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Employment and Stock Options Plan Explained




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This article tells you almost everything you wanted to know about Employment and Stock Options Plan. I've written it as a summary of the thread: What are Share Options Worth? (http://slashdot.org/askslashdot/00/01/13/2342249.shtml) from slashdot.org and some extra research.

Published: January 2000 (during bubble #1 explosion)

By Stas Bekman.



You and a Start-up

  • Shares, Vesting and Taxes.

    The important issue here is longterm capital gains. Taxes. They suck. When you first get hired, you will be given a piece of paper from the board that says how many shares you have and how much the strike price is (strike price: the amount you may purchase shares for). This paper is your option grant.

    There is an important date on here (surprisingly enough, called the grant date) which is the date that you officially begin vesting. But this date also have important tax implications. You only get long term capital gains tax rates (20%) if you hold your stock (not the option) for two years after the grant date and one year after the excercise date (the day that you purchased stock from your options).

    These periods overlap. If you sell your stock either less than two years from your grant date or less than one year from your excercise date, then you have what is called a disqualifying disposition. Basically, the money you get from your stock sale will be treated like normal income.

  • HOLD ONTO stock for at least 12 months.

    Even if you are NOT restricted under SEC Rule 144 with respect to sale of your stock, HOLD ONTO IT for at least 12 months. Why? If you dump your stock instantly, you get socked with short term capital gains tax on it. That's about 40%. Holding it for a year or more turns it into long term capital gains, at 22%. It's a no-brainer, unless you've got something that's guaranteed to offset the extra 18% you'll fork out in taxes to put your $$ into immediately

  • Taxes

    Be aware that taxes eat a significant chunk of the value, unless you hold for over a year. Cashing in during the first year will cost you around 43% of the amount in taxes.

    Spend a lot of time at the Motley Fool messages boards dealing with employer granted stock options and take a look at this www.fairmark.com site. There is a lot of information here.

    There are different types of options, so be aware that different laws apply differently to them.

  • Vesting.

    4 years: vest 1/48th per month over that period. Sometimes you'll find a "one year cliff" in which nothing vests for the first year but at one year you magically vest 1/4 of your options and then 1/48th of the total options per month after that. I heard of one place that vested 1/4 per year rather than incrementally per month.

    If the company goes IPO, you will have to wait for 6 months/1 year before being able to exercise the options.

  • AMT.

    Remember those three latters. If your company is successful, you will hate those letters.

    In the US there are 2 Federal tax systems. The standard income tax that you are used to and then the Alternative Minimum Tax (AMT).

    AMT is much simplier to calculate. It is basically (close to but not exactly) your income tax, but no deductions. Then you take one huge deductions at the end of adding everything else up. That personal deduction is usually so big that you never have to pay AMT. You will have to calculate your AMT when you excercise your options (turn them into real stock).

    Your tax basis of your options in your strike price (tax basis: what is the base amount you use to calculate your tax costs). When you excercise the options, your tax basis will be raises to the current value of the stock (if I excercised today, my tax basis for my options would go from $1.50 to $103 and if I did this to 5000 shares, I would be liable to pay AMT on $507k).

    You have to pay AMT on this spread (spread: the difference of your strike price and the fair market value of the stock). The only good things that comes out of AMT is that when you sell your shares, you will calculate the taxes next time against your excercise price instead of your strike price.

    And the other good thing is that AMT is just a matter of time: ever year after paying AMT, if you do not pay AMT, you can get a deduction in the amount of the difference your AMT and your normal income tax. Basically, in the years you are not liable for AMT your taxes will be greatly reduced. So you really only loose the opportunity cost of the AMT amount (which can still be huge).

  • Lockup Expiration.

    Lockup Expiration is another thing. When a company goes public. All the pre-IPO shares cannot be traded (this mean employess, board members, investment banks, etc...). You have to wait, usually, 6 months to do anything with them. Our six month expiration was up in December. However employees still counldn't sell.

    There are also blackout periods where employees cannot sell. Blackout periods start before earnings are announced and continue until the SEC mandates 3 days after the earnins report is released (this is true of all nonpublic information -- you cannot trade on nonpublic information, and if you do know nonpublic information you must wait until 3 days after that information is made public).

  • Make sure EVERYTHING is in writing!.

    Get the share price on paper. Get the company to justify that price.

    Ask around what a standard grant is at the company in question. I was told when I joined the company I currently work for that when I joined (6 months before IPO) that my shares would most likely be around $8. After joining the company, those same shares (1000) were granted to me at a whopping $18.90 -- a much different than my expectations. Later, the company went public at $11/share. Effectively making my options worth nothing until the stock price climbed to above my grant price.

