Your Definitive Guide to Equity CompensationAugust 19, 2019
What Is Equity Compensation?
Equity compensation is the portion of total compensation that lets employees own a slice of their company. Shares of company stock as compensation supplement the more traditional forms of compensation like salary, bonuses, commissions, and employee benefits (insurance, paid leave, etc.).
Access to equity shifts an employee’s relationship with their employer. Understanding what equity compensation is, how it works, and the important levers one has can support decisions that increase the probability of obtaining financial independence at an earlier age.
Why Does it Matter?
New hire equity grants and equity refresh grants for existing employees are becoming more popular for several reasons. Namely, they:
- – Attract and retain talent in a competitive job market
- – Encourage an ownership mentality from employees of all levels
- – Are more cost effective for the employer than paying cash
From an employee perspective, ownership in a business can jumpstart one’s path to financial freedom. The traditional method of exchanging one’s time for a salary and bonus creates saving potential to benefit from the effects of compounding over time. But owning a percent of the business while also renting out time offers the ability to capture additional upside and increases the odds of experiencing life-changing levels of wealth more quickly.
How this Guide is Organized
Rather than multiple piecemeal blog posts for you to sort through, this comprehensive guide is applicable irrespective of what equity compensation complexity you’re navigating. This information is essential to properly frame trade-offs when switching companies/roles, understanding and negotiating job offers, or making decisions with your current equity comp package.
For maximum benefit, we recommend investing the time to read the entire guide to absorb the framework. However, the content is organized to outline incentives and important considerations based on company stage. So, you can use the following hotlinks to get what you need and then read the rest later to complete your mental model:
- – Public companies (RSUs)
- – Late-stage private companies (RSUs)
- – Mid-stage private companies (NSOs & ISOs)
- – Early-stage private companies (Restricted Stock & ISOs)
These building blocks offer a foundation for strategic thinking about equity from first principles. This framework offers context to help you make decisions regarding company stock that could save you tens of thousands or even hundreds of thousands of dollars.
QUICK NOTE: Although this essay is comprehensive, the inherent nuance of equity comp is at odds with brevity. To limit the length, we are hosting informational webinars and writing follow up pieces for a deeper dive into the most complex aspects to supplement the framework. You can sign up via this link for access to follow up content.
Equity Incentives from the Ground Up
Companies offer shares of stock as an equity incentive to attract and retain top talent and to align that talent with the long-term vision of the organization. Early in a company’s life, founders carve out a percent of the total shares of stock in the company (often between 10% and 20%) as an “employee pool.” As a company identifies crucial roles to be filled, prospective employees are offered shares from the employee pool.
The Board of Directors, made of founders, investors, and advisors determine the equity grants for these new employees. Knowing that quality employees are the primary driver for the long-term success of any company, equity arrangements dictate that employees earn access to chunks of ownership over time based on a vesting schedule.
Although less common today, 401(k) plans can have vesting schedules in place for the employer match to incentivize a similar long-term commitment to the company.
E.g. Employer matches 5% of employee contributions, but the employee must work at least 1 year to keep any of the match and 4 years to keep all of it.
Equity vesting terms vary, but the premise is fundamentally the same. Companies cannot reach goals without their talent invested in the long-term vision of the company. And nothing says “let’s work our asses off, we’re in this together” like the prospect of turning hard work and sacrifice into the next unicorn with infinite upside.
This dynamic is at the heart of the equity compensation structure and demonstrates why equity packages differ based on the stage of the organization. Understanding the incentives at each stage of a company’s life offers a lens through which we can more clearly think about company stock.
Equity at Public Companies
Public companies offer the best starting point to understand equity compensation because they are the least complex and most like the type of equity we’re accustomed to – the stock market for publicly traded companies. Public companies generally only offer access to Restricted Stock Units (RSUs) as a portion of total compensation.
Restricted Stock Units get their name because these units are not actually shares of stock. A grant of units represents a promise of a specified number of shares under certain conditions. When RSUs vest and the restrictions are lifted, the units convert to actual shares of stock in the company and earn voting rights.
A company’s vesting schedule dictates when an employee has access to the shares. The most common vesting schedule is a four-year period where the first chunk vests 12 months after grant, referred to as a “one-year cliff”. Usually 25% of the granted shares vest at the one-year cliff and the remainder vest monthly (1/48th of the original grant) or quarterly (1/12th the original grant) over the remaining 3 years.
