Understanding Employee Stock Options in Private Companies

Employee stock options can be a powerful tool for private companies to attract and retain top talent, but they can also be complex and confusing. One key aspect of employee stock options is that they are typically granted to employees at a specific price, known as the strike price.

This strike price is usually set by the company's board of directors and can be a fixed amount or a formula-based amount. For example, it might be set at the fair market value of the company's stock on the date of grant.

As an employee, it's essential to understand that employee stock options are not a guarantee of wealth, but rather a potential opportunity to earn a profit. To exercise your options, you'll need to pay the strike price and then sell the shares at the current market price, hopefully making a profit.

The value of your employee stock options will depend on the company's performance and the overall stock market.

Additional reading: Net Operating Profit after Taxes

Employee stock options are a type of equity compensation granted by companies to their employees and executives.

They are call options that give the employee the right to buy the company's stock at a specified price for a finite period of time. This price is usually spelled out in the employee stock options agreement.

ESOs cannot be sold, unlike standard listed or exchange-traded options.

The greatest benefit of a stock option is realized if the price of a company's stock rises above the call option exercise price. If this happens, the employee can exercise the option and obtain the company's stock at a discount.

The employee may then choose to immediately sell the stock in the open market for a profit or hold onto the stock over time.

On a similar theme: When to Exercise Employee Stock Options

Employee stock options (ESOs) can be a great way to share in the success of a private company, but it's essential to understand the benefits and risks involved.

For employees, ESOs offer a chance to directly share in the company's success through stock holdings. This can be a motivating factor for employees to be fully productive and feel a sense of ownership.

ESOs can also provide financial gains when stock obtained at a discount is sold for a profit. Depending on the plan, there may be tax savings upon sale or disposal of the shares.

However, there's a risk of losing time value if the stock doesn't appreciate in value. In fact, the potential loss of time value can be quite steep, as demonstrated in the example where holding ESOs to buy 1,000 shares at an exercise price of $50 resulted in a $35,000 loss in time value.

For employers, ESOs are a key recruiting tool for top talent and can boost employee job satisfaction and financial well-being. They also incentivize employees to help the company grow and succeed.

Here's a breakdown of the benefits and risks of ESOs:

Employee stock options (ESOs) are a type of equity compensation granted by companies to their employees and executives. ESOs are call options that give the employee the right to buy the company's stock at a specified price for a finite period of time.

The terms of ESOs are fully spelled out in an employee stock options agreement, which typically includes the strike price, expiration date, and vesting schedule. The strike price is the price you pay to buy shares of stock if you exercise your options.

There are two main types of ESOs: incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs are generally only offered to key employees and top management, and receive preferential tax treatment. NSOs, on the other hand, can be granted to employees at all levels of a company, and profits on these are considered ordinary income.

To receive stock, you must exercise your options when they vest. When you exercise 25% of your ESOs, you will get 250 shares of the company's stock at the strike price.

Additional reading: Brk.b Outstanding Shares

The tax implications of receiving ESOs are complex, but generally speaking, the option grant is not a taxable event. However, taxation begins at the time of exercise, and the sale of acquired stock triggers another taxable event. The tax payable at the time of exercise is a major deterrent against early exercise of ESOs.

Here are the key points to consider when reviewing your equity compensation package:

The option grant itself is not a taxable event, but taxation begins at the time of exercise. You'll pay taxes on the spread, also known as the bargain element, which is the difference between the exercise price and the market price.

Ordinary income tax is applied to this spread, and the IRS considers it as part of an employee's compensation. You'll report the assumed gain to state and federal tax authorities.

The sale of the acquired stock triggers another taxable event, and if you sell the shares at any time up to one year after exercise, the transaction would be treated as a short-term capital gain and would be taxed at ordinary income tax rates.

Suggestion: Employee Stock Options Tax Treatment

If you sell the shares more than one year after exercise, the profit would qualify for the lower capital gains tax rate.

Here are the key tax implications to consider:

Exercising your stock options while the company is still private can be costly, with the average Secfi customer requiring $543,000 to exercise their stock options in 2021, with roughly 73 percent of that amount going toward covering their tax bill.

