Understand Your Startup Stock Options

You've joined a startup or are considering joining one. Perhaps you've had a previous experience where stock options didn't turn out as expected. If you're seeking a comprehensive grasp of how employee stock options grants operate, what key aspects to consider, and how to best prepare, whether for exercising your stock options or negotiating favorable terms for your grant, this document offers a concise overview.

Please note that this document does not provide legal or tax advice. It is advisable to consult with your own professionals before making any decisions related to stock options.

What is a stock option?

A stock option is a contract that provides you with the right, but not the obligation, to purchase a stock at a predetermined price and on a specific date. This predetermined price is commonly referred to as the exercise price or strike price. Therefore, if your employer grants you 100 options, it doesn't mean you own 100 shares outright. Instead, you possess the opportunity to acquire 100 shares at the previously agreed-upon strike price. Executing this purchase is referred to as "exercising your option."

The majority of startups offer their employees Incentive Stock Options (ISOs), although some may opt for Non-qualified Stock Options (NSOs). Throughout this post, we will focus solely on ISOs. However, if you wish to explore the differences between ISOs and NSOs, you can find more information here.

Understanding the Equity Component of an Offer

When evaluating an equity offer, it's essential to consider several key components:

• Number of Options: This indicates the quantity of shares you have the right to purchase.
• Percentage Ownership: This represents your ownership stake in the company's total outstanding equity, assuming you exercise all your options. The calculation is (number of options) / (total outstanding shares issued by the company).
• Strike Price: The per-share price at which you can exercise your options.
• Vesting Schedule: Typically, equity grants are subject to vesting, meaning you won't receive all your options immediately but over a specified period. A common vesting schedule is four years with a one-year cliff. If you depart the company within the first year, you receive nothing. After one year, 1/4th of your shares vest, followed by monthly 1/48th vesting. Various other vesting schedules exist; for example, some companies use a five-year vesting period with a six-month cliff. Amazon employs a unique vesting schedule where 5% vest after year one, 15% after year two, and 40% after years three and four.
• Post-Termination Exercise (PTE) Window: Upon leaving your job, you typically have a mere 90 days to decide whether to exercise your options. After this period, you forfeit your options, often leading to a situation known as "golden handcuffs." However, some progressive companies like Pinterest and Asana are introducing longer PTE windows, such as 5, 7, or 10 years. It's important to note that even with an extended PTE window, ISOs will convert into NSOs after the initial 90-day period.

When should I exercise my options?

Determining the right time to exercise your options hinges on your individual financial circumstances. However, it's crucial to fully grasp the various possibilities and the significant tax implications associated with each choice. Below describes each scenario and provides a series of examples.

Exercising One Year Before IPO

One of the optimal moments to exercise your options is approximately one year before the Initial Public Offering (IPO). If you exercise your options a year prior to selling and your grant date was at least two years before the sale date, you'll only be subject to the more favorable long-term capital gains tax rate on your profits, rather than the typically higher income tax rate.

However, if the fair market value (determined by the most recent 409a valuation) of your company's shares has risen above your strike price, you may also incur the Alternative Minimum Tax (AMT) liability at the time of option exercise. The federal AMT rate is 28% of the difference between the fair market value of your shares and the value of your shares at the strike price.

The primary challenge for many individuals with this strategy is the upfront cash requirement to exercise the options. If that's a hindrance, you can opt to postpone exercising until after the IPO.

Exercising and Selling Post-IPO

In situations where you can't afford to exercise your stock options but your company has already gone public, you can consider a cashless exercise. In this arrangement, your employer or a brokerage firm extends a loan to facilitate option exercise, followed by an immediate sale of the stock at the prevailing market price. The proceeds from the sale are then used to repay the loan. This practice is common, especially at startups, where employees may lack the financial means to exercise their options. Typically, the mechanics of obtaining the loan, selling the stock, and repaying the loan are handled by the company, with the employee receiving the proceeds once the entire transaction is concluded. It's important to note that with this approach, any gains from selling the stock will be subject to ordinary income tax rates since the stock has been held for less than a year.

Early Exercising

Many startups permit their employees to exercise options before they fully vest, a practice referred to as early exercising. Early exercising makes sense when you have a strong belief in the company's potential for a successful exit or when the overall exercise cost is manageable. This approach has two big upsides:

1. You’ll owe zero AMT at the time you exercise your options if your strike is equal to the company’s last 409a valuation.
2. The 1-year countdown to qualify for long term capital gains tax starts ticking.

Keep in mind that early exercising is risky and you should only early exercise if you are comfortable losing your entire investment.

How can I protect myself in advance?

Negotiating better terms for your stock option grant can reduce your risk and improve your financial situation. However, not all companies are open to negotiation, and your ability to do so depends on your bargaining power.