A job offer at a public company with equity comp likely includes base income, bonus opportunity, potential sign-on bonus, and a “new hire grant” of RSUs. Equity refresh grants are often available for existing employees based on level, and generally coincide with an annual review or promotion.
Scenario: An offer letter includes an RSU grant for $100,000 worth of company stock currently valued at $50 per share (equal to 2,000 total shares). Assuming a four-year vesting schedule with a one-year cliff, 500 shares will land in the employee’s account 12 months from the grant date. This means that in addition to salary and bonus, the employee expects to earn another $25,000 per year (assuming the stock is still valued at $50 when it vests).
An employee is first taxed at the time the RSUs vest because the grant date is inconsequential from a tax perspective. The total value of the stock that vests each year (number of shares that vested multiplied by the market price of the stock on the vesting date) is treated as ordinary income.
The IRS considers income from RSU vests as ordinary income and uses “supplemental wage rates” to determine tax withholding. The mandatory minimum withholding rules for RSUs differ from salary withholding that is dictated by the how an employee completed the Form-W4. 22% is the minimum Federal withholding for RSU income under the new TCJA tax laws.
States may impose additional withholding requirements. For example, California has a minimum supplemental withholding rate of 10.23%. Ignoring FICA and Medicare taxes for simplicity, a California resident would automatically have 32.23% of the vested shares sold to cover taxes the day the shares vest. The remaining 67.77% of the vested shares would land in the employee’s stock plan account. Employees can then choose to either hold the stock or to liquidate it.
Potential Capital Gains Taxes
Held RSUs are treated like any other capital asset. The vesting price and vesting date are treated as the cost basis and purchase date respectively. Holding the shares for at least 12 months from the vest date qualifies the asset for long-term capital gains treatment. Long-term capital gains rates are up to 15% lower than short-term gains rates because short-term gains are taxed at ordinary income rates. Irrespective of whether shares are sold as short-term or long-term, no additional withholding is applied by the company. It is also possible for held shares to drop in price after they vest, resulting in a capital loss if they are sold at a lower price.
RSU grants represent a guaranteed number of shares an employee will receive in the future provided they stay employed with the company. This helps employers retain talent for longer periods of time. Additionally, since an increase in the company’s market price increases the value of future RSU vests, employees are incentivized to work towards the long-term success of the company. This is obviously in addition to, and separate from, the promotions and cash bonuses they may also receive for helping the company grow.
Equity refresh grants are generally issued based on time in role, for individual contribution, or for beating company benchmarks. This new grant will hopefully be worth more when it vests in the future, but to receive those shares the employee must stick around through the new vesting schedule. If an employee leaves before a vesting schedule is completed, all unvested shares are forfeited.
Public companies also use the liquidity of their public stock to differentiate themselves from private companies. Employers often refer to their RSUs as “same as cash” because employees can exchange shares for cash in the public stock market the day shares vest, increasing the employee’s annual cash flow. Private companies may offer a comparable total compensation number, but it’s unlikely any of the private equity will have liquidity in the near-term.
Prospective Employees considering a non-entry level role or who are filing joint tax returns with a high-earning spouse will likely under-withhold on Federal taxes. The 22% Federal withholding on RSU income is often below their effective tax rate, resulting in an unexpected tax bill in April. Under-withholding may also require paying quarterly estimated taxes to avoid under-withholding penalties throughout the year. Employees who do not have enough cash on the sidelines to make those payments must be prepared to sell vested stock to avoid penalties.
Existing Employees should be aware that large equity refresh grants are meant to make leaving the company more difficult. Leaving the organization forfeits unvested shares, so only the vested and unsold shares offer access to the potential upside of the company stock. These golden handcuffs are often cited as why employees don’t switch companies even though the switch may be more intrinsically rewarding.
While it’s never easy to walk away from the possibility of tremendous wealth of future vests, it’s important to note the following:
- – New hire grants are likely the largest grant an employee receives, except for a big promotion into a senior/executive role.
- – Many employees earn most of their equity vests in the first four to five years at a company because future grants are smaller. Even if one receives a significant grant in years three or four, waiting to realize the value of those vests means sticking around for an additional four years.
As pointed out earlier, RSU income at public companies has one primary advantage over other forms of equity compensation – liquidity. The ability to sell in the public market at vest for a known price is a blessing. Having a plan for how many after-tax shares to hold and how much to sell for other goals is critical. As the most straightforward and flexible form of equity available, public company RSUs are a great foundation to explore how to think about equity structures at private companies.
