Stock Options 101
Stock options are how most people get compensated for the outsized risk of working in a fintech start-up.
And surprisingly, stock options remain one of the least understood areas of how start-ups operate.
Here, we’ll cover the basics as well as the common misconceptions (e.g., which parts of stock options are strictly legal and which parts are business decisions that can be negotiated)
- What is equity (versus debt). What is incentive equity?
- How is strike price determined?
- How is grant date of your option different from the start date of vesting?
- Should you exercise early if you leave your company and what happens to your options if your company gets acquired?
- What is the different between an NSO and ISO?
- And finally, everyone’s favorite topic: taxes!
First, what is equity versus debt.
A company’s capital structure is how it ingests capital and then what rights it gives to the providers of that capital.
Very generally, the types of capital can be separated into debt versus equity.
However, when we get into more nuance, the capital structure is more like a ladder. The ladder generally follows the risk-return spectrum.
The folks on the top are the most secure and get paid first. They’re smiling with their bags full of cash as they stroll back to their offices from bankruptcy court but, in most instances, they don’t get invited to the IPO party.
The folks on the bottom are the ones you’ll see ringing the bell at the NYSE.
What is incentive equity?
Incentive equity is a way for a company to incentivize its employees by giving them a share in the future growth of the company.
It is at the bottom of the ladder because it requires no upfront payment by the employee and so the company is getting no real tangible capital for giving a stock option (other than the employee’s services).
When a company gives you a stock option, it is essentially free in that you don’t need to pay anything for it. It is just an “option” to exercise a right in the future.
And, therefore, from the employee’s perspective, it is also the least secure and the riskiest asset in the company’s capital structure. It is the one to get paid only after the banks (debt), the investors (preferred stock), and the founders (common stock) get paid.
Components of a stock option.
A stock option is one form of incentive equity. It is a right to buy shares of a company (typically, common stock) at a pre-determined, fixed price known as the the “strike price.”
There are generally four key components of a stock option. Some are very technical and legal in nature and others are business decisions:
Legal things:
Grant date: The date the board of directors of the company approves your grant. Until this happens, your stock options don’t exist.
Strike price: The fixed price at which you can buy your shares no matter how valuable the shares become later.
Business things:
Vesting: How you own your stock options over time. While the market standard is to grant stock options so they vest over three or four years, this is a purely business decision, and the company can fix vesting to be any period of time.
Number of shares: How many shares you can buy with your option. This is fixed at the time of your option, and is very much a business decision.
Let’s talk about the “strike price” with an example.
Example: Mr. Valentine is awarded a stock option to buy 100 shares of Duke & Duke Co. at $1 each. Why just one dollar, Mortimer?
One dollar is the value of the company’s shares when Valentine is awarded the stock option.
Fast forward two years and Duke & Duke Co is doing well because of Mr. Valentine’s ingenious new cost cutting and trading strategies.
The value of the common stock is now $5. Valentine decides to exercise his stock options. He still gets to buy his shares at $1. His net value is then $4.
The goal of the strike price concept is two-fold:
- By fixing strike price, reward employees who take on more risk by starting at the company earlier
- Incentivize employees to increase the value of the common stock they have the right to buy
How is the strike price determined?
The strike price = the fair market value of the common stock at the time the option is granted.
How does a company determine the fair market value of its shares when it's not publicly traded? It does what is commonly called a 409A valuation.
A company can do its own 409A valuation but typically it will hire a vendor to do this. There are plenty of vendors that do this for a fixed fee.
The 409A valuation becomes “stale” after 12 months or whenever there is a material event affecting the value of the company (debt or equity capital raise, major customer, acquisition offer). So, if you just joined a company that recently raise capital, you probably won’t get your stock options right away because it likely needs to do a new 409A valuation.
(Legal side note. The “strike price” is the most legal and technical parts of a stock option. It is illegal for a company to offer a strike price below the fair market value of the common stock of the company.
In the earlier example, if Mr. Valentine had been awarded a stock option with a strike price at $0.50 when the fair market value of the shares was $1, he is netting a $0.50 gain right away. That’s sort of like the company secretly depositing $0.50 in his bank account. The IRS likes to tax anything of value, and that $0.50 looks like hidden value.)
How do grant date and vesting start date work?
As we saw above, your grant date is the date the Board approves your stock options. Until this happens, your stock options don’t exist
This typically doesn’t happen when you start employment (administratively, it would be difficult for the Board to approve options each time an employee starts).
When you hear of backdating stock option scandals, people are usually referring to the grant date. The grant date is a legal concept because the Board needs to determine the fair market value of the shares at the time it is granting the stock options. If you backdate an option, you might be getting the benefit of a lower value.
Vesting is how you own your stock options over time, and your vesting start date is when the clock starts running.
At most companies, your vesting start date is your first date of employment regardless of your grant date.
