There are several pieces of conventional wisdom you may hear about Stock Based Compensation (SBC). Much of it may be true in certain cases, but it is not always true. Each individual's equity situation is unique and should be treated as such. Below are some of the common narratives you may hear and where there are exceptions to the rule.
ISOs vs. NSOs
Incentive Stock Options (ISOs) do get special tax treatment. However, it is often the case that employees who hold ISOs do not realize their favorable tax treatment. They often exercise their options at or near a liquidity event such as an acquisition or an IPO. In order to qualify for long-term capital gains tax treatment, you need to hold your shares for at least two years from the grant date and at least one year from the exercise date.
There is a strategy called a cashless exercise, or same-day sale, where folks exercise vested options and immediately sell a portion of them in order to pay for the costs of exercising and any tax burden. What often happens is ISO holders unintentionally stumble into a situation that looks a lot like a cashless exercise. Someone may exercise their ISOs and trigger a tax liability due to the Alternative Minimum Tax, or AMT. You can read more about AMT here. In short, when a company’s value has gone up significantly between the date options are granted and the date options are exercised, the increase in value on paper could be taxable. Under AMT, the spread between the current Fair Market Value (FMV) share price and the exercise price could be considered income and taxed at a rate of 26%+. To cover AMT, you may need to sell a portion of your options on the exercise date to cover the tax bill. All those shares sold at the date of exercise incur short term capital gains tax, as opposed to the more preferable long term capital gains tax rate. As a result of this phenomenon, many argue that Non-Qualified Stock Options (NSO) are better because they are simpler for the option holder to understand and easier for an employer to administer.
Stock Compensation vs. Cash Compensation
The narrative of getting rich off SBC is well described. If you were one of the first 100 employees at Microsoft, Facebook, and Google, you made enough money via company stock to never work again. Although some company's shares appreciate significantly, consider the many failed companies which went after the same opportunities as Microsoft, Facebook, and Google. SBC is designed to allow people to share in the upside of a venture and also incentivize them to hit goals and make progress on objectives which drive the company's overall value. Unfortunately, the value of a company does not always increase each day or even each year. If you worked at companies such as Facebook or Twilio in the 18 months after their IPO, you may have wished you negotiated a higher compensation and a lower stock package.
In addition, options can have no value, which why some argue for the use of RSUs or restricted stock as a form of SBC. If you have an option, you have the right to purchase shares at a fixed share price (the strike price or exercise price). The strike price implies a certain valuation for your company, which is often set by the 409A valuation. You can read more about 409As here. If the valuation of your company declines or does not increase over the duration of your employment, the share price may dip below the exercise price of your option, in which case you have no reason to exercise. If you were to exercise your options and try to sell your shares, you would lose money.
RSUs & Restricted Stock vs. Options
Some argue that RSUs and restricted stock are more favorable than options because they are simpler. An employee does not need to make decisions about when to exercise, though there are still other topics to think about such as early exercising (if you have restricted stock) and deciding when to sell versus hold.
Additionally, there is the idea that RSUs and restricted stock are more favorable because unlike options, they never go underwater. This idea is true in theory but not always in practice. It is true that your RSUs will have a value when you vest and receive your shares, which is determined by the FMV. It does not matter if your company’s value is the same or 5x higher since the grant date. As a private company though, receiving stock does not mean you can turn around and sell that stock. You need a liquidity event before that can happen. You may end up in a situation where you receive RSUs at a private company and are told that your company will have gone public by the time you vest. If you vest and your company is still private, you may owe a big tax bill without the ability to sell your shares. You can read more about taxes on RSUs here.
Let’s say your RSUs vest, and you receive stock when the value of your shares is $10.00. Unless you file an 83(b) election and pay your taxes early, you will pay taxes on your stock as it vests. So you will pay a tax on your shares at $10.00 per share value. If your company halves in value from there and then you get the opportunity to sell, you will still generate proceeds at sale ($5.00), but now you may have a capital loss ($10.00 minus $5.00). In this case, you may wish you had received cash compensation or options instead. It is common for RSUs or restricted stock to be given at companies that are approaching a liquidity event such as an IPO or a sale or are public. Not every company that is “close to a liquidity event” has that intended liquidity event, however.
When to Exercise Your Options
Let's say you have options struck at $3.00 per share, and the price per share of the last round of financing was $5.00, then you may think you should exercise your options because you can sell your shares for $5.00.
When you exercise your options, you will receive a share of common stock. Common stock is the most junior class of stock in what is known as the preference stack, which includes preferred stock and common stock. Preferred stock “sits on top of common” because preferred shareholders often get first money out in an exit due to liquidation preference. There are other rights conferred on preferred stock which make it inherently more valuable than common stock, so the preferred price per share will always be higher than the common price per share. Do not be surprised if you see shares of common stock selling at a 10% to 20% discount to the price of preferred shares. If you are interested in learning more, you can read more about common and preferred stock here.
When you hear about share prices for a company, you cannot think about it in a vacuum. If you are at a private company backed by Venture Capital (VC) or Private Equity (PE), you must consider it in conjunction with the amount of money that has been raised historically and the dollar amount of preference that must be paid back to preferred shareholders before common shareholders can receive any proceeds.
- A common example: Say a company has 1 million shares of preferred stock and 1 million shares of common stock. The preferred stock comes from external financings and will likely carry a right to be paid back first in the event of liquidation, a liquidation preference. If there are only enough proceeds to pay back the preferred shareholders for the amount they invested (say your company raised $50 million and sells for $50 million), then common shareholders and option holders will receive no proceeds.
Lastly, all of this assumes there is a liquid market for shares in your company, which is often not the case with VC-backed businesses or PE-owned businesses. At public companies, liquidation overhangs and preference stacks tend to be less consequential. By the time a company goes public, investors will likely have converted their preferred shares to common shares.