Sometimes, companies may not fully understand why you're asking for changes. They might misinterpret your caution as a lack of commitment to the role. In some cases, this could be a tactic to discourage negotiation, either through intimidation or simply because they don't know much about stock options.

To handle such situations effectively, it's important to explain your reasons for requesting changes and back them up with industry data. Express your belief in the company's future and your desire to align your success with theirs. At the same time, acknowledge the fast pace of startups and the potential for unexpected changes. Emphasize that favorable stock option terms allow you to focus on your role with confidence.

While it's ideal to consult a legal professional before signing any contract, it might not always be financially feasible. Depending on the importance of your equity compensation, you may or may not want to invest in legal advice. In such cases, you can still take steps to understand your options, use tools like ChatGPT for clarification, and seek guidance from online resources and communities to ensure you interpret your grant correctly.

Assuming your grant follows industry standards, the primary point to negotiate is often an extension of the exercise period. The standard 90-day window for exercising options can be difficult if you leave your job, as it requires you to buy your options without a steady income. Advocating for a longer exercise period company-wide, like 10 years, shows your commitment to fair treatment for all employees. This request benefits not only you but also highlights your desire to work for a company that doesn't burden departing employees with immediate financial obligations.

However, having an extended exercise period doesn't necessarily mean you should wait to exercise your options. As mentioned earlier, holding stock options for at least one year before selling them results in a more favorable capital gains tax rate, while selling within a year incurs standard income tax rates. This tax planning is similar to the public stock market, where investors aim to minimize tax liability.

In the startup world, selling shares typically happens during exit events like liquidations, mergers, or an IPO. This makes the timing of option exercise crucial. In general, if you believe in your company's long-term success and can afford it, exercising your options as they vest is often a good choice. While this approach involves more frequent transactions and complex tax filings, it allows you to begin the one-year holding period quickly for each group of options, ultimately improving your potential financial outcome.

Exercise periods are just one example. Below I’ll list more terms worth understanding and considering for negotiation in your options grant.

• Extended Exercise Period: As mentioned, extending the exercise period beyond the standard 90 days, often to several years, can be a significant negotiation point.
• Accelerated Vesting: Negotiating for faster vesting schedules, such as monthly rather than annually, can allow you to gain access to your options more quickly.
• Early Exercise: Requesting the ability to exercise options before they fully vest, known as early exercising, can be advantageous if you have confidence in the company's growth.
• Additional Equity Grants: Negotiating for additional stock option grants can increase your ownership stake in the company.
• Performance-Based Grants: Some employees negotiate for performance-based stock grants, tying the options to specific company or individual performance metrics.
• Double-Trigger Vesting: This condition ensures that your options vest upon certain events, such as a change of control (acquisition) and your termination.
• Clawback Protections: Negotiating protections against the company clawing back vested options can safeguard your interests.
• Anti-Dilution Provisions: These provisions protect your ownership stake in case the company issues more shares, preventing dilution of your equity.
• Information Rights: Requesting access to company financial information and updates can help you make informed decisions about your options.
• Tax-Efficient Structures: Exploring tax-efficient options for exercising your options and managing your equity can be a valuable negotiation point.
• Relocation Assistance: If your job requires you to relocate, negotiating for relocation assistance can help offset the costs associated with moving.
• Fair Market Valuation: Ensuring that the company conducts regular, accurate 409a valuations to determine the fair market value of the stock can protect you from unexpected tax liabilities.
• Non-Compete and Non-Solicit Clauses: Negotiating the terms of non-compete and non-solicitation clauses can help protect your career options in case you leave the company.
• Board Observer or Advisor Roles: Requesting the opportunity to serve as a board observer or advisor can provide insights and influence in company decisions.
• Legal and Financial Counsel: Negotiating the company's support in covering legal and financial advisory fees related to your stock options can be beneficial.
• Buyback Rights: Clarifying the conditions under which the company can buy back your vested shares can provide peace of mind.

I hope you find this information helpful, but please remember that it only scratches the surface. I strongly encourage you to conduct your own research and consider seeking guidance from legal and tax professionals, especially when dealing with substantial sums of money. The key is to equip yourself with knowledge, take the time to review the documentation, and proactively request favorable terms whenever feasible. However, it's essential to weigh the pros and cons of your requests and decide when to push and when to let go, considering the potential risks involved.

The startup landscape is intricate, particularly because founders often find themselves managing significant finances for the first time in their lives. Despite appearances, their roles are challenging, and mistakes can impact employees. While it's important to be empathetic and understanding, it's equally crucial to voice your concerns when something doesn't seem right. It's worth noting that life isn't always fair, and seeking perfect fairness in every situation can sometimes lead to unfavorable outcomes.

Happy Selling,