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I'm confused about stock options. The numbers in the following story are fictional because I'm keeping the actual offer confidential. This is an American private company with a promising future:

  • Current valuation estimated between 1-3 billion
  • Valuation more than doubled in the last year
  • Been generating revenue for > 2 years

I've been offered a package that includes 100k stock options at 5 dollars a share. They vest over 4 years at 25% a year. Does this mean that at the end of the first year, I'm supposed to pay for 25,000 shares? Wouldn't this cost me 125,000 dollars? I don't have this kind of money.

Am I confused about something?

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Casey - we have specific questions regarding the stock. Is it a publicly traded company? If not, how are shares currently traded? Does the company itself make a market, allowing employees to sell the shares they are granted via incentive programs? –  JoeTaxpayer Nov 25 '12 at 4:44
    
Hi Joe, clarified my question. This is a private company with a promising future. Not sure about internal trading, but I'll ask the company about this. C. Ross, this is a US company (Silicon Valley) –  Casey Patton Nov 25 '12 at 22:37
    
Got it. So the question moves to that of liquidity, after the first options vest, do you even have the ability to take a profit? Hopefully a simple question for you to get straight answers from your company. –  JoeTaxpayer Nov 28 '12 at 4:57
    
Yes. You are confused :) When the option vests you do not need to exercise it. Nothing happens at the end of the first year beyond the fact that you could now buy shares at the option strike price if you so wish. –  Guy Sirton Oct 12 at 23:41

5 Answers 5

ISOs (incentive stock options) can be closed out in a cashless transaction. Say the first round vests, 25,000 shares. The stock is worth $7 but your option is to buy at $5 as you say. The broker executes and sells, you get $50,000, with no up front money. Edit based on comment below - you know they vest over 4 years, but how long before they expire? It stands to reason the longer you are able to hold them, the better a chance the company succeeds, and the price rises.

The article Understanding employer-granted stock options (PDF) offers a nice discussion of different scenarios supporting my answer.

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Alternatively, per Wikipedia, " If the market price falls below the stock exercise price at the time near expiration, the employee is not obligated to exercise the option, in which case the option will lapse." –  AakashM Nov 23 '12 at 10:10
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Keep in mind that you don't have to exercise those options when they vest. You may want to decide to keep them hoping that the stock will keep going up. If say the stock in 5 years reaches $100, you still have the right to buy 25K shares at $5. –  Vitalik Nov 23 '12 at 14:19
    
@Vitalik - Under most circumstances, your best risk-adjusted return will be to get rid of your incentive stock options either immediately, or the day that you get better tax treatment. Your financial well-being is already tied to the performance of your company! Most people will be better served by diversifying the funds sooner, rather than later, even if the stock performance is looking pretty good for the time being. If your options could be sold for $10,000, pretend that you have $10k of cash, and ask yourself: would you rather buy $10k of company stock, or $10k of diversified assets? –  fennec Nov 23 '12 at 23:22
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@fennec - the $10k isn't $10k worth of stock, it's 5,000 shares that are simply $2 in the money. If the stock were to double from there, $7 to $14, he'd be $9 in the money and his $10k profit jumps to $45k. What you've ignored is the time value of the option which if it runs 10 years, is pretty large. Strategy for options is quite different from ESPP or stock grants. –  JoeTaxpayer Nov 23 '12 at 23:40
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@Casey Patton , this entire post assumes that the company is public and that there is a market for the shares of that company. If there is no liquid market then you will be stuck with the shares and no realized reward, unless you like voting rights maybe. –  CQM Nov 24 '12 at 9:30

I've been offered a package that includes 100k stock options at 5 dollars a share. They vest over 4 years at 25% a year. Does this mean that at the end of the first year, I'm supposed to pay for 25,000 shares? Wouldn't this cost me 125,000 dollars? I don't have this kind of money.

At the end of the first year, you will generally have the option to pay for the shares. Yes, this means you have to use your own money.

