How to Understand Stock As Part of Total Compensation
Stock options. Many employees of startups and corporations get to hear this term when their compensation is being discussed. It is often used as a proxy for ‘if the company makes it big, then you get to share in that too, and you will be wealthy.’ However, behind the simple term lies a complex mess of financial, legal, and taxation regulations that can dramatically change what stock options mean and how they affect your stock compensation.
If you have real concerns about your own situation concerning stock, paying for it, cashing it in, and how that affects your compensation and taxation situations, then you should consult a financial advisor, lawyer, or taxation professional. But this article should give you the basics for understanding how stocks affect your compensation.
Stock is a component of total compensation when it is offered. Some forms of stock compensation can also be relatively simple. But there isn’t one kind of stock – there are many. They operate differently and should be evaluated in terms of compensation differently.
How stock is awarded
Typically stock is awarded to an employee over four years with a wait for the stock award to begin vesting and a period at which the stock is awarded. A typical stock award is for a four-year period, with monthly vesting and a one-year period before any stock is awarded. This means the stock is awarded every month for four years, but the first award is delayed for a year and consists of all that year’s stock at once. If the employee is granted 10,080 shares, they would get 2,520 after a year and then 210 per month. The waiting period before any stock is granted is called a ‘cliff.’ The total period is the length of the award and how often stock is awarded is the vesting schedule.
Common types of stock compensation
RSUs – Restricted Stock Units. A form of share where once you have vested, you own them. RSUs are tradeable shares in the company that you can sell as soon as you own them, apart from some closed trading periods depending on the employee role and existing laws. They are called restricted because you are restricted from ownership and sale until you have vested them according to the schedule under which you were granted them. These are the commonest stock grant in publicly traded companies and are relatively easy to value since they are effectively the same as any common stock being traded, and their value is the current market value.
ISOs – Incentive Stock Options. The commonest stock grant in startups. These grants are technically not stocks but options to buy the company’s stock at a price set when the options are granted. This is called the strike price. For the employee to be compensated, first, the employee has to pay for the stock option at the strike price, and then they have to be able to sell the stocks to someone else. These stocks are how early startup employees can become wealthy if the company has an IPO. Unfortunately, it is more likely they never become sellable. And if they aren’t sellable, they are valueless. However, it is often significant if they end up having value because the strike price is typically a tiny fraction of the eventual sale price.
NSOs – Non-qualified Stock Options. These stock options are similar to ISOs in the way they are granted and can be exercised. There is one big difference, however. They are not qualified as a capital gain vehicle by the IRS, so they are treated very differently for tax purposes. In other respects, they are the same and must be purchased and sold for the employee to gain compensation.
ESPP – Employee Stock Purchase Plan. Some companies operate an ESPP in addition to other stock plans, and others only offer an ESPP. An ESPP can technically be offered by any company but is usually only offered by companies where the stock can already be traded. Typically, employees can use a portion of their salary up to a given limit to buy shares in the company every quarter at a discounted rate. Since these shares are usually publicly tradeable, they can generally be sold immediately.
Other variations in stock. Preferred Stock gives the stock owner some preferential rights – typically regarding the sale and liquidation of the company if that should happen. Preferred stock is usually non-voting, but not always. Common stock is the most usual category of stock and represents an ownership interest in the company and thus is also voting stock. The voting stock allows the holder to vote at stockholder meetings. There are even rarer forms of stock that are restricted in other ways, and for these, you would need to consult an attorney or financial professional to understand their implications.
How an employee should value stock.
Public stock price. If a company’s stock is publicly traded, then any form of options or RSUs can be valued at their current market value less any cost to acquire them. Public valuation is typically how RSUs and ESPP shares are valued, making them easy to value at any moment. However, future statements of value cannot be regarded as accurate.
409a Valuation. A 409A valuation is an appraisal of the fair market value of the common stock of a private company by an independent third party. Startups pay for these assessments and then use the findings to set the price at which employees can purchase shares of the company’s common stock.
Fair market value. In the absence of a 409a valuation, perhaps because the company is a too early stage to have one yet, there are various ways to set some kind of fair market value, including looking at what the price is that recent investors have paid and how that price has changed over time. Combine that with any revenue shift, and an estimate can be made.
Strike price (or grant price or exercise price). This is a price set by the company when stock options are granted to an employee, and it represents the amount the employee will have to pay for the shares when the time comes to exercise their option to own the shares. For most employees, this is either within 90 days of leaving the company or when they are in a position to sell the shares.
Dilution
One last stock term to understand is dilution. If you are getting stock in a private company, the company quite possibly will still be going to do more fundraising via investment. When they do that, they usually issue more shares to sell to the investors. The value of each share is diluted at that point because suddenly, each share is a smaller percentage of the company’s total shares than before. This can reduce the value of stock considerably.
Stocks and taxes
It is important to understand that there are many tax consequences to being awarded stock, exercising it, and then selling it. Under some circumstances, a gain in value will be considered ordinary income; under others, it will be a long-term capital gain and taxed at a lower rate. The rules apply depending on how long you own the stock when you sell it, and under what circumstances.
Stock calculations for total compensation
The value of stock options at any moment in time is commonly considered to be the current 409a valuation less the strike price. For example, if the strike price is $0.50 and the 409a valuation is $7.53, each share is worth $7.03.
When evaluating stock for total compensation purposes, you should use either the public price of a stock or a 409a valuation if it isn’t a public stock. Remember to take off the strike or exercise price. If you are evaluating an offer from a company, ask them for information about the strike price and current 409a valuation. Also, ask what percentage of the outstanding stock the offer represents. This gives you an alternative way to evaluate the stock offer.
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