How to Understand Private Company Stock Options.
Employees are the primary beneficiaries of private company stock options.
Jules Frazier/Photodisc/Getty Images.
Related Articles.
1 Employee Stock Purchase Options 2 Understanding Employee Stock Options 3 What Are the Benefits of Employee Stock Options for the Company? 4 Fair Value Method Stock Options.
Small companies often do not have the financial size to offer potential or high performing employees salaries that are commensurate with their large, publicly traded corporate peers. They attract and keep employees through other means, including by giving them greater responsibility, flexibility and visibility. An additional way is through the offering of stock options. Private companies may also use stock options to pay vendors and consultants.
Stock Options.
A stock option is a contract that gives its owner the right, but not the obligation, to buy or sell shares of a corporation’s stock at a predetermined price by a specified date. Private company stock options are call options, giving the holder the right to purchase shares of the company’s stock at a specified price. This right to purchase -- or “exercise” -- stock options is often subject to a vesting schedule that defines when the options can be exercised.
Employee Stock Options.
Employee stock options typically fall into two categories: outright award and performance-based award. The latter is also referred to as an incentive award. Companies either grant outright awards of stock options upfront or on a vesting schedule. They grant incentive stock options on the achievement of specific targets. The taxation of the two differ. Employees who exercise their outright award options are taxed at their ordinary income tax rate. Incentive stock options are generally not taxed when exercised. Employees who then hold the stock for more than a year will pay capital gains tax on subsequent gains.
Payment for Goods and Services.
A startup or rapidly growing small business needs to conserve cash. A company can negotiate to pay its consultants and vendors in stock options to conserve cash. Not all vendors and consultants are receptive to payment in options, but those who are can save a company a significant amount of cash in the short term. Stock options used to pay for goods and services generally have no vesting requirements.
How It Works: Grants.
A Better Day Inc. authorizes 1 million shares of stock but only issues 900,000 to its shareholders. It reserves the other 100,000 shares to support the options it has provided to its employees and vendors. A Better Day’s current valuation is $1.8 million, so each of the 900,000 issued shares has a book value of $2. The company grants a group of newly hired employees 50,000 options to buy stock at $2.50. These options vest equally over a four-year period, meaning the employees can exercise 12,500 options at the end of each year for years one through four.
How It Works: Exercise.
Two years later A Better Day has grown significantly. It now has a valuation of $5 million. It also has issued another 50,000 shares to support the options that were exercised. The price per share is now the $5 million valuation divided by the 950,000 currently outstanding shares or $5.26 per share. The employees who exercised their stock would have an immediate pre-tax profit of $2.76 per share.
References (4)
About the Author.
Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.
Photo Credits.
Jules Frazier/Photodisc/Getty Images.
More Articles.
How Do I Provide Stock Options?
Incentive Stock Options & the IRS.
The Advantages of Owning Minority Shares of a Privately Held Company.
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Mashable.
Entertainment.
Perhaps you’ve heard about the Google millionaires: 1,000 of the company’s early employees (including the company masseuse) who earned their wealth through company stock options. A terrific story, but unfortunately, not all stock options have as happy an ending. Pets and Webvan, for example, went bankrupt after high-profile Initial Public Offerings, leaving stock grants worthless.
Stock options can be a nice benefit, but the value behind the offer can vary significantly. There are simply no guarantees. So, whether you’re considering a job offer that includes a stock grant, or you hold stock as part of your current compensation, it’s crucial to understand the basics.
What types of stock plans are out there, and how do they work?
How do I know when to exercise, hold or sell?
What are the tax implications?
How should I think about stock or equity compensation relative to my total compensation and any other savings and investments I might have?
1. What are the most common types of employee stock offerings?
Two of the most common employee stock offerings are stock options and restricted stock.
Employee stock options are the most common among startup companies. The options give you the opportunity to purchase shares of your company’s stock at a specified price, typically referred to as the “strike” price. Your right to purchase – or “exercise” – stock options is subject to a vesting schedule, which defines when you can exercise the options.
Let’s take an example. Say you’re granted 300 options with a strike price of $10 each that vest equally over a three-year period. At the end of the first year, you would have the right to exercise 100 shares of stock for $10 per share. If, at that time, the company’s share price had risen to $15 per share, you have the opportunity to purchase the stock for $5 below the market price, which, if you exercise and sell concurrently, represents a $500 pre-tax profit.
At the end of the second year, 100 more shares will vest. Now, in our example, let’s say the company’s stock price has declined to $8 per share. In this scenario, you would not exercise your options, as you’d be paying $10 for something you could purchase for $8 in the open market. You may hear this referred to as options being “out of the money” or “under water.” The good news is that the loss is on paper, as you have not invested actual cash. You retain the right to exercise the shares and can keep an eye on the company’s stock price. Later, you may choose to take action if the market price goes higher than the strike price – or when it is back “in the money.”
At the end of the third year, the final 100 shares would vest, and you’d have the right to exercise those shares. Your decision to do so would depend on a number of factors, including, but not limited to, the stock’s market price. Once you’ve exercised vested options, you can either sell the shares right away or hold onto them as part of your stock portfolio.