  • Negotiation.

    1. They may choose not to tell you how many shares are outstanding. This is a minus, as you cannot make judgements about the value of your shares based on what YOU think the company is worth. None-the-less, you should be told a) the current estimated value per share b) the option price.

      These two numbers need to be handed to you IN WRITING, or you're being taken for a ride. The percent difference between these is called the "options discount". That is, you are being allowed to buy an item (stock) at a discount. You should expect between 50 and 99% discount. Any less is not much of a deal.

    2. They should NOT have a clause in the options plan that allows them to just pull the shares back from you at any time. In reality, they always can, but it's a major pain in the ass.

      They should *not* be allowed to imply inform you that your options are no longer yours unless you are fired for cause, and even then, stock that you have purchased (e.g. the options have vested, and you paid the option price) should never revert to them.

    3. You should either receive your full vesting or there should be a substantial acceleration in the plan in the event of a substantial change of ownership (e.g. you get bought out or go public). You don't want to join the company, have them go public and then not be able to sell your stock, as you watch its price plummet.

      The ways I've seen this done are: a) 1 year acceleration b) 1/2 of remaining options vest immediately c) the full plan vests immediately, but there is a restriction on when you can sell. Think about this aspect of the plan carefully.

    4. MAKE SURE the company has registered the options with the SEC. If they havn't registered them, the only way you can use the option is to buy them, and hold them for a year.

      (Got burned pretty bad on that, left my last company, went to cash out the options I had vested (Would have made for a down payment on a house or a new car) and turns out the turkeys never registered them! By the time they were finally registered, the company had finished bright sizing, and was worthless!)

      Be careful. Talk to a lawyer and an accountant about this kind of stuff, there are SOOOO many ways to get burned, and only a few ways to get paid this way.

  • Get a real trading account.
  • Options costs nothing to your company!

    Options are 'free' to the company giving them to you. It costs them nothing to give them out, and so are often used to try to entice people to work for less then they are worth.

    Demand what you are worth, and if they want to give you options on top of that so be it.

    Options are a great way for startups to underpay their tallent and 'handcuff' them so that they won't leave when they'd rather be somewhere else.

  • Non-Public company options are worth ZERO.

    The options are worth ZERO DOLLARS until your company is either bought by a public company, or goes public.

  • % of company is what important .

    Don't focus on the number of shares: it's the percentage of the company you own that will determine what you make on options.

    I have two friends - both received 1000 shares in a pre-IPO startup. When IPO-time arrived, both companies felt the need to adjust their stock value - they like the initial offering to be in the $10-$20 range.

    Friend A's company made a 2-1 split, and he came out with 2000 shares.

    Friend B's company made a 1-10 split, and he came out with 100 shares.

    MORAL - before IPO, the number of shares is almost meaningless. The percentage is key.

    If your company is sold for $100,000,000 and you own 0.1% you get $100,000. It doesn't matter if you had 5 shares or 500,000 shares.

  • Acquisition and Liquidation
    1. In case of an acquisition you can get burned badly by liquidation preferences. You have to keep an eye on this as the rounds of funding come in -- it gets renegotiated each time. I let my CEO know that I'd hit the road if we ever got burdensome liquidation preferences. This made a huge difference in the cash I took away from my last company, since we were acquired at a price where the preferences almost mattered.

      (Liquidation preferences are goodies that go to VCs if the company is acquired for less than a certain price. First they get back their original investment; then they get their fractional share of the remainder. Employees get shagged rotten.)

    2. Another thing to watch out for in case of acquisition: What is the acceleration schedule? If you joined this company today and they were acquired tomorrow, you would have vested in zero shares. Your options will still be worth something, but the payoff is still in the future. Sometimes there is acceleration by a certain number of months (18 is typical) which means your vesting schedule accelerates that much. In the scenario just described, with 18 month acceleration, you would immediately be able to cash in on 18 months worth of your options.

    3. "Liquidation Preferences" as described in this are the rights attributed to a type of stock called "Participating Prefered" stock. It is quite unusual to see this these days, with an oversupply of VCs and cash, and a relative shortage of good ideas looking for money.

      If the company-side lawyers are halfway decent, and the company isn't super desperate, you'll be unlikely to see participating prefered; if you *do* see it, call the VCs on it, and they'll more than likely scale back to straight prefered. If they won't, then shop around and find someone who will give you better terms.

      On acceleration, this is also atypical for all but the most senior employees, and even then not a given.