Equity at Late-Stage Private Companies
What does it mean when you hear a company is worth $1billion?
At both private and public companies, it means that the last price investors paid for the stock multiplied by the number of shares outstanding equals $1billion. However, the price investors paid for private company stock does not equate to the value of each share an employee owns. Private companies offer investors a different class of stock (preferred stock) than they offer employees (common stock). Because investors are buying different types of shares, employees should not rely on the post-fundraising headlines to project the value of their common stock. Common stock is usually less valuable than investor class stock.
The share value for a private company is also not assessed by the public market or the most recent round of funding. Rather, common stock price is determined by an independent third party through a 409A valuation. The 409A value establishes the price per share relative to the company’s financial strength and market position.
It’s important not to get lost in the company valuation game when thinking about one’s personal finances. Although 409A valuations are generally kept fairly confidential, they are what employees and prospective employees should focus on when thinking about their equity package.
Employees at late-stage private companies are most likely to see RSUs. RSUs at private companies work similarly to public company RSUs, but there are a few key differences.
The number of RSUs in a grant is determined by the 409A valuation instead of the price of the publicly traded stock at grant. Because 409A valuations reprice shares less frequently than public markets and often coincide with raising new rounds of capital, there is less volatility and accuracy in price.
The taxation of these shares also does not work like RSUs of public companies. Private company RSUs are classified as Double Trigger or Single Trigger.
Example – Double Trigger RSUs
Double Trigger RSUs are the most common form of RSUs in private companies. As the name implies, there are two triggers that must be met for granted shares to be considered taxable income. First, the shares must vest, just like at a public company. The second trigger is that shares must be sellable or transferable due to change in control. Change in control could be caused by an event like an acquisition or the company going public. This means there is no tax event when double trigger RSUs vest. Taxation occurs when the employee has the right to sell or is forced to sell. The price per share multiplied by the number of sellable/sold shares becomes taxable income.
Scenario: An employee is granted 20,000 double trigger RSUs that vest over 4 years with a one-year cliff at a current price per share of $10. Assume the price at year 1 is $10, year 2 is $15, and the company goes public at the end of year 3 when the stock price is $20 per share. Also assume the share price is $15 when the last 5,000 shares vest in the 4th year.
Initial Taxes on Double Trigger RSUs
The price of the company stock at vest does not matter for double trigger RSUs. When the company goes public at $20 per share, all 15,000 shares become taxable. The supplemental withholding rates (22% for Feds plus the applicable state rate) are withheld from the $300,000 of RSUs and the shares now have the liquidity of publicly traded stock. The final 5,000 shares that vest in the 4th year are then treated like public company stock.
*for simplicity, vesting amount ignores withholding and assumes annual vesting
Potential Capital Gains Taxes on Double Trigger RSUs
Another important thing to note is that the 15,000 shares start the 12-month clock towards long-term capital gains when the company goes public. Using the example, if the employee sold those shares at $15 per share 12 months later, they would realize a long-term capital loss of $5 per share.
Example – Single Trigger RSUs
These are less common because many founders and investors believe it gives employees ownership of shares too quickly. However, single trigger RSUs can still be found at subsidiaries of publicly traded companies or at companies without VC funding. So, it is still important to understand how they work.
Scenario: Using the same example from above. An employee is granted 20,000 single trigger RSUs that vest over 4 years with a one-year cliff at a price per share of $10. Assume the price at year 1 is $10, year 2 is $15, and the company goes public at the end of year 3 when the stock price is $20 per share. Also assume the share price is $15 when the last 5,000 shares vest in the 4th year.
Initial Taxes on Single Trigger RSUs
Vesting is the only trigger for these RSUs to be taxed at ordinary income rates, much like public company RSUs. Although vested shares cannot be readily sold without approval, each share is multiplied by the current 409A valuation at vest to determine the ordinary income incurred. Supplemental withholding rules apply to single trigger RSUs at vest.
*for simplicity, vesting amount ignores withholding and assumes annual vesting
Potential Capital Gains Taxes on Single Trigger RSUs
Single trigger shares begin their 12-month clock toward long-term capital gains treatment once they vest. While tax needs to be paid during the year of vest, these shares provide better optionality at liquidity. When the company goes public, the employee incurs $100,000 of tax instead of $300,000. The first two vests can also be sold at long-term gains rates on the difference between the vest price ($10 and $15) and sale price ($20).