You generally dont have to buy ANY until the whole option vests, after 4 years in your case, at which point you either buy, or you are considered 'vested' (you have equity in the company without buying) or the option expires worthless, with you losing your window to buy into the company. This gives you plenty of opportunity to evaluate the company's growth prospects and viability over this time. Regarding options expiration the contract can have an arbitrarily long expiration date, like 17 years.

You not having the money or not isn't a consideration in this matter. Negotiate a higher salary instead. I've told several companies that I don't want their equity despite my interest in their business model and product. YMMV.

Also, options can come with tax consequences, or none at all. its not a raw deal but you need to be able to look at it objectively.

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I think stock options and equity are more than just a financial incentive, especially in a small company. Employees with stock options or with equity are more motivated in seeing the company succeed, increase of product quality rather than those who just work for a paycheck. I know at least I am. –  Vitalik Nov 24 '12 at 13:52
    
@CQM - There's typically a long period after vesting, but before expiring, 10 years is common. I've never seen a situation that didn't permit a 'cashless exercise' even with closely held, non-public shares. Do you have any links/docs supporting this answer? –  JoeTaxpayer Nov 24 '12 at 18:27
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@JoeTaxpayer it is highly likely that there will be no willing buyers, your scenario assumes that the options were immediately bought and sold and that the employee gets just the profit difference. In a typical scenario with illiquid securities, there is no one to sell to, so they will be simply bought and there will be a PAPER profit immediately, but there is no way to realize that profit. Off the top of my head I don't have a source for this, but since this is a fundamental aspect of securities liquidity the burden of proof will be on you to disprove it. –  CQM Nov 24 '12 at 20:16
    
@CQM I'll concede that such issues are possible, but likely or not, the OP can tell us the liquidity of his own company stock. If he confirms your scenario, it's a tough situation to own shares that one cannot sell. And instead of a potential windfall, this may turn into a significant risk. I'd not exercise such options until these facts are well understood. –  JoeTaxpayer Nov 24 '12 at 20:58
    
Can you provide examples of or references to the type of situation you're referring to? –  C. Ross Nov 25 '12 at 13:34
  • An option is just that, an option to buy a share. Not the obligation. When your options vest, you will have that option. If you can trade the share for higher than the strike price of your option, then you could make money. If it is trading lower, or there is no market, nothing happens. You just keep the option until it expires. (Look up when it expires - usually 10 years. Also, pay close attention to your vesting schedule. This matters if you decide to leave. If you vest only annually, you would want to stay for a whole year to make sure you vest that year's stock).
  • If you leave the company, you should look at what will happen to your options. A lot of times, you will be required to exercise them within 90 days if you want to keep the shares, regardless of the price of the stock. If your company is private, the price of the stock will be set by a valuation (409a) that is done. So even if there is no market for your shares, they still have a "price" from the IRS perspective. You may also be forbidden from selling your shares to anyone else.
  • In some cases, if you exercise your option, you will be liable for the income gain in the difference between your strike price and the current price of the stock. Say you have an option with a strike price for $1. The shares are trading at $5, or the 409a valuation says your shares are worth $5. If you exercise that option, you now own a share worth $5, and you only paid $1 for it. The IRS now wants their taxes on that $4 of gain. This may be due during that year or not, depending on the type of options you have and other factors that I'm not certain about.
  • It's generally seen as a good thing if you would like to take more compensation in the form of equity. Companies see this as an alignment of interests. You want the company to do well in the long term so that both you and everyone else profits.
  • In order to correctly evaluate this offer, you should find out how many outstanding shares there are. If you ask, your company should tell you. Also, ask about the vesting schedule and if there is a restriction on selling your shares. Also, ask if the company can buy back your shares without your approval if you leave. Finally you have to take a guess as to the liquidity of your future shares (i.e. chances of IPO) and the future valuation or market cap of the company. Based on all that info, you will be able to decide if that tradeoff is right for you or not.
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Stock options represent an option to buy a share at a given price. What you have been offered is the option to buy the company share at a given price ($5) starting a given date (your golden handcuffs aka vesting schedule).