Determining the value of employee stock options (ESOs) can be a complex task, especially for private companies. This is because there is no market price reference point, unlike exchange-traded options.

Option pricing models are needed to value ESOs, and your employer is required to specify a theoretical price of your ESOs in your options agreement on the grant date. The value of ESOs can vary widely depending on the assumptions made in the input variables, such as expected length of employment and estimated holding period before exercise.

Related reading: Class B Shares Private Company

The main determinants of an option's value are volatility, time to expiration, the risk-free rate of interest, strike price, and the underlying stock's price. Understanding the interplay of these variables is crucial for making informed decisions about the value of your ESOs.

Time value is a very important component of options pricing. If you are awarded at-the-money ESOs with a term of 10 years, their intrinsic value is zero, but they have a substantial amount of time value.

Here's an example of how option prices can change based on different volatility levels:

The key takeaway from this section is that merely because your ESOs have no intrinsic value, do not assume that they are worthless. Because of their long time to expiration compared with listed options, ESOs have a significant amount of time value that should not be frittered away through early exercise.

Readers also liked: Time in the Market vs Timing the Market Graph

Exercising stock options can be a complex process, but understanding the basics can help you make informed decisions. The most important choice you'll make is deciding when to exercise them, and this decision can have significant financial implications.

Exercising your stock options pre-exit typically carries higher financial risk, as well as higher potential financial rewards. You could face surprisingly high exercise costs, with the average Secfi customer requiring $543,000 to exercise their stock options in 2021. Roughly 73 percent of that amount went toward covering their tax bill.

If you decide to exercise your stock options after an exit event, your risk plummets because you can see exactly how much it will cost to exercise your stock options, how much you'll owe in taxes, and how much the shares are ultimately worth.

Here's an interesting read: Exercise Stock Options

Holding onto your stock options until expiration can be a smart move, but it's essential to understand the implications.

You'll still have to pay taxes on the exercise, even if you don't sell the stock. This is a key consideration, as the tax bill can be steep. For example, if you exercise 10,000 shares of stock options at a strike price of $1 per share, and a 409A valuation of $5 per share, you'll report an assumed gain of $40,000 to tax authorities.

Check this out: Common Share Equity

The value of your stock options will decay over time, a process known as theta. This decay happens at a rate that's a square root function of the time remaining. As a result, the time value of your options will decrease as they get closer to expiration.

The composition of your option's value will change as it moves from being out-of-the-money (OTM) to in-the-money (ITM). For example, an OTM option with a $50 exercise price and a stock price of $75 will have less time value and more intrinsic value. The further out of the money that an option is, the less time value it has.

Here's a breakdown of the value composition for in-, out-, and at-the-money (ATM) options with a strike of $50:

Keep in mind that even if you hold onto your stock options until expiration, you'll still give up some value due to the decay of time value. However, holding onto your options can be a good strategy if you believe in the long-term prospects of your company.

You've got a limited time to exercise your stock options after leaving your job, known as the post-termination stock option exercise window. This window is typically 90 days, but some companies offer up to 10 years.

If you fail to exercise your stock options within the 90-day window, you'll likely lose them forever. It's a good idea to review your employee contract or speak with HR to confirm your company's specific policy.

The type of stock option you have also affects your post-termination exercise window. If you're earning ISOs and your company has a longer-than-90-day window, they'll automatically turn into NSOs after 90 days. NSOs have less generous tax benefits than ISOs.

Determining the fair market value (FMV) of your company's stock is crucial when structuring incentive stock options (ISOs). This is because the exercise price should be set at the stock's FMV on the grant date to avoid adverse tax consequences.

Private companies often face challenges in determining FMV, which can require external valuations to ensure accuracy. A 409A valuation, also known as fair market value, is an appraisal of the value of a company share for tax purposes.

To mitigate potential dilution and valuation impact, companies need to assess how ISOs might affect their valuation. This can be done by considering strategies to minimize significant dilution.

Here are some common considerations for private companies:

Structuring Incentive Stock Options (ISOs) is a crucial aspect of private company compensation. The exercise price, or the price at which employees can buy the stock, is foundational to an ISO. Typically, it should be set at the stock's fair market value (FMV) on the grant date to avoid adverse tax consequences.