The use of double trigger RSUs was brought to prominence by Facebook to increase employee compensation while not increasing their cash burn. Private companies compete with public company RSU liquidity by hyping the “obvious” upside of their shares. And the general assumption working at late-stage companies is that employees only must stick around for a few years before they experience a liquidity event.
The benefit to double trigger RSUs is that there is no investment risk. Employees don’t pay for the shares and won’t owe tax until they can sell. Single trigger RSUs have investment risk equal to the tax paid on the vested shares. However, in instances when the share price increases from grant to liquidity, single trigger RSUs are generally more tax efficient.
The flipside of no investment risk on double trigger RSUs is the massive tax bill from all the accumulated vested RSUs the year in which the second trigger occurs. The effect of taxation on accumulated shares in one year can quickly push an employee into the highest tax brackets. Because of the under-withholding issues addressed above, this likely means having to sell more shares to cover the tax bill.
The major downside to single trigger RSUs is the inability to sell vested shares in the open market even though they incur tax. Like public RSUs, the supplemental withholding rates (22% for the Feds) likely means under-withholding. Since private RSUs cannot be sold, the cash to cover the additional tax must come from another source to help avoid penalties.
Prospective Employees should consider how long the company has been private and get as much information as possible about previous funding rounds and valuations. Companies that stay private longer may not have as much upside as newer late-stage companies. More tenured late-stage companies may have been private for so long that they raised private funding from most of the investors who would traditionally buy when the company goes public. Once public, shareholders could be looking for an exit while the demand for shares is lower. In many instances, employees who joined a private company within 12 months of going public saw the value of their shares stay flat or decrease upon access to liquidity. Uber is a recent example worth visiting. This experience is counter to the hype of the valuation headlines and the upside employees were sold on when they received the job offer.
Existing Employees would benefit from anticipating the value of future grants. Equity grants target a specific dollar amount, say, $200,000 over 4 years of vesting. Companies determine the number of shares in the grant by dividing the $200,000 by the current share price. As the stock price goes up, equity refresh grants need fewer and fewer shares to meet the same $200,000 equity compensation target. This means fewer shares vest and participate in the (hopeful) increase in stock price. And because new hire grants are generally higher to incentivize talent to join the company, an existing employee may need to negotiate a higher refresh grant to make it worth sticking around.
Equity at Mid-Stage Private Companies
Mid-stage private companies are younger and smaller versions of late-stage companies. Founders, employees, and investors are all looking to increase share price in anticipation of future liquidity. Because the price per share is generally lower earlier in the life of a company, RSUs don’t offer the same benefits as they do at companies with higher share prices.
The inherent flexibility of Stock Options makes them the most common form of equity compensation at mid-stage companies. Options are simply the right to purchase shares of company stock at a set price on a future date. To demystify the complexity of options, it’s important to have a common understanding of some key terms:
- – Grant Date: Date the equity offer is implemented after signing the Option Agreement.
- – Exercise Price: The fixed price at which one can exercise the right to buy a share of the company until the option expires – also called strike price or grant price.
- – Vest Date: The date a chunk of options becomes exercisable.
- – Exercise: The purchase of shares, triggering a taxable event that also begins the long-term capital gains clock. Exercised shares are owned and receive voting rights.
- – Expiration Date: The last day one can elect to exercise their right to purchase an option.
These terms are the foundation for understanding Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). An employee is likely to see both types of options at mid-stage companies, so it’s important to understand how they differ to build out the most effective strategy.
Non-Qualified Stock Options were creatively named because they do not qualify for special tax treatment like ISOs.
Scenario: One’s stock agreement includes a grant of 10,000 NSOs with an exercise price of $10. Shares vest over 4 years with a one-year cliff, and the right to buy expires 10 years after the grant date. 12 months from grant date the new employee has the right to purchase 2,500 shares at $10 irrespective of what the 409A valuation is at that time.
If the 409A valuation at the time of exercise is the same as the 409A at grant, there are no tax consequences because the employee didn’t receive any economic benefit. The employee paid $10 to receive a share valued at $10. Taxes are only incurred if the 409A valuation was higher than the exercise price at the time of exercise.
