It’s almost become a cliché: young tech workers join a start-up, work hard for a year to take the company public, then pocket millions of dollars when they cash in their stock options.
As a result of this well-known tale, IT workers now view stock options as the ticket to fast money. According to the National Center for Employee Ownership, between seven and 10 million employees receive stock options in the United States, up from only one million in 1992.
Start-ups are using options as a primary tool to lure and retain talent. The NCEO reports that stock options are the most prevalent employee ownership practice in venture capital companies.
If you’re considering going to work for a start-up that offers stock options, here’s an idea of how they work: a company gives an employee options to buy a certain number of shares of the company’s stock at a set price, usually the market price at the time the options are handed out. The options come with an expiration date and a vesting period.
The most important thing to remember when negotiating stock options is to scrutinize the details before signing anything. Read on for more advice on how to handle stock options.
Options vs. salary
If the options plan a potential employer is offering looks generous, take a closer look at the salary. Experts warn employees that taking a big options package in lieu of a generous salary is not wise.
“Gary,” a vice president in the software industry who has been in the IT field for 25 years, has been part of three stock option plans and made money on all three. “However, on the first two, I would have made the same amount or more had I been paid at the market rate,” he said.
Gary and others advise workers to weigh options and salary along with the company’s reputation, its prospects for the future, and which investors or partners have already signed on. Financial advisers recommend starting with a salary that covers expenses and balancing that with options to generate future wealth. Ask for an options boost with each performance review and salary increase.
Some employees will ask for additional option grants instead of cash bonuses. But you might be better off taking the cash bonus and investing it in mutual funds.
Here’s a good rule of thumb to use when weighing options against salary: take-home value of the options should equate to about 60 percent of the face value. An options package with a face value of $50,000, for instance, should net an employee about $30,000 after the strike price (see the definition in “Terms to remember “ in the navigation bar to the right) is paid and the options are fully vested.
In addition, take a close look at the vesting schedule of the option plan. Many start-ups set up options to vest on a four-year cycle, which means one fourth of the options vest one year after the options are granted and the remainder vest over the next three years. The expiration date to cash in options, in most cases, is 10 years from when the options are granted.
Because Internet time is so fast, some companies are now offering monthly vesting after the first year, rather than annual vesting. Gary believes this is more beneficial to workers.
“Many companies offer large options with a vesting period of three years for 50 percent and 25 percent in the fourth and fifth years,” he said. “If you are going to offer options in lieu of pay and bonuses, then why not provide a plan where [options] vest at a minimum of a year, or monthly, as some companies do? Some companies offer a five-year vesting program with 1/60 vested per month.”
Other do’s and don’ts
When you sit down with that potential employer to negotiate your options, it’s important to find out how many shares the company intends to issue, what percentage of the company your stake will represent, and how much your options are worth. Most companies should be able to give you at least ballpark figures to all those questions. If you don’t know these figures, however, you won’t be able to make an informed decision about what to do with your options.
It’s unwise, in most cases, to cash in all of your options at once. Stocks mature and become more valuable over time, and to cash in prematurely would cause you to lose out on future dividends. One strategy may be to set up a calendar where you exercise options in increments over a period of years. This averts the danger that one bad quarter for your company might ruin the value of your stock.
Gary also advises that employees understand what happens if they pass away, become disabled, retire, or leave for another job. A good plan will allow employees to pass on their options to family members without unreasonable penalties, or hang onto them once they’ve left the company. He also recommends negotiating for protection if the company goes public while you’re still vesting. “This is critical when the stock trades below the grant price,” he said.
Another piece of advice: don’t let your options expire unused. There is usually some profit to be made from the options, however small, and it’s your entitlement for the work you’ve done.
A few cautionary words
Option plans often provide a greater benefit to the company than to its employees. Gary calls stock options the “golden handcuffs” for retention because employers know that if workers own options, “whatever it takes in hours and commitment they will do.”
In addition, companies that offer options packages often pay lower wages, don’t pay bonuses, and place a moratorium on promotions until employees are fully vested.
“This is too much,” Gary said. “You should negotiate to keep your wages as high as possible. Options are not guaranteed.”
Another drawback is the potential dilution of options during future rounds of funding. If the company needs additional funding, the value of employees’ stock options is diluted each time the company receives those additional funds. To keep the overall size of the grant stable, some plans include an anti-dilution provision, which issues employees additional shares each time the company receives further rounds of funding.
Among other disadvantages is the tax trouble that usually comes with stock options. If you cash in your stock or exercise your options, the Internal Revenue Service taxes the profit as ordinary income. Your best bet is to consult an attorney or tax specialist prior to making any such moves.
Winning the stock options game
The word on the street seems to be that stock options are a nice perk, but they don’t always measure up to what’s expected.
Four months ago, “Keith” joined a firm that promised him directorship of the company and a 10 percent share option. He’s worked hellish hours with almost no help. And the future doesn’t look any brighter: he’s yet to receive any written confirmation of employment or a stock option plan on paper.
For all of his trouble, Keith feels that he “should be given at least double what has been offered. That is, 20 percent instead of a 10 percent share option.
“I am now thinking of striking out on my own because I feel we are too slow and too out of focus,” he said.
When “Wes” took his current job as a database administrator in the healthcare industry, he received 500 options, vesting at 100 per year starting at one year of service. These could be purchased at 85 percent of market value. Since then, he’s received a bonus of an additional 500 shares for being involved in a Y2K effort that was business-critical.
While he’s satisfied with his package, Wes worries that “if the company folds, I most likely have no recourse. There are no true bonuses for meeting the mark on projects unless the CEO decides to give them out in an ad hoc manner.”
Gary believes option packages can work, however.
“Options, because they are defined, help both parties to focus on the business objectives,” he said. “Employees can win big if they assist a strong management team in executing their plan. Companies win big if they can encourage and retain people to focus on the execution of the company goals.
“Talent is at a premium and it is definitely an employee’s marketplace if they understand the rules,” he continued. “You must separate the hype from reality.”
There’s a lot more to the stock option game than we can cover here. Got any tips for negotiating stock agreements? Tell us about them by posting a comment below orsending us a note.With so much lingo surrounding stock option plans, here’s a list of definitions that may come in handy as you review a company’s offering.Non-qualifying option—the most common type; the difference between the strike price and the current market value of the shares is counted as additional income and taxed at the individual’s appropriate income tax rate.Incentive or qualifying option—an option with no tax cost to exercise, as long as the employee keeps the shares for at least one year. Beyond that, profits from the sale of the shares are taxed at the capital gains rate of 20 percent.Takeover clause—an article in the option plan that specifies what happens to employees’ options if the company is sold. Usually, options are immediately vested if the company is sold, giving employees the chance to cash out all their shares.Strike price—the price at which the employee can eventually buy shares of company stock. Publicly traded companies grant shares at the market price, while privately held firms usually can’t determine what the strike price will be until an initial public offering.Registered shares—shares whose offering is registered with the Securities and Exchange Commission.Alternative minimum tax—taxation on exercised options that fixes the value of restricted compensation; amounts to 26-28 percent of the income from the sale.Cliff vesting—an instance when all the options can be exercised at once.Contract puts—contracts to sell stock in the future at a set price on the company’s stock.Repricing—the lowering of the stock option purchase price already granted to employees; usually happens when the stock price tanks.Dilution—the company issues new rounds of options in order to keep talent; as a result, the additional shares dilute the stake of existing shareholders.Sources: Business 2.0,Forbes, and the National Center for Employee Ownership.