If the company's value doubles in 1 year and the shares are liquid (i.e. you can sell them) then you've just made $125k of profit. If the company's value has gone to zero in 1 year then you've lost nothing other than your hopes of getting rich.

As others have mentioned, the mechanics of exercising the option and selling the shares can typically be accomplished without any cash involved. The broker will do both in a single transaction and use the proceeds of the sale to pay the cost of buying the shares. You should always at least cover the taxable portion of the transaction and typically the broker will withhold that tax anyways. Otherwise you could find yourself in a position where you have actually lost money due to tax being owed while the shares decline in value below that tax. You don't have to worry about that right now.

Again as people have mentioned options will typically expire 10 years from vesting or 90 days from leaving your employment with the company. I'm sure there are some variations on the theme. Make sure you ask and all this should be part of some written contract. I'm sure you can ask to see it if you wish. Also typical is that stock option grants have to be approved by the board which is normally a technicality.

Some general advice:

  • Don't put too much weight on the valuation numbers for a private startup, those come out of mostly thin air based on some future expectations. These do not have to meet the more stringent requirements for public companies or an IPO process and as a future employee your ability to do due diligence on those is pretty minimal. It's nice that the company has revenue but it's future value depends on being able to make a profit. Anyone can make a revenue while losing money.
  • Be very careful about how you account for the value of these options in your total compensation. A lot of people would say you should value those at zero.
  • If things do work out, which is probably a couple of years away, figure out some strategy for converting these options to $. I know people who sat on a paper profit of millions only to see it mostly disappear as the valuation of the company plummeted. Don't be too greedy. Like any investment you'll want to have some sort of exit strategy that gives you some risk/reward compromise. Again, this is probably years away.
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the short answer is: No. you do not HAVE to pay $125,000.00 at the end of your first year. that is only the amount IF you decide to exercise.

*fine print: But if you leave or get let go (which happens quite frequently at top tier Silicon Valley firms), you lose anything that you don't exercise. you're basically chained by a pair of golden handcuffs. in other words, you're stuck with the company until a liquidation event such as IPO or secondary market selling (you can expect to spend a few years before getting anything out of your stocks)

Now, it's hard to say whether or not to exercise at that time, especially given we don't know the details of the company. you only should exercise if you foresee your quitting, anticipate getting fired, AND you strongly feel that stock price will keep going up. if you're in SF bay, i believe you have 10 years until your options expire (at which point they are gone forever, but that's 10 years and usually companies IPO well within 7 years).

i would recommend you get a very good tax advisor (someone that understands AMT and stock options tax loopholes/rules like the back of their hand).

I'm going to take a long shot and assume that you got an amazing offer and that you got a massive amount of ISOs from them. so i'll give this as an advice - first, congrats on owning a lot on paper today if you're still there. you chose to be an early employee at a good tech company. However, you should be more worried about AMT (alternative min tax). you will get enslaved by the IRS if you exercise your shares and can't pay the AMT. suppose, in your fictional scenario, your stock options increase 2x, on paper. you now own $1 Mil in options. but you would be paying $280000 in taxes if you chose to exercise them right now. Now, unless you can sell that IMMEDIATELY on the secondary market, i would highly advise you not to exercise right now. only exercise your ISOs when you can turn around and sell them (either waiting for IPO, or if company offers secondary market approved trading).

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If the valuation is 1-3B he's almost certainly not an early employee. Your yes answer isn't to the question he's asking. He wants to know if he will have to pay that amount and the answer is no. He is only likely to exercise if he can make a profit immediately. It would be extremely risky to exercise otherwise and since he doesn't have the money not really relevant. –  Guy Sirton Oct 12 at 23:48
    
Whatsapp had 55 employees at the time of the $19B acquisition by facebook. it's very possible to still get an "early employee" type package, depending on his fictional company. But yeah, i guess my answer was kind of confusing. i'm trying to say that you would have to pay $125k IF you decide to exercise. but maybe i didn't emphasis the IF enough. i'll add that. thnx for the note. –  Dzt Oct 14 at 23:47

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