Assume the company raised a round of funding and the new 409A is $12 per share when the employee exercises the right to purchase the first vest of 2,500 shares.
In this case, the employee would pay the exercise price of $10 per share. Because the employee paid $10 for something that is deemed to be worth $12, the IRS claims the employee received an economic benefit of $2 per share. This economic benefit is taxed at ordinary income rates as if it were wages. So, the employee’s W-2 wages would increase by $5,000 ($2 x 2,500 shares) as a result of the exercise. The applicable tax withholding is taken through payroll deductions based on W-4 elections rather than supplemental withholding rates like RSUs.
Potential Capital Gains Taxes
The only silver lining to paying taxes on the economic benefit is that this amount gets added to the cost basis of the exercised shares. Assume the 2,500 shares exercised were sold 12 months later when the second vest is available for exercise. The long-term capital gain per share on a $15 sale price is only $3 per share because the cost basis includes the price paid ($10) and the economic benefit taxed on exercise ($2).
Companies are quick to offer NSOs and may even offer NSO grants when they are late-stage. The key reason for offering NSOs is the company can take a tax deduction the year in which an employee exercises. NSOs can also be offered to consultants, contractors, and advisors whereas ISOs are only available to full-time employees. Unexercised and forfeited options also go back into the employee pool and are eligible for grants to other employees.
Employees want access to NSOs because options, unlike RSUs, provide flexibility over when shares are taxed. In most situations, however, an employee would prefer an ISO grant over an NSO grant due to enhanced tax benefits that are discussed below.
The “Incentive” part of ISOs is explained by the preferential tax treatment relative to NSOs.
Scenario: Assume that in addition to the NSO grant above, the employee was granted 10,000 ISOs with the same $10 exercise price and four-year vesting schedule. After 12 months the employee can elect to purchase 2,500 NSOs and 2,500 ISOs. We already know that the cost of the NSO exercise was $25,000 plus the tax due on the $5,000 of economic benefit at a $12 share price. But what is the total cost to exercise the ISOs?
The immediate cost to exercise would also be $25,000. However, unlike NSOs, the $5,000 of economic benefit from the spread does not necessarily incur tax.
The economic benefit from ISOs is included in the Alternative Minimum Tax (AMT) calculation instead of the regular tax calculation.
AMT is a separate tax calculation that parallels the usual tax calculation to ensure high income earners are not using advanced tax strategies to avoid paying their share of tax. The thresholds that determine if AMT is due depends on the types and amount of income a household earns in a given tax year as well as their tax filing status. If the tax calculation shows an AMT liability of $10,000 more than the traditional tax calculation, then one must pay the traditional tax amount plus $10,000 of Alternative Minimum Tax.
Even though the $5,000 of economic benefit in the example below is included in the AMT calculation, in most instances an ISO exercise that small would not incur AMT. This differs from NSOs because any economic benefit from an NSO exercise incurs tax no matter the amount.
Potential Capital Gains Taxes
Taxes on ISOs become more complex when selling exercised shares. ISOs sold at least 24 months after the grant date and 12 months from exercise are considered a “qualified disposition”. Qualified dispositions are taxed at long-term capital gains rates. If the 2,500 shares exercised at year 1 are held until the year 2 vest, they meet the 24-month and 12-months criteria. The $5 gain per share would qualify for long-term gains treatment and avoid taxation at ordinary income rates. Note that the ISO gain is $5 when the NSO gain is $3. That’s because the ISO did not incur tax on the economic benefit, so the cost basis per share did not increase.
However, if an exercised ISO is sold before either the 24-month or 12-month threshold, the sale is considered a “disqualifying disposition”. By disqualifying the beneficial tax treatment of the ISO, the sale is treated like an NSO sale incurring ordinary income on the spread between the sale price and the exercise price.
Irrespective of stock option structure, ideally the stock price goes up over time. For NSOs, delaying exercise means paying more ordinary income on the spread (current price minus exercise price) than would have incurred earlier. Delaying ISO exercise on a rising share price increases the odds of paying AMT in the year of exercise.
Each ISO exercise requires employers to provide a Form-3921 to determine if any AMT is due. There is too much detail to explore here, but exercised ISOs that incur AMT have an AMT basis in addition to a regular tax basis. The AMT basis can help reduce the potential of AMT during years in which those shares are sold. Finally, based on the amount of AMT incurred, Alternative Minimum Tax credits may also be available in future years to reduce the AMT calculation which can ultimately limit the amount of regular tax owed.
