Your privately held company just gave you stock options, either in the initial offer or after you’ve been working there for a while. What do you do? WHAT DO YOU DO? (gratuitous 90’s movie reference for your entertainment)
First, a quick primer on what stock options are, to bring everyone up to speed. (Ha! “Speed”…get it? Okay, maybe you need to be at least 40.) howstuffworks.com provides the following, I think straightforward, explanation:
“Stock options from your employer give you the right to buy a specific number of shares of your company’s stock during a time and at a price [called the exercise, grant, or strike price] that your employer specifies.
Both privately and publicly held companies make options available for several reasons:
- They want to attract and keep good workers.
- They want their employees to feel like owners or partners in the business.
- They want to hire skilled workers by offering compensation that goes beyond a salary. This is especially true in start-up companies that want to hold on to as much cash as possible.”
Back in ye olden days of the mid-2000s, I was in this position myself, at a startup in San Francisco. I had a bunch of options, granted at different times, with different strike prices. I didn’t exercise any options until I left the company, and even then I only exercised the cheapest ones with the idea that “If this company hits it big, I don’t want to feel a fool for missing out entirely. On the other hand, I don’t want to waste my money if the company goes nowhere.” Yes, my analysis was fairly, uh, un-nuanced. But, it turned out okay: I spent $300 exercising the options, and that turned in $2500 5 years later. Nothing to sneeze at, but nor was it remotely life-changing.
We tend to kind of freak out about stock options. My pet theory is that our Collective Freak is based on this combination:
- We’ve heard many stories of people getting Filthy Rich, and we’re excited by the prospect that it might happen to us.
- Stock option grants are drafted by lawyers and are therefore hard to thoroughly understand unless we’re also a lawyer.
- Even if we understood how it all worked, the value of a stock options is quite impossible to estimate well.
Put it all together and we have: There’s potentially so much at stake, and yet we have little ability to make a reasonably calculated decision about it. We humans hate the feeling that we don’t control our own fate.
Dan Shapiro’s 2010 blog post amply illustrates the incredible complexity (and futility?) of trying to calculate or predict how much your options are worth. I don’t want to get into that. Either now or with my clients.
Thankfully, for the most part, the process is a lot easier than we think it is. Yes, there are a lot of technical fiddlybits (term of art, I assure you) about stock options. But the real questions don’t focus on the stock or the company…they focus on your own financial situation.
You can’t control the value of your company stock (options).
You can control how you integrate them into the rest of your finances.
Find Out Everything You Can About Your Options, Company Stock, and Company
I’ve just finished saying that estimating the value of your stock options is folly. But it is definitely not folly to be as informed as possible about your stock options, company stock, and company. Aside from your interests in your stock options, being aware of and interested in your company’s financial situation can only make you a more informed “consumer” of your employment there.
If you work for an Amazon or a Microsoft, you know exactly how much company stock is worth and the current health of the company (as can anyone else in the public). But if your company is private, company financial information, including how much company shares are worth, is much harder to get at and sometimes juuuust kinda arbitrary.
You can get a lot of this information either from the stock option award agreement (the document you’re given that lays out how many options you’ve been granted, what the strike price is, and all the other terms) or by asking your HR department. Some of the basics you should know are:
- When are you allowed to exercise your options? When do your options vest, that is, when are you allowed to exercise them? Also, how long after leaving the company can you still exercise your options? What if you’re fired (let go “for cause”) or laid off? Can you still exercise them if you leave for that reason? Is early exercise allowed?
- What kind of stock options are they? Incentive (ISO) or Non-Qualified (NQSO)? The tax implications are very different. For example, when you exercise ISOs, you don’t owe tax (aside from possible Alternative Minimum Tax). When you exercise NQSOs, you owe taxes right then and there.
- Do you own your vested options or stock outright? Or does your company retain “repurchase rights”? Repurchase rights allow your company to buy or take back stock or options you have in the company when you leave the company. Mary Russell, an attorney who “counsels individuals on equity offer evaluation and negotiation, stock option exercise and tax choices, and sales of startup stock,” explains why this is so horrid for you, the employee.
