I work/have worked with a variety of companies that sometimes compensate me via equity. I accept it when I feel taking on the risk is worthwhile and see some level of value to the project. Equity for work is all fine and good, but unfortunately the tax laws are setup in a way to almost discourage this. Simply put, stock options suck unless you know what you are doing. I’ve had great stock-option relationships and poor relationships (If you are reading this and I have options in your company, thanks and this doesn’t apply to you!). What I’m relaying below is information that I learned the hard way. Send thankful donations directly to me – this post will save you a ton of money and frustration!
So, you are either a consultant or a recent hire, and you’ve been offered stock options… What should you beware of?
1) These are OPTIONS. Not actual shares!
So many people seem to forget this. When you are granted options, it means you will eventually be able to BUY shares in the company at a set price. Nothing is being given to you. So lets say you are granted 10,000 shares at $1.00 per share. You will have to spend $10,000 to “exercise” those options. That is of course, if they are “vested”.
2) Vesting will take a long time.
Most companies I’ve heard of have a 4 year vesting schedule. 25% after a 1 year “cliff” and then on a monthly basis after that. This means, if they fire you 364 days after hire, you have no rights to the options. If you leave after exactly a year, you have a right to exercise 25% of what you were given. Be careful to read the fine print about what happens if your company is sold or changes control! In fact, read it all because it gets pretty detailed.
3) The taxes suck!
Two scenarios… First, using the above option, lets assume your company gets sold for $2.00 per share. You exercise your shares for $1.00 netting a good $10,000 profit. Only, even if you worked at the company for four years, you only “held” the shares for a limited amount of time, so you are paying tax at your normal income. It’s not a long term capital gain! Your take just went from $10,000 to a number much less appealing, depending on your tax bracket.
Scenario two: you realize maybe your shares will be worth something someday, so you “exercise” them early. Lets say that you exercise $10,000 worth of shares. Lets also assume that the latest valuation of your company is $3.00 per share (this can be a private company)…. In the case of Non-Qualified Stock Options (the most common you’ll see), the IRS will tell you that you received value in that appreciation. So you will spend $10,000 to exercise and then pay tax on the $20,000. Even though you may not be able to actually sell those shares on the open market! Now, sure, there are Incentive Stock Options that make it possible to avoid this issue – but most companies will not offer them. Why? Because with NQSO’s, they get a deduction when you exercise. With ISO’s, they do not. How nice of them!
Lets say you are working with a start-up, and they offer you options. Then, a year later, eager for funds, they accept some venture capital dollars. This “strategic” partnership is going to really help them accomplish their long term plans, after all. Those dollars and shares have to come from somewhere, so the board releases more shares to the total pool. You’ve just been diluted. To explain in simple terms – If there were 1,000,000 shares in circulation before and you had 10,000, you had 1% of the company. Now they just took on another X dollars in desperation and suddenly there are 2,000,000 shares floating around. You are now worth .5% of the company. Hopefully, the value of the company increased thus making your same 10,000 shares worth more. But maybe not…
The takeaway? If you have dreams of becoming rich with stock options, think again. It probably won’t happen.
With that harsh reality, here are some steps to take which will help you as you negotiate:
1) Ask questions!
- What is the exercise price?
- What is the vesting schedule?
- Is it an ISO or NQSO?
- How many shares are currently out there (after all, you want to know what your piece of the pie is)?
2) If you are working with a start-up in a large capacity BEFORE they incorporate, become a founder. When a company is founded, the shares are worth almost nothing. This is the time to get involved – get a flat percentage of the company and take steps to protect yourself against massive dilution. If you remember nothing else from this post, remember that only those at the founder level really make out in an acquisition. Agree in advance what your percentage will be and again, take steps to protect against dilution. Anyone who saw “The Social Network” will remember dilution at work – what a menace!
3) If they are going to offer you stock options and you are going to discount your rate and or salary (not smart on the salary side!), remember that the value of options and the value of your services are not a 1:1 proposal. Another example: if you are working at a rate of $100/hr, and you charge $50 in cash and $50 in stock equivalent, that stock equivalent can get you into a lot of trouble. You can receive it and then pay taxes on it when you receive it. Or you can get options and then pay later to exercise, then paying tax on the amount you earned – if it turned into anything. A good compromise is to take options to buy instead of outright shares, but getting a premium on top of the $50. So maybe $75 of options for every $50 of discount you gave. After all, you are floating the company a loan – who wants to give away money for no interest? And, if the company does sell, the added value you received will take some of the pain away from the most likely scenario – the exercising of the option and the instant sale to the buyer – resulting in taxable income at your normal rate. Dont’ forget if you actually scored a big payday, your “normal rate” will of course go up as well.
4) Predict the future. Contemplate if this company has a chance to go somewhere. Find out who is on the board, who the founders are, what their backgrounds are, their track record. Do research on them. This is especially important to those who are working in a partnership capacity, but even employees can research this at the same time. What is the potential of this to grow into such a huge enterprise that your shares actually become worth something? If they are offering you the options in the first place then you have a right to know these things.
5) Believe in the company! Don’t bother with options or risk or anything similar if you truly don’t believe something can be made of the company. I will always work for partial equity if the project is worthwhile. Even despite all of the crap above!
This isn’t meant to be a post that deters you from taking options if you are offered them. But carefully consider their worth and don’t be distracted by the opportunity at massive riches down the line. Again, chances are it won’t change your life if the options are bought and sold. But it could be a nice little bonus if you do it right.