It’s critical to note that in addition to the Federal AMT calculation, the following states have their own AMT structure: California, Colorado, Connecticut, Iowa, Minnesota, and Wisconsin. Precision with exercising ISOs can save tens of thousands of dollars in taxes at the state level as well.
The objective of offering ISOs is attracting talent. The ability to purchase shares at a lower, fixed price as they increase in value is a massive benefit to employees who can afford to exercise. Although there is investment risk exercising options earlier in the life of a company, the tax benefits are generally greater.
A secondary objective is retaining talent that joined with an ISO grant. Not only do stock options have an expiration date, ISOs have a tight post-termination exercise window of up to 90 days. This means that an employee must exercise all vested ISOs within 90 days of leaving or all unexercised ISOs (vested and unvested) are lost. Employees who cannot afford to exercise options may feel trapped if the price of the shares has increased and they don’t want to lose the upside of the grant.
However, many companies are making the employee-friendly decision to convert unexercised ISOs to NSOs at termination for an extended exercise window. Obviously, ISO treatment is preferable to NSOs, but converting the options is better than losing them. Here is the best resource we’ve found for companies that offer extended exercise windows.
Those who don’t have excess cash to pay for the cost to exercise their stock options might consider a “cashless exercise”. A cashless exercise is the process of exercising options paired with selling enough of the exercised shares to pay the total exercise cost. This leaves the employee with fewer owned shares but no out of pocket payment. However, there are there tax consequences to this decision for NSOs and ISOs. Plus, employees of private companies may be unable to participate in a cashless exercise because of selling restrictions on the private stock.
A drawback of being granted a lot of ISOs or ISOs with a high exercise price is that ISOs are highly regulated by the Internal Revenue Code. In a given calendar year there is a limit to the number of ISOs that can vest while still retaining ISO status. During the year, if the ISO vest’s total exercise cost exceeds $100,000, the shares above $100,000 will be converted to NSOs. In the example above, the total exercise cost reaches $50,000 so this rule is not triggered. This “$100k rule” can be frustrating for employees who were unaware of the limits as it changes the expected benefits of the options agreement presented during the hiring process.
The investment risk of the high exercise price and the complexity of the tax situation is another reason why options are not exercised before a company goes public. If employees wait until the company goes public to exercise, there is an added benefit of immediate liquidity and more confidence in the value of the stock. However, ISOs still require the holding period rules to be met otherwise they will be treated like an NSO exercise. Even if an employee waits, there is a chance they won’t be able to realize the benefits of the ISOs that seemed so appealing when they joined the company.
All these considerations are important while navigating employment and equity decisions. But there are two important bits of information that should be noted to offer broad context about equity at mid-stage companies.
First, there is no guarantee the stock will be worth more in the future. The price could drop for several reasons. A “down round” would likely result in a price drop. A down round occurs when a startup raises money at a lower valuation than was previously established. If a company needs money but hasn’t made much progress since the last fundraising or the VC market is uninterested, founders may be forced to raise capital at a lower price per share which influences the price per share of common stock. The company could also be acquired with deal terms that favor founders and executives at the expense of investors and common stockholders. Amazon’s acquisition of Eero is an example of how this could happen and is worth reading.
Second, the typical tenure of a startup employee is only 4 years which may not be long enough to experience a liquidity event. In recent years, the average age of a company from founding to going public increased from 6.5 years to 10.5 years. Carta, an equity management and valuation company, has significant data about private company equity plans because of the services they offer. One of the most jarring data sets they’ve shared is in this post about the percent of employees in their database that exercise options:
- – 96% of companies on Carta have a post-termination window of 3 months or less.
- – Of the employees who left their company with vested stock options, 94% HAD NOT paid to exercise a single share.
- – The higher the exercise price, the less likely employees are to take the investment risk of paying for the stock even when the value of the shares is significantly higher than the exercise price.
Prospective Employees need to consider the cost to exercise their stock options. Total compensation figures should not be compared apples-to-apples, especially if the equity compensation is in a different form of stock. Taking lower cash compensation for more equity upside with stock options may sound like the more lucrative option. However, not having the cash to pay the exercise price, let alone the potential tax bill can be counterproductive financially and emotionally draining. So, before joining a company being sold as the next unicorn, ask yourself if you can realistically afford to capture the upside (if it happens at all) or whether you’ll have to walk away without ever realizing the upside value.