Options are typically four year vesting, one year cliff — meaning 25% of your options vest on your first year anniversary of start date, and then they vest monthly over time until your 4 year anniversary at which point 100% of your options vest.
Here’s an example:
October 1, 2022: Valentine joins Duke & Duke Co which has promised him him 1,000 shares as part of his compensation.
November 1, 2022: The prestigious Board of Directors of Duke & Duke Co meet. Management reports to the Board that it did a 409A valuation in July which determined the common stock value to be $2 and that no material event has occurred since then.
The Board grants Valentine an option to buy 1,000 shares at a fixed strike price of $2 with a 4 year vesting period with a 1 year cliff.
Grant date: November 1st
Vesting start date: October 1st
September 30th, 2023: Valentine has the right to buy 0 shares of Duke & Duke
October 1st, 2023: Valentine has the right to buy 250 shares of the Company at $2 each (25% of his option).
November 1st, 2023: Valentine has the right to buy 270 shares of the Company at $2 each (another month’s worth of vesting added).
What happens if you decide to leave your company?
A stock option is a right to buy shares but doesn’t include the underlying shares.
Let’s say Valentine leaves Duke & Duke Co on October 1, 2023 to start a new venture with his new friend, Louis.
He will usually have 90 days after his last day of work to exercise his options by paying $500 (250 shares x $2 each).
(“Usually” because this is just the market — there’s no set legal rule here. The company can override 90 day period, and many companies have instituted unlimited or 10 year exercise periods)
If he doesn’t exercise, he leaves with nothing and those 250 shares go back in to the Duke & Duke stock option pool for another employee.
When should you exercise your stock options?
Exercising stock options then is obviously a personal decision. You have to pay to own shares you’ve earned.
But once you’ve exercised, you just own your shares. Unless your company is publicly traded, you likely have to wait for some liquidity event (IPO or M&A event) to get someone to buy your shares, and that may never happen.
On the other hand, if your company made it to the NYSE ringing the bell ceremony, you might be pretty sour you didn’t exercise.
So, generally, your analysis on exercising will probably depend on:
- your ability to fork over the exercise price without materially impacting your personal financial situation — and;
- your assessed probability of the company being successful enough in the future to have a liquidity event.
However, if you’re not leaving the company, you may still want to exercise your options for tax reasons.
Benefits and Risks of exercising:
By owning the shares directly, you get to start the clock on long term capital gains (the tax rate typically lower than short term capital gains), which requires you to own the shares for at least 1 year.
(The one caveat to this is the AMT, or the Alternative Minimum Tax, which is a separate way to calculate taxes and can tax you on the spread between your strike price and value at the time of the exercise. The AMT is complicated and so we’d advise you to check with your tax advisor if you’re thinking of exercising.)
If you don’t exercise your shares, and your company gets acquired, you would pay short term capital gains on any gains.
Here’s how that would work:
If the stock price at acquisition is above the strike price, you will get a “cashless exercise”.
- Stock valued at $5
- Your strike price is $2
- You will get $3/share (i.e., you don’t need to actually pay the $2 to acquire the shares first)
You will get taxed for short term capital gains for $3/share since you only owned the shares for a nanosecond.
If you exercised a year or more before the acquisition, you would have paid $2 at the time of exercise, and then $5 at the time of the acquisition. You would still have been taxed at $3/share but at the long term capital gains rate.
So, if you’re leaving the company, you have a decision to make on whether to exercise that may be important.
If you’re not leaving the company, the main reason to exercise early is to optimize for taxes.
What’s an NSO versus ISO?
An NSO is a non-qualified stock option. An ISO is a qualified stock option.
What exactly are getting qualified here for?
Special treatment by the IRS.
Generally, an ISO doesn’t get taxed when you exercise (exception: AMT, see above).
It’s difficult enough to find the money to exercise your options especially if you’re leaving the company. And then taxing you on those unrealized gains doesn’t seem fair (unrealized gains because you likely don’t have a market to sell your shares yet so you’re paying taxes on just paper money).
Only full time employees can get ISOs.
An NSO, on the other hand, gets taxed when you exercise on the difference between your strike price and the value of your shares at the time of your exercise, or the “spread”.
An NSO is typically given to consultants, directors, advisors, and consultants.
More complications
We can get into a lot more here such as how preferred stock plays a role in exits and how that can impact stock options, how the secondary private markets can make exercising a more attractive option, RSA/RSUs versus stock options, and trade off in stock options between early stage and late stage companies.
But this is probably enough to digest for now. If there are particular areas you wish we would have delved into in more detail, please drop us a line in the comments section, and we’ll consider it for a later post.
Finally, Randolph and Mortimer would have wanted you to know that:
While we hope you found this post helpful, please note that the information in this post is not intended to be legal, financial, tax, or regulatory advice. Please consult your own advisor when considering your stock options…options.
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