Restricted stock grants (which may include either Awards or Units) provide employees with a right to receive shares at little or no cost. As with stock options, restricted stock grants are subject to a vesting schedule, typically tied to either passage of time or achievement of a specific goal. This means that you’ll either have to wait a certain period of time and/or meet certain goals before you earn the right to receive the shares. Keep in mind that the vesting of restricted stock grants is a taxable event. This means that taxes will have to be paid based on the value of the shares at the time they vest. Your employer decides which tax payment options are available to you – these may include paying cash, selling some of the vested shares, or having your employer withhold some of the shares.
2. What’s the difference between “incentive” and “non-qualified” stock options?
This is a fairly complex area related to the current tax code. Therefore, you should consult your tax advisor to better understand your personal situation. The difference primarily lies in how the two are taxed. Incentive stock options qualify for special tax treatment by the IRS, meaning taxes generally don’t have to be paid when these options are exercised. And resulting gain or loss may qualify as long-term capital gains or loss if held more than a year.
Non-qualified options, on the other hand, can result in ordinary taxable income when exercised. Tax is based on the difference between the exercise price and fair market value at the time of exercise. Subsequent sales may result in capital gain or loss – short or long term, depending on duration held.
3. What about taxes?
Tax treatment for each transaction will depend on the type of stock option you own and other variables related to your individual situation. Before you exercise your options and/or sell shares, you’ll want to carefully consider the consequences of the transaction. For specific advice, you should consult a tax advisor or accountant.
4. How do I know whether to hold or sell after I exercise?
When it comes to employee stock options and shares, the decision to hold or sell boils down to the basics of long term investing. Ask yourself: how much risk am I willing to take? Is my portfolio well-diversified based on my current needs and goals? How does this investment fit in with my overall financial strategy? Your decision to exercise, hold or sell some or all of your shares should consider these questions.
Many people choose what is referred to as a same-day sale or cashless exercise in which you exercise your vested options and simultaneously sell the shares. This provides immediate access to your actual proceeds (profit, less associated commissions, fees and taxes). Many firms make tools available that help plan a participant's model in advance and estimate proceeds from a particular transaction. In all cases, you should consult a tax advisor or financial planner for advice on your personal financial situation.
5. I believe in my company’s future. How much of its stock should I own?
It is great to have confidence in your employer, but you should consider your total portfolio and overall diversification strategy when thinking about any investment – including one in company stock. In general, it’s best not to have a portfolio that is overly dependent on any one investment.
6. I work for a privately-held startup. If this company never goes public or is purchased by another company before going public, what happens to the stock?
There is no single answer to this. The answer is often defined in the terms of the company’s stock plan and/or the transaction terms. If a company remains private, there may be limited opportunities to sell vested or unrestricted shares, but it will vary by the plan and the company.
For instance, a private company may allow employees to sell their vested option rights on secondary or other marketplaces. In the case of an acquisition, some buyers will accelerate the vesting schedule and pay all options holders the difference between the strike price and the acquisition share price, while other buyers might convert unvested stock to a stock plan in the acquiring company. Again, this will vary by plan and transaction.
7. I still have a lot of questions. How can I learn more?
Your manager or someone in your company’s HR department can likely provide more details about your company’s plan – and the benefits you qualify for under the plan. You should also consult your financial planner or tax advisor to ensure you understand how stock grants, vesting events, exercising and selling affect your personal tax situation.
Images courtesy of iStockphoto, DNY59, Flickr, Vicki's Pics.
How an Employee Stock Ownership Plan (ESOP) Works.
ESOPs Provide a Variety of Significant Tax Benefits for Companies and Their Owners. ESOP Rules Are Designed to Assure the Plans Benefit Employees Fairly and Broadly.
ESOP Rules.
Uses for ESOPs.
To buy the shares of a departing owner: Owners of privately held companies can use an ESOP to create a ready market for their shares. Under this approach, the company can make tax-deductible cash contributions to the ESOP to buy out an owner's shares, or it can have the ESOP borrow money to buy the shares (see below). To borrow money at a lower after-tax cost: ESOPs are unique among benefit plans in their ability to borrow money. The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible. To create an additional employee benefit: A company can simply issue new or treasury shares to an ESOP, deducting their value (for up to 25% of covered pay) from taxable income. Or a company can contribute cash, buying shares from existing public or private owners. In public companies, which account for about 5% of the plans and about 40% of the plan participants, ESOPs are often used in conjunction with employee savings plans. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level.
Major Tax Benefits.
Note that all contribution limits are subject to certain limitations, although these rarely pose a problem for companies.
Stay Informed.
Our twice-monthly Employee Ownership Update keeps you on top of the news in this field, from legal developments to breaking research.
Related Publications.
You might be interested in our publications on this topic area; see, for example:
Understanding and Communicating ESOP Valuations.
Discusses how valuations work, special ESOP considerations, and how to communicate valuations to employees.
ESOP and 401(k) Plan Employer Stock Litigation Review 1990-2017.
Categorizes and summarizes litigation over company stock in ESOPs and 401(k) plans.
Administrative Issues for ESOP Companies.
Essays on administrative issues for ESOP (employee stock ownership plan) companies.
S Corporation ESOPs.
Covers tax issues, plan design, compliance, administration, valuation, sustainability, and more.
Floor Price Protection in ESOP Transactions.
Discusses how price protection works, its impact on valuation, and fiduciary perspectives.
The ESOP Communications Sourcebook.
Shows ESOP companies how to communicate the plan to employees as well as customers.
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Link to Us.
NCEO Membership Brochure.
Read our membership brochure (PDF) and pass it on to anyone interested in employee ownership.
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