Existing Employees should focus on their time horizon at the company to build a strategy for exercising options. Options granted earlier will generally have a lower exercise price, which means more shares can vest before hitting the $100k limit. However, the benefit of exercising ISOs with a higher exercise price is that it reduces the likelihood of owing AMT. Exercising options across grants with different exercise prices could strike an effective balance from a cost perspective.
Equity at Early-Stage Companies
If private company equity is the wild west relative to public companies, early-stage companies are the new frontier. However, the inherent risk of these new ventures means more upside for those that become successful.
At the earliest stages, companies are idea rich but cash poor. Competitively compensating top talent under this cash constraint means offering a higher ownership percentage of the company than later-stage ventures. Equity is also generally structured for more cost-effective ownership given the risks employees bare. While the exact total compensation amount may not be the same, the potential of life-transforming wealth helps orient the company’s human capital around a central mission.
Aligning employee efforts with the long-term mission of the organization is most effectively done with ISOs and Restricted Stock Awards (Restricted Stock). We won’t revisit ISOs because the only difference with younger companies is that exercise prices are generally lower. Restricted Stock, however, needs to be explored because they are not the same as RSUs.
When granted Restricted Stock Awards, an employee must elect to either accept or decline the grant. Accepting the grant provides immediate ownership and voting rights for the granted shares even though the shares have not vested. Like single trigger RSUs, income is earned when restrictions lapse at vest and the amount taxable is determined by the Fair Market Value (FMV) of the shares at the time of vesting. Restricted Stock agreements may require employees to pay the employer the FMV of the shares at the time of grant, differing slightly from stock options where the exercise price is paid after the options vest.
The FMV of Restricted Stock is set by the Board of Directors before a “priced funding round” has been raised, at which point a formal valuation for the company is established. Shares of Restricted Stock may be granted for pennies per share prior to funding because the viability of the business and product have not yet been proved. As a company creates value for customers the price per share set by the Board should increase. Eventually the price per share is anchored to the 409A valuation established when the company is funded.
Scenario: An early employee receives a Restricted Stock grant of 20,000 shares at a valuation of $1 per share. The stock agreement indicates a traditional four-year vesting schedule with a one-year cliff. The stock agreement also requires the employee to purchase each share at current FMV. Assume the employee accepts the grant and pays the company $20,000 for the shares. 5,000 shares will vest each year and ordinary income is determined by the FMV at vest.
Let’s assume that the value of the stock is still $1 at the 12-month cliff, $3 during the second and third years, and $5 throughout the final year of vesting.
Under normal conditions an employee is not taxed at the time of grant. Taxation occurs when the restrictions are lifted at vest and is determined by the difference between the FMV at vest and the cost per share paid at grant multiplied by the number of shares vesting.
Employees can either use cash to pay the tax bill or, if the employer allows, sell shares to cover any tax liability.
Employees who accept Restricted Stock grants may also make an 83(b) election within 30 days of grant. Section 83(b) of the tax code, allows employees to shift the tax implications of these shares to the time of grant rather than when they vest. An 83(b) election realizes ordinary income on the value of the grant less the amount paid for the shares at grant. In the example above, there would be no ordinary income tax due on the grant because the employee paid $1 per share and the shares were valued at $1 – meaning the employee earned an economic benefit of $0.
Whether tax is due on the 83(b) election or not, there is no taxable event when the shares vest. This gives employees more control over future tax events because the next trigger for taxation is the choice to sell.
Potential Capital Gains Taxes
Employees who make an 83(b) election must still wait until vest for the sell restrictions to be lifted, but the 12-month holding period clock for long-term gains treatment begins at grant. This strategy can significantly reduce taxes owed on the company stock if the share price rises between grant and the date of sale. Without an 83(b) election, the holding period for long-term gains begins on the date of vest, not the date of grant. Whether or not an 83(b) election is made, the cost basis for the vested shares equals the amount paid for the stock, if any, plus the fair market value per share included in ordinary income incurred.
However, there are some drawbacks to making an 83(b) election. If an employee makes an 83(b) election and leaves the company, any unvested shares are forfeited, and the employee is unable to claim a tax loss on the value of the forfeited shares. The amount paid per share at grant, however, can be reported as a capital loss for the forfeiture of unvested shares.
