Bruce Brumberg, editor-in-chief of myStockOptions.com.
4. Will there be any money leftover after the investors get theirs?
If the company doesn’t have an IPO but instead gets sold, the angel investors and venture capitalists usually have what are called preference rights that guarantee not only that they will get their investment back but that they’ll also receive X% return of their initial funding for every year since they invested with the company. For instance if a company that got initial investment back in 2000 is about to be sold and the investors are guaranteed a 7% return for every year of their nearly 15-year investment on top of the money itself, there could be almost no money leftover for common stock holders. If you can, find out these terms and try to calculate what price tag the company must hit in order for the investors to be paid. If you think the sale price could be higher than that threshold, that increases the chances money could be leftover for employees, though that isn’t guaranteed if the company isn’t sold for cash, but stock instead.
5. Could your shares be further diluted?
If the company needs more funding, its new valuation could make your shares worth more. On the flip side, the number of shares could also grow, diluting yours.
One of Chen’s friends had 40,000 shares in a biotech company. In a later round of funding, they got consolidated 300 to 1, leaving him with 133.33 shares. A subsequent round of another 300 to 1 consolidation left him with 0.44 (!) shares. This type of occurrence is relatively rare, but more common in startups in capital-intensive industries such as biotech that can take a decade or more to mature. It’s less common in certain kinds of tech companies that don’t require a lot of capital and could mature quickly.
The question is whether the growth in company value will be faster than the increase in the number of shares. If the valuation is already high but the company will need more funding, the boost in valuation might not outpace the dilution of shares, so your future shares may be worth little.
6. Would it still be worth it after taxes?
The two main types of stock options are non-qualified stock options, which are less desirable, and incentive stock options, typically reserved for executives.
Let’s you have non-qualified stock options that allow you to buy stock for $1, and you exercise at $10. As stated above, you’ll pay ordinary income tax on the bargain element ($9). You’ll also pay FICA taxes for Social Security and Medicare. (Only earnings up to $117,000 for 2014 and up to $118,500 for 2015 are subject to the Social Security tax, but all earnings are subject to Medicare tax.) If you can, exercise when your income has exceeded the threshold to avoid paying that tax.
Selling the stock will result in another tax —this time a long- or short-term capital gains tax based on whether you have held the security for more than a year or a year or less. (For most people, long-term capital gains are taxed at 15%, and short-term gains at your ordinary income tax rate.) If you hold for more than a year and sell when the price has reached $15, you’ll pay long term capital gains tax on $5. If you hold for six months and sell when the price is $12, you’ll pay ordinary income tax on $2.
In the end, unless your budget gives you a clear answer or the company is close to exit and you know how the likely terms would affect your shares, whether or not to exercise your options is a game of probabilities, and if you decide to play, you should be just as willing to lose as to win.