      Acceleration causes trouble in the event of an acquisition if it's not properly structured. This is because of the technical details of how an acquisition happens. If there is a change in the equity positions in the company shortly prior to an acquisition, it makes it hard to account for the acquisition as a Pooling Of Interests, which makes it less attractive to the buyer. It means that any "goodwill" in the acquisition price (that is, the difference between the book value of the acquired company and the price paid for it) shows up on the expense side of the acquirer's balance sheet.

      Ever heard those "Earnings were $x or $x+nnot including a one time charge associated with the acquisition of company Y" things? That's goodwill showing up on the wrong side of the balance sheet. Companies typically don't care about individual engineers enough to grant them acceleration, and even if they do, it might have to be waived if the company negotiates an acquisition. IANAL, nor an accountant, but IAA entrepreneur.

    4. Look out for dilution - how many more shares will your company need to sell to get the investment required to get to the point where it's self sustaining (or goes public)? if they keep printing shares over and above the original pool your percentage of the whole will drop (on the other hand you will probably continue to be paid as a result)

    5. Taxes - usually you have 2 choices - either pay for the stock up front when you are granted it (but before it vests - it goes into escrow in the mean time) or pay for it the day you exercise your options (usually this is also when you sell the stock - companies often allow you to do a 'cashless' exercise where the stock gets sold, they get paid at the option price [and often take out taxes too] and you get the difference) - the big advantage of the first one is that you can lock in long term capital gains (ie lower taxes) on the investment while in the second case you probably have to pay as income at your top marginal rate, the downside is that you have to put real $$ away into an investment you're already putting your life into (but then if you are a founder you're probably paying 1c/share anyway) - but if the company tanks you can write off the investment loss

  • Ask to see the business plan

    When you are looking at options ask to see the business plan. After all they are asking you to take a pay cut at the option of taking stock, you want to make sure this time your invsting in the company is worth it. You may be supprised at the difference of what they tell you they are doing and their actual business plan laid out in ink; then again perhaps not. Either way you've got a right to be informed before making your decision.

  • Cashless exercise of options

    Ask about cashless exercise of options too. That's when you give up a certain number of options in exchange for your stock. For example, let's say you have 100000 options at $0.10 each. Suppose you don't have $10000 around to exercise. Were you to do a cashless transaction, you take the IPO price, say $10.00, and convert ONE $0.10 option into 99 shares of stock. Note, you may have to claim the appreciated value of the options as income ($9.90 per option you gave up).

  • Non-Disclosure, Acceptable; Non-Compete, UNAcceptable!

    A company has the right to protect is technology, trade secrets and the like. As such, you will be presented with a Non-Disclosure Agreement. That is fine, sign it. But when the company wants you to sign a Non-Compete, give them two options for them to choose from:

    1. No, I will not sign it. You must hire me without my signing it.

    2. Okay, with one additional addendeum: You place the duration of the Non-Compete x My Salary (e.g. 2 years x $30K = $60K) in an escrow account. Should I leave the company and you state I am in violation of my Non-Compete clause in my new employment (whether 3rd pary or self-employeed), you agree to release those escrow funds to me.

    You will get stares, disbelief and other "pep-talks" from others. But the fact of the matter is that "non-competes" ARE at least partially enforcable in many states IF you sign. As such, don't. If they won't reason, get a lawyer. He may not get rid of the non-compete, but he will narrow its focus so you can work after you leave the company.

    As it was with my new company. I refused to sign the non-compete. My future boss, his boss, the head-hunter, and everyone else tried to reason with me. After a week, I got a lawyer, and we write a narrowed agreement. The next day, my future employer threw the Non-Compete completely out, they wanted me on-board ASAP. They said they would draft a new, narrower Non-Compete for everyone later on (or expand the Non-Disclosure). Unfortunately for them, no state law that I know of will enforce an agreement on you AFTER you have already started employment.

Employee Stock Purchase Plan

  • At the place I work, we have both. Out ESPP works pretty much how you describe it, except that we get to buy the stock at 85% of the lower market price at either the beginning or the end of the 6 month period. Another words, let's say the 6 month window begins on July 1st, at which time the stock is at $10.

    We have an elected amount of money deducted from our paycheck each pay period and this money gets put into an escrow account. On December 31st, the stock closes at $26 per share. Well, at that point, we get to buy the stock at $8.50, effectively making $17.50 per share profit if we turn around and sell it immediately. Conversely, if the stock took a dive, and closed on December 31st at only $5, then we'd get to buy it at $4.25, which is 85% of the lower price.

Alternatives

  • Be an independent contractor.

    Get to work at a couple of new startups a year, make more than any human should, and get to do the fun stuff of building up their business without the boring side of having to sit around maintaining it for the following years

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