The structure of Restricted Stock Awards incentivizes long-term alignment between early employees and founders. Founders have a challenge in finding the most suitable price for their early-stage stock. The price needs to be high enough so shares sold to investors raise enough capital that can then be used to grow the business. The price should also be low enough that prospective hires can afford to purchase their Restricted Stock, pay the tax due on an 83(b) election, or pay to exercise their ISOs. Paying for shares, if necessary, means employees have skin in the game.
From an employee perspective, it’s easier to believe shares worth $2 can increase 10x ($20/sh) than it is to believe shares worth $20 can 10x ($200/sh). The premise is that over time, the potential upside of equity ownership in the smaller company will make up for the lower cash compensation, the risk of joining a new venture, and the illiquidity of early-stage company stock. If an employee believes in the mission and can afford the financial risk, it’s easier to justify staying at an early-stage company irrespective of other employment opportunities.
The potential upside of equity in an early-stage company is unparalleled because every successful company was once a small organization. Optimizing the upside from a tax perspective requires the company to intentionally structure stock plans that favor employees. But the onus is on employees to understand the trade-offs well enough to take advantage of the full offering of an equity plan and negotiate as needed.
Prospective Employees should understand how the total compensation package will influence their financial well-being in the short-term because it’s pointless to receive a large Restricted Stock grant if one cannot stick around long enough for the shares to vest. Early stage companies generally offer less cash compensation which could impact one’s ability to maintain lifestyle or save for the future. Plus, it’s important to have enough cash on the sidelines to pay for shares at grant, if necessary, or the potential tax bill in the year of vest or, if choosing an 83(b) election, at the time of grant. One also needs to consider how many years they think they will stay at the company. That can help determine if an 83(b) election makes sense based on the given vesting schedule. Finally, what if venture capitalists are not interested in the product and the stock price goes to $0? Early-stage companies are fighting for customers and relevance and have more obstacles to overcome to prove their value.
If a job offer includes a grant of ISOs, it is likely worth negotiating for the ability to early exercise the ISOs. An early exercise of ISOs allows the employee to exercise at grant instead of waiting until vest. Not only does this limit the potential spread between future FMV and exercise price (reducing the likelihood of paying AMT), it also means that shares are owned by the employee. The decision to early exercise can be paired with an 83(b) election on the exercised shares. This is the only time shares other than Restricted Stock can qualify for an 83(b) election because 1) 83(b)’d shares must be owned but not vested and 2) the election must be made within 30-days of grant.
Existing Employees may prefer ISO grants after their first year or two with the company rather than refresh grants of Restricted Stock. Restricted Stock grants will either force upfront payment (for shares or via tax on 83(b) election) or force tax at ordinary income rates on vest in future years when the stock price is higher. As discussed in the ISO section above, one can strategically exercise enough ISOs to avoid paying AMT so the only cost would be the cost to exercise. Unlike Restricted Stock, ISO grants offer flexibility over how many shares are purchased, when they are purchased, and how that tax bill will impact the employee.
If an existing employee does not anticipate working at the company through the entire vesting period of grants made after the new hire grant, then it is likely not worth the cost to make an 83(b) election or early exercise decision on ISOs.
This framework flowed from the equity we’re most accustomed to toward equity at earlier stages where the upside is higher, but the outcome is more ambiguous. You can now flip it on its head to begin with early-stage companies and understand why equity at public and late-stage companies is structured the way it is.
No matter what stage of a company you work at or are considering for employment, equity ownership in an organization is the best way to increase long-term wealth. However, with possibilities for unbelievable rewards also come the associated risks. Decisions around equity compensation should not be made lightly as they can increase or decrease one’s wealth by hundreds of thousands or even millions of dollars.
Employment pays for life experiences, creates opportunities for personal growth, and can be a source of meaning in life. If you have all three at your current gig, that’s amazing and you should be delighted. If you need a new job that offers something your current employer doesn’t, you now have a better sense of the trade-offs that you may see at companies of different sizes. No matter what you’re looking for, here are a few key points to keep in mind:
- – Does the base salary cover spending needs plus savings capacity outside your 401(k)?
- – Do you have enough cash to cover any additional tax associated with your equity structure?
- – Can you afford to pay the exercise price on the stock options that you’re granted?
- – How long could you realistically see yourself working at the company?
- – Is the potential future upside of private company stock worth the illiquidity risk within the context of your life situation?