Understanding Stock Options: A Guide for Early Employees

As an early employee at a private technology company, stock options can be one of the most valuable and complex aspects of your compensation. Understanding how they work, their potential benefits, and the risks involved can help you make informed decisions that maximize your financial future. This guide breaks down the key aspects of employee stock options so you can navigate them strategically.

What Are Employee Stock Options? 

Employee stock options give you the right to buy a specific number of company shares at a set price. This price is often referred to as the "exercise" or "strike" price and is based on the company’s valuation at the time the options are granted.

The lack of public market pricing can make understanding the value of your options a bit more complex. For private companies, a periodic independent appraisal known as a 409A valuation typically determines the value of stock options.

Why Do Private Companies Offer Stock Options? 

Gaining a stock grant is a pivotal moment in an employee's tenure at a company. For startups and growth-stage tech firms, they serve multiple purposes:

• Attracting top talent: Competitive salaries can be difficult for early-stage companies. Stock options provide an alternative form of compensation with high potential upside. By offering stock options, companies can provide employees with a potential future financial gain without immediate cash outlays. 
• Retaining employees: Most stock options vest over time, encouraging employees to stay and contribute to the company's success.
• Aligning interests: Since financial gain is tied to the company’s growth, stock options create a shared incentive for success between employees and investors.

Types of Stock Options

Most private tech companies offer one or both of the following types of stock options:

• Incentive Stock Options (ISOs): Available only to employees, ISOs have tax advantages if specific holding requirements are met. However, they may trigger the Alternative Minimum Tax (AMT) upon exercise.
• Non-Qualified Stock Options (NSOs): Can be granted to employees, board members, and consultants. NSOs lack the tax benefits of ISOs, but offer more flexibility in terms of recipients and exercise conditions.

Understanding Vesting Options

Most stock option plans include a vesting schedule that dictates when you earn the right to exercise your options. A common structure is a four-year vesting period with a one-year cliff, meaning:

• No options vest until you complete one year at the company (the "cliff").
• After one year, 25% of your options vest, with the remainder vesting monthly or quarterly over the next three years.

This structure aims to promote employee retention and encourage long-term commitment to the company.

Valuation Challenges in Private Companies 

Valuing stock options in private companies can be difficult due to the absence of a public trading market. Unlike public companies with readily available stock prices, private companies rely on 409A valuations to determine the fair market value (FMV) of shares. This valuation affects:

• The exercise price for new option grants.
• Tax implications when exercising options.

Option values change over time, especially as a company grows. This is why understanding the current value of your option grants is important. Three primary data points can help employees estimate the value of their options:

• Latest 409A valuations: Understand the strike price of your current option grants relative to the new 409A valuation at which new stock options are being granted.
• Primary funding rounds: Understand the valuation that was ascribed to your company in its latest funding round. Next, determine how this valuation translates to a price per share. This can provide an estimate for the current market price for your options.
  
  EquityZen provides capitalization table analysis¹ for the private companies we transact with. This helps shareholders and investors understand the price per share for private companies based on their latest rounds of funding.
• Secondary trades: The price of your company’s stock in the secondary market is a helpful marker for the value of your startup equity. Marketplaces like EquityZen provide data on secondary trading to help shareholders understand what their options are worth. 
  

Exercising Your Stock Options

Once your options vest, you can choose to exercise them, meaning you can buy shares at the strike price. However, exercising options requires careful consideration. Employees should evaluate their financial situation and the potential risks and rewards of exercising options. Some key considerations include:

• Cost: You must pay the strike price for each share. When exercising large quantities of shares this can be expensive. To help ease the burden of this upfront cost, some companies allow for cashless exercise.
• Taxes: Exercising ISOs may trigger AMT. Meanwhile NSOs result in ordinary income tax on the difference between the strike price and the fair market value at exercise.
• Liquidity: Unlike public company shares, private company shares are harder to sell before an exit event like an IPO or acquisition. Because of this, employees historically had to wait for a liquidity event to realize the value of their shares. Luckily, marketplaces like EquityZen enable shareholders to sell their shares before an exit event.

Exit Strategies and Liquidity Events

Your stock options become valuable when the company undergoes an exit event, such as:

• Initial Public Offering (IPO): Employees can sell their shares once they become publicly traded. Most employees can sell pre-IPO shares after a 6-month lock-up period.
• Acquisition or Merger: The acquiring company may offer a cash payout or shares in the new company.
• Secondary Market Sales: Many startups allow employees to sell shares to private investors before an exit. EquityZen has worked with over 450 private companies on secondary market sales, enabling liquidity for early employees and other shareholders. 

Understanding the company’s exit strategy and timeline can help you make strategic decisions when exercising your options.

Tax Considerations for Early Employees

Taxes play a crucial role in stock option strategy.² Key tax implications include:

• ISOs and the AMT: ISOs offer favorable tax treatment, allowing employees to defer taxes until they sell the shares. This allows employees to potentially benefit from long-term capital gains rates. However, shares may be subject to the alternative minimum tax (AMT) at the time of exercise. 
• NSOs and Ordinary Income Tax: NSOs result in ordinary income tax on the difference between the strike price and the fair market value of the shares at the time of exercise. This tax is due in the year of exercise, regardless of whether the shares are sold. The lack of preferential tax treatment means that employees must carefully consider the timing of exercising NSOs to manage tax liabilities.
• 83(b) Elections: If allowed, early exercising options and filing an 83(b) election can reduce long-term tax liability, but it involves upfront costs and risk.

Given the complex tax implications of stock options, employees should engage in careful planning. Consulting with tax professionals is essential to help employees understand the potential tax liabilities associated with exercising options and selling shares. By planning ahead, employees can minimize their tax burden and maximize the financial benefits of their stock options.

Strategic Considerations for Early Employees

• Understand your stock option agreement: Review key terms, including number of shares, vesting schedule, exercise window, expiration date and tax treatment.
• Assess financial risks: Ensure you can afford the costs and potential tax implications of exercising options.
• Stay informed on company valuation and exit plans: Understand the market value for your company's shares and what potential liquidity opportunities could arise.
• Consider professional advice: A financial or tax advisor can help optimize your exercise and tax strategy. This can help you decide when to sell your stock.

Conclusion

As an early employee in a privately held company, your stock options can be a significant financial opportunity. However, they come with complexities that require careful planning and strategic decision-making. By understanding how stock options work, their tax implications, and potential liquidity events, you can make informed choices that maximize your outcomes.

Not investment advice. Any decision to exercise your options or sell your shares is yours alone, and neither EquityZen nor any of its affiliates provides any recommendation or advice in this regard.

Footnotes

1. Not all private company issuers maintain up-to-date Certificates of Incorporation, and foreign company issuers may not be required to file Certificates of Incorporation (or an equivalent document) in the jurisdiction in which they operate. A lack of publicly available and verifiable information can materially impact the accuracy of information provided, including without limitation, estimates relating to the valuation and capitalization of companies subject to investment.

2. This information should not be construed as professional tax advice; consult with a qualified tax professional for guidance specific to your individual situation.