- What kind of rights do you have as a shareholder if you exercise your options? Different options turn into different kinds of company shares, which in turn accord different rights to shareholders. Much like what was discussed in the above post about valuing stock options, your stock might be on the bottom of the ladder. Most likely, as an individual contributor, you’re going to get the shares with the least rights, and the lowest possibility of turning shares into Actual Money when a “liquidity event” occurs.
- What percentage of company ownership do your options represent? The number of options you are granted is a rather meaningless number.
If you are granted 100 options and there are only 1000 shares in the company, sweet! You are on track to own 10% of the company, all else equal. (By the way, so not going to happen for an individual contributor.) But if you are granted 100 options and there are 1M shares in the company, well, you can own 0.01% of the company (more like it). And keep in mind that your percentage ownership can shrink…and probably will.
John Greathouse’s 2009 blog post (yes, that VC dude who got in Big Trouble when he suggested women obscure their gender in Social Media) goes into more detail about how to figure out the percentage ownership your grant represents.
Even if you get fairly specific answers to the questions above, please don’t let it persuade you that you can make a well-informed decision about what your options will be worth in the future. The information can, I think, best be used to avoid making bone-headed mistakes, not actively making prescient ones.
Start with Your Own Finances
People tend to start their thought process with the stock options and work their way to their personal finances. I propose the reverse: start by looking at your personal finances (the stuff you can control) and work your way into the best decision regarding the stock options (which you can’t control).
Ask yourself these questions:
- How much can you afford to lose? Until your company has announced it’s going IPO or getting acquired (or some other definitive indication of “these shares are turning into actual money”, that they’re no longer “imaginary fantasy money,” as one of my clients calls them), you don’t have any realistic idea that there’s gold in them thar hills. So, any money you spend exercising options until then is simply a gamble.
- How much are you willing to lose? In investing, these two concepts (how much can you lose, and how much are you willing to lose) are known as risk capacity and risk tolerance. The former is an objective financial measure. Willingness/tolerance is an emotional measure.
To be extreme about it, when you’re 30, maybe you can afford to lose all your money, because you have the next 3-4 decades to save for retirement. But I’m guessing that losing all your money would make you very unhappy, so you’re not willing to lose more than, say, $1000 or $5000 or $15,000 in a gamble on your company.
- Can you go without this money for a while, even if you eventually get it back? Money invested in company stock is illiquid (it’s hard to turn the stock back into easily accessible cash). So, even if the shares eventually are worth something, until then, you don’t have access to that money.
Think Through the Possible Outcomes
So, what are your choices?
- Exercise all of your stock options.
Upside: If your company hits it big, you might just hit it big, too.
Risk: You risk losing all the money you spend exercising the options. And if they’re NQSOs (or you’re subject to AMT), you risk owing tax, too, on stock that could eventually be worth nothing.
- Exercise some of your stock options. Who said it was all or nothing, huh?
Upside: If your company hits it big, you could hit it a smaller slice of big, too.
Risk: You risk losing all the money you spend exercising the options (and paying associated taxes), but this time at least you’ve put less money at risk.
- Exercise none of your stock options.
Upside: You don’t risk any money on the fate of your company. And let’s face it, most startups fail. Statistically speaking, this is probably the most prudent choice.
Risk: Your company actually becomes valuable, and you kick yourself for missing out.
The best decisions in investing (or gambling) are made only with hindsight. Because the risk of losing your money in a startup is so high, focus on not jeopardizing the rest of your financial life in order to get a piece of the action. But if you can manage your risk and still afford to make a bet on your company, feel free.
Especially if you are receiving a significant (potentially life-changing) amount of options, you should get legal and/or tax counsel. Stock option agreements are legal documents and, as such, are largely Greek to us non-legal folk. But the details can have profound consequences for your finances.
Question: What are you doing with your stock options in your private held company? You can leave a comment below.
Do you want to understand your options and how to make them work best for you? Do you want to figure out how to take part in your company’s potentially lucrative future, without jeopardizing your own? Reach out to me at firstname.lastname@example.org or schedule a free 30-minute consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.