Determining the fair market value (FMV) of a private company's stock can be challenging, often requiring external valuations to ensure accuracy. This is especially true for private companies, as they don't have a public market price to reference.

To determine the exercise price, companies need to consider the FMV of their stock. This can be done through external valuations, such as a 409A valuation.

Here are some key considerations for structuring ISOs:

Companies need to assess how ISOs might affect their valuation and consider strategies to mitigate significant dilution. This can be done by implementing vesting schedules that incentivize employees to stay with the company and earn their options over time.

Concentration risk is a significant consideration for private company employees with employee stock options (ESOs). This risk arises because all your ESOs have the same underlying stock.

Having a large number of ESOs can lead to a concentration of wealth in your company's stock, making you vulnerable to market fluctuations. This is a major concern highlighted by the Financial Industry Regulatory Authority (FINRA).

If you also have a significant amount of company stock in your employee stock ownership plan (ESOP), you may unwittingly have too much exposure to your company. This can be a double-edged sword, as a downturn in the company's stock price can have a devastating impact on your financial situation.

A diversified options portfolio can help mitigate concentration risk, but it's essential to be aware of this risk and take steps to manage it.

Counterparty risk is a valid issue that's hardly ever considered by employees who receive employee stock options (ESOs). As the counterparty to your ESOs is your company, there's no intermediary to guarantee performance.

In the U.S., listed options have the Options Clearing Corp. as a clearinghouse, which eliminates counterparty risk. But with ESOs, you're at the mercy of your company's financial situation.

Monitoring your company's financial situation is crucial to avoid being left with valueless unexercised options or worthless acquired stock. It's a prudent step to take, especially in uncertain economic times.

Employee stock options can be a complex and confusing topic, but understanding some common terms and concepts can help you navigate the process. Here are some key terms to know:

A 409A valuation, also known as fair market value, is an appraisal of the value of a company share for tax purposes. This valuation is crucial when exercising incentive stock options (ISOs).

Broaden your view: Damodaran on Valuation by Aswath Damodaran

The vesting period is the length of time an employee must wait before they can exercise their employee stock options (ESOs). This waiting time serves as an incentive to the employee to perform well and stay with the company.

A cliff is a type of vesting schedule that designates the length of time an employee must work for a company before their options start to vest. This can be a significant hurdle for employees who leave the company before reaching the cliff.

Exercise refers to the act of buying the shares that are available to you through your employee stock options. This can be a crucial decision, as it determines how much of the company you will own.

Incentive stock options (ISOs) give you the right to purchase shares at a specified price and could qualify for advantageous tax treatment. This can be a significant benefit for employees who are considering exercising their options.

Non-qualified stock options (NSOs) give you the right to purchase shares at a specified price, but do not offer the same tax benefits as ISOs. This is an important distinction to make when considering your options.

Recommended read: Capital Gains on Employee Stock Purchase Plan

Here is a list of common exit strategies for company shareholders:

Understanding these common terms and concepts can help you make informed decisions about your employee stock options and navigate the process with confidence.

ISOs have their limitations, and one of the most significant drawbacks is the cap on vesting. Only $100,000 worth of stock options can vest annually per employee.

This means that any options exceeding this limit are automatically converted into non-qualified stock options, which don't offer the same tax advantages as ISOs.

The Alternative Minimum Tax (AMT) can be a major pitfall for employees exercising ISOs. The difference between the exercise price and the market value of the stock becomes a preference item for AMT purposes.

This can lead to a higher tax bill for the employee, even if the amount isn't treated as ordinary income for regular tax calculations.

Managing ISOs can be a complex task, requiring companies to maintain meticulous records. These records must include details like issuance dates, exercise prices, vesting schedules, and expiration dates.

Companies must also ensure timely communication with employees about their ISOs and any related tax implications. This can be challenging, especially for smaller companies without dedicated HR or finance teams.

Take a look at this: Present Value of Tax Shield

When exercising stock options, people often rely on cash savings to cover the costs.

You could be facing significant stock option exercise costs, depending on your specific situation. Even if you have the money, you might not feel comfortable tying up so much cash in an illiquid asset.

Cash savings are a common solution for paying off stock options.

Taking out a loan is another option, but it's essential to consider the interest rates and repayment terms.