Stock ownership or options
This page is based on personal experience, and is based on what I know of American tax law. I am not a lawyer, however, and can not claim that this information is currently accurate. Use it at your own risk. See also a paper on stock I wrote for fellow employees of a company several years ago. It covers a bit more material, stock goes into more depth on some topics. You can get paid in stock or in options. If you get paid in options, you receive the right to buy the stock later, at a set price. If the stock is selling on the open market for more than the strike price, you can exercise the option, buy the stock for the strike price, and then sell it immediately for the market price, pocketing options difference as profit. The lower the strike price, the more profit you make. That means that the maximum profit the option holder can realize is movement in the stock price after the time options are issued. With stock, there are no cash flow concerns. Once you own the ownership, you own it. With options, however, you need to come up with the money to exercise the options. Rarely—and never in a venture backed by professional investors—will you be given that ability. The holding period can range from 6 months to 3 years. The intent of this is to prevent monkey business in which insiders are allowed to purchase pre-public shares immediately before an IPO and then turn right around and sell them. In fact, there options currently a strong movement in ownership to eliminate the holding period. To make matters worse, taxes can cause a cash flow issue in all of this. When you exercise the options, the difference between the option strike price and the market price of the stock is treated as normal income, taxable at your full tax rate. Your full tax rate can be quite high, once state and federal are both taken into account. When you sell the shares you acquired by exercising your options, ownership up or down movement in the share price since the date of exercise counts as a capital gain or loss. Possibly subjects you to the alternative minimum tax AMT. When you sell the shares, the difference between the strike price and the share price is taxed. If the shares have been held for less than a year, the normal income tax rate is used. If they have been held more than a year, stock capital gains rate is ownership. If you want compensation that vests over time in a private company, stock may be a poor choice. As each block of stock vests, it constitutes taxable income equal to the fair market value of the stock at the time of vesting not at the time the contract is written. You have to come up with ownership cash to pay the taxes some other way. Options are more palatable, but they introduce a quandry. In a private company, you would like to exercise your options as soon as possible. You will start the liquidity counter ticking early, so your holding period will be over by the time the stock is tradeable. And if your options are not incentive stock options, they will generate a normal income tax rate hit. You also want to take that hit which happens at exercise time on as low a stock value as possible, and have stock of your gains happen as a capital gain or loss. But on the other hand, you might not want to exercise your options until the company goes public. The shares you receive from the exercise will be fully liquid, and you can trade them immediately. But your entire gain market price minus strike stock will be taxed as normal income. That can be a huge incremental tax burden. Whether to exercise options while a company is still private is a complicated, individual question. The answer depends on your regular tax brackets, your capital gains brackets, how long you think it will be until the stock goes public, and how much money you have to pay taxes on the options exercise. Well, then you have to find someone to buy your shares ownership you want to make any money off them. What happens if more stock is issued to give to new investors? Your shares get diluted. If you are in a very powerful negotiating position, you may be able to get an anti-dilution provision, which lets you maintain your percentage ownership in the firm even when new shares are issued. Stock if the company gets bought out while I own options or stock? This depends on your agreement and the terms of the sale. An IPO or acquisition can drastically change a company, effectively making it a different place than you signed up to work in originally. If you can swing it, the safest thing to do is to require that your options or shares vest immediately upon a public offering or acquisition. How much should I ask for? As much as you can get. A few very, stock rough rules of thumb: Options effectively traded salary for equity without getting enough stock to compensate them for the risk they took or options the fact that it took two years before they saw the money. Keep in mind that subsequent funding rounds will dilute you. What matters is the percentage you own when the company goes public or is acquired. The percentage you own today may be less options. It depends what percentage ownership is of the company. If the company is the next AMAZON. See the essay on Equity Distribution to get an idea of what percentages are options percentages. You are investing your time and reputation with the company. Any aboveboard company would instantly reveal those numbers to a monetary investor. Without knowing the percentages, you can not evaluate the value of your options. Companies split their stock immediately before going public, or they reverse-split their stock, to adjust the share price. You may have 30, options today, but a pre-IPO reverse split of ownership will leave you with just 15, shares after the IPO. One was 2-for-3, the other was 1-for-2 reverse split. Once you know what percent you own, find the value by multiplying the expected company valuation by your percentage ownership at IPO. Remember that the IPO itself dilutes all shareholders. But how do you know that 3, shares today will still be 3, shares at IPO? Does the company care if they give me stock or options? They may, but if they do, it is only because of the accounting treatment or administrative overhead of giving out stock. Either way, they are giving you ownership or an option of ownership in the company. One of the critical things I learned from Stever [was to]…give myself permission to want it all; to not think in terms stock mutual exclusivity. The results have been remarkable. To date, I have built a business which is almost unprecedented in scale among independent entrepreneurs under the age of 40 and I can trace a lot of that right back to Stever. All rights reserved in all media. Things to Know about Stock vs. Download my stock on Stock and Options. Links Get-it-Done Guy podcast. Random Quote One of the critical things I learned from Options [was to]…give myself permission to want it all; to not think in terms of mutual exclusivity. The right to buy or sell stock at a predetermined price. The price at which an option lets you buy stock. The price at which stock is selling on the open market. You rarely receive stock or options all at once. The schedule over which shares or options vest. Often, a person receives a certain number of shares each quarter or each year. If the company issues an additional 1, shares to investors, there are now 2, outstanding shares. This is called dilution. When a company is public, its shares are registered with the SEC. Options which get special tax treatment: No tax hit when exercised. If you are receiving actual stock shares that vest, the moment they vest, the amount vested becomes treated as normal income, taxable at your full tax rate. When you sell your shares, you realize a capital gain or loss on any movement in share price from the time that you acquired the shares.
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