How do Employee Stock Options Work?

[ER_Hopeful]

I'm about to join a small start up company and it offers an employee stock option plan. some of its terms & conditions is as follow, can someone explain it to me in English.

it says I'm entitled to 100,00 shares of Series A common stock at an exercise price of 45 cents/share. 1/4 of the shares shall vest on the one year anniversary of my commencement date. 1/36 of the rest will vest after each full month.

I've never had ESO before so I'm clueless. Did some quick googling but want to pick the brains here. some of my questions:

1. say after 1 yr, I'd like to sell the 1/4 vested shares, who do I sell it to? back to the company ? how do you determine the market value of the shares since it's not publicly traded?

2. say after yr 1, the value of the stock is 50 cents, does that mean I can buy at 45 cents and pocket the 5 cents profit(subject to tax, of course) ?

 

[SVHoper]

Since you say that it is a small company and the shares are not publicly traded... there may well be no market for your options until a liquidity event like an IPO or acquisition... and this may not ever happen.

The "value" of the shares can be similarly without any value to you, but a value for accounting and company valuation for raising capital.

However, if there is an IPO - they could be worth millions

 

[kaneohe]

Why don't you ask the company for a copy of the stock plan? Perhaps they may hire someone to value the private company on a periodic basis based on
comparison w/ similar public companies. Or maybe something else.

You also want to find out if they are incentive stock options or non-qualified stock options.

 

[Got2golf]

We have been through several companies with preIPO stock options (only one of 4 hit it big). You should get a good book and learn all about them. Then learn some more. If you can, you should see if you can do an "83b" election - to purchase the stock options now (pre IPO) and then hold them until after IPO. Big tax advantages to doing that. The biggest thing is to work your *** off to make the company successful so that you do go public and that you do make millions. In the end, it is typically the venture capital people and founders that make the mega millions. Be prepared for a roller coaster! It is an exciting adventure - with no guarantees - not for the faint of heart. Just make sure you still get a good salary since the IPO may never happen. Best of luck to you!

 

[Brat]

One way to assess the odds of a purchase or IPO is to look at the success of the venture capital firms involved with your employer. I agree that even with the strongest VCs success is far from certain. Stock options can be worth a lot, or nothing at all.

If the firm is bought out or goes public you should sell as much as necessary to pay your tax liability as soon as legally possible.

My daughter is in venture capital. She once observed that the way you an predict a business disaster is to watch the CFO chair. If the CFO leaves (short of an obvious career move, death or planned retirement) expect the worst. In my experiance I say watch the movement of Sales Representatives. They know the industry and their competition and if they start moving one direction follow them.

 

[clifp]

Good advice so far.

As a general rule there won't be a market for the shares of your company, until they go public, or in some rare instancing to fellow workers or current investors.

If the company gets to around 100+ employees or the Board of Directors will typically set a "fair value" for the stock for new employees and new investors, this price is updated 1-4 times a year. Companies often keep this information pretty secret so make friends with somebody in HR or finance.

100,000 shares sounds like a lot, but what is really important is to see what percentage of the company you will own when fully vested. Obviously a 100,000 share in a company with 5,000,000 shares outstanding (2%) is much bigger deal than 100,000 share if the company has 100 million shares outstanding (.1%).

I wouldn't try and make a modest profit in this situation i.e. don't hope that it goes up to $.50 so you can make a $.05/share. The most likely situation is that the shares will be worth nothing, a decent chance they'll be worth $2-$5 in take over situation, or $10-15 in an IPO or late stage merger for the lucky few.

But stock options can be life changing, they were for me.

 

[RunningBum]

If the firm is bought out or goes public you should sell as much as necessary to pay your tax liability as soon as legally possible.

I don't understandthis comment. You don't have a tax liability UNLESS you sell shares, do you? The only ESOPs I had were at an already publicly traded company so possibly it's different for a private company, but I don't see how the company going public or being bought out is a taxable event for an individual.

Edit: As soon as I posted this I remembered that exercising the options (whether you sell or not) is a taxable event. Are you forced to exercise when a private company goes public or is bought out?

 

[Rambler]

I don't understandthis comment. You don't have a tax liability UNLESS you sell shares, do you? The only ESOPs I had were at an already publicly traded company so possibly it's different for a private company, but I don't see how the company going public or being bought out is a taxable event for an individual.

Edit: As soon as I posted this I remembered that exercising the options (whether you sell or not) is a taxable event. Are you forced to exercise when a private company goes public or is bought out?

If the company is bought but left as a standalone entity, it could be that they leave the options in place, or the shares could vest immediately and you would most likely have to sell upon the transaction or wait until the squeeze out. OP, you need to check the plan to see if the options vest immediately on takeover or any other takeover provisions.

Upon IPO, in every case I have looked at, the options are still valid on the original vesting schedule. If it looks like it is headed for IPO, hang on to the options as long as you can and then buy the shares if it appears the offering price will be higher than the strike price. Usually in an IPO the offering will be much highr than the early employees/optionees' strike price. A friend of mine went to Yahoo in their early days, got a bucketload of options, and for a while was a stock option millionaire several times over. I pulled in a good sum on options myself over the years but it wasn't an easy ride, and in the crash I left too much on the table in options when I should have cashed and run. They finally expired last year, worth less than the toilet paper they were written on as our stock had been hit so hard.

Good luck,

R

 

[Brat]

What Rambler said. Stock options can bring great wealth but they can kill you financially if you aren't careful and don't have knowledgeable guidance. Even tech executives get burned.

If the new job is work you want and the salary is acceptable stock options can be a nice plus.

 

[SteveL]

Basically, this approach to compensation is an attempt to link your efforts to the success of the business. The shares won't be worth anything unless the company goes public. You need to know when the options expire. There is no need to exercise unless the company has had an IPO, and, even then, if you exercise you may be prevented from selling your shares except for certain "quiet " periods each quarter. One of my sons worked for a couple of startups before he went to grad school. His options turned out to be worthless.

It is fun to speculate about what something might be worth. It is much more important to know what kind of financing this company has, and what its burn rate is. Most of these start ups burn through money, and need a series of fund raising from venture sharks, and other sources. If they burn up all the money before their product makes it to market, then the boat sinks.

 

[eridanus]

What Got2Golf wrote. Do an 83b purchase. It turns your gains into long-term capital gains.

The downside is that you'll be buying the shares before you know they'll be worth anything. *Flush* You can always claim the loss if it doesn't fly.