Ask HN: How exactly do stock option grants work? | Hacker News Reader

Ask HN: How exactly do stock option grants work?

43 pointswlfsbrg30 comments

I'm part of a 100+ person startup and I've just received my stock option agreement packet, and (not surprisingly) I'm terribly confused.

I've been granted X shares of an "Incentive Stock Option" and I have an "Option to purchase Common Stock of the Company". Does this mean I have to buy into my own stock?

Also it looks like it will take five years to vest, so what happens if the company is acquired/goes public between now and then?

Any help is greatly appreciated. I still do my taxes using the online TurboTax basic plan, to give you an idea of how not difficult my taxes are currently. :)

UPDATE: Wow thanks everyone for your responses so far! I looked a bit more at the paperwork and it says (paraphrasing): 1/4 of my shares will vest on my 1-year anniversary and then 1/48th remaining will vest each month after.

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Congratulations! Vest in peace.

Now, it's been a while since I've had to think about any of this, but I'll try to answer your questions:

ISOs (Incentive Stock Options) are options that do not carry a tax burden. Meaning, if you exercise your options (purchase them at the strike price) you do not have to pay taxes on any profits you make on them.

Common stock is called common to differentiate it from preferred stock which is typically given to investors, founders or to purchase board members. The primary difference being is if your company goes under, those guys get taken care of first.

Vesting periods usually work like this:

You have a cliff -- which is, essentially, a time gate that says "if you leave before date x, you get no shares. after date x, you are able to purchase all of the shares you earned prior to date x (in your case probably 12/60ths of total allotment) and earn the right to purchase an additional 1/60th of your options every month thereafter."

What happens if you are acquired? There are several possibilities depending on the type of acquisition.

1) You might be given a new grant

2) You might be given cash in exchange for vested shares and a new grant based on the pool of the parent company

Going public I'm less familiar with, but I'm under the impression that you can unload any stock you own onto the market barring any contractual agreements (CEOs and significant shareholders, if I recall correctly, are disallowed from divesting over a certain amount per month so as not to affect valuation).

> Meaning, if you exercise your options (purchase them at the strike price) you do not have to pay taxes on any profits you make on them.

Huh? You absolutely have to pay taxes on any profit you make when you sell the shares. In addition, you may also need to pay taxes at the time of exercise on the difference between the strike price and the fair market value, in the form of AMT.

http://fairmark.com/execcomp/isoexer.htm

Sorry, that was very poorly worded.

From your link, this is the point I was trying to get across:

"For purposes of the regular income tax, the exercise of an incentive stock option is a non-event. There is no tax — in fact, nothing to report on your tax return — when you exercise an ISO. This is dramatically different from the treatment of nonqualified options. Generally you report compensation income equal to the difference between the fair market value of the stock and the amount paid under the option when you exercise a nonqualified option."

You still need to be very careful about this as the difference between strike and fair market counts toward AMT. Folks exercise ISOs and then hold them planning on selling at one year. In the mean time, the market plunges making the shares worthless, yet you still have to pay AMT. Double ouch.

#include <IANAL.h>

You basically have the "option" to purchase the stock for a set price (your strike price) for some period of time.

Yes, to exercise your options you would have to purchase the stock at the strike price, and then sell it at the current (higher) price. With few exceptions, you can't do any of this until/unless the company IPO's and is publicly traded.

Because you have not been granted anything of direct value (that would be a stock grant, not an options agreement), you have no tax liability, because, well you don't have anything :)

5 Years is a bit rough, a typical vesting schedule is 4 years, typically with a 1 year cliff (nothing vests until you reach 1 year of employment, then 25% (or in your case probably 20%) of the shares are vested, meaning you could exercise them. After this, a proportionate amount of additional shares vests each month until the 4 or 5 year mark).

If something happens to the company before the 5 year period, some combination of losing any/all shares (vested or not), getting new/additional shares, getting an entirely new allocation of shares, or having the strike price adjusted is likely to happen.

You don't actually own anything until you exercise (buy) the shares. And I HIGHLY recommend you don't purchase any of the vested shares until the company is public, and only then when you intend to exercise them immediately (which is generally a cashless transaction).

The hard facts are that until there is an IPO, common stock (what you have options to) is very likely to get whacked around a fair bit, and you stand to lose far more than you gain.

And I HIGHLY recommend you don't purchase any of the vested shares until the company is public, and only then when you intend to exercise them immediately (which is generally a cashless transaction).

Usually true, but not always. There are situations in which purchasing shares over several years prior to a pricing event can avoid AMT screwing you. It is rare, but it happened to me once. It happens when the details of the pricing event count as income under AMT, but not under ordinary tax rules. If you have large deductions under ordinary tax rules (the most common is the federal deduction for taxes paid to the state), then AMT can hit you.

If you think this might happen to you, discuss with a competent accountant. The rules are complex, I don't know them, and all I can usefully tell you is that it is possible, it is rare, and I very nearly was in a case where it would have happened. (I was careful to purchase options early so that eBay's purchase of Rent.com with stock would not trigger AMT consequences. Then the deal was changed to cash and it didn't matter.)

All of this is standard. You probably aren't getting screwed.

You've been given options, not actual stock. This should not concern you. The difference between options and stock is largely a tax matter. In both cases, you've received an instrument with a very low current price that will be lucrative to you if the price appreciates (in, for instance, a takeover).

When you leave the company, you'll be required to shell out some cash to keep your exposure to the company's upside; you didn't give numbers, but if you stay until you're mostly vested, expect it to cost a couple thousand dollars. You'll have to decide whether the company's prospects merit the investment.

If the company is sold before you leave, you won't have to exercise your options in advance (you'll still need to exercise them, but this will be a no-brainer since the stock value will have appreciated). The difference between leaving and staying with respect to your options is risk.

As with every company, your options vest, meaning they become available to you in waves on a vesting schedule. This should not concern you; even the founders in your company have a vesting schedule.

What happens when the company is purchased? It depends. If you're lucky, there is a company-wide change-of-control clause that gets you instant access to the upside of the sale. You're probably not that lucky. The most likely outcome is that you'll have a mostly locked-in upside, but that you'll have to work through the remainder of your vesting schedule to get it. There are lots of sticky details (such as what happens if you're terminated before you vest after a change of control), but it's a waste of time to worry about them now.

You didn't ask, but do know: as employee 50+N in a 100+K-person startup, you are extremely unlikely to get any concessions in the terms and conditions of your equity grant. The company's board reviewed and agreed on this plan; it is a big deal to change it for anyone.

The real question is the company valuation and its financing terms. You should have been informed as to what % of the common stock your grant works out to, so you can work out what an $Xmm acquisition means to you. You should also probably be able to find out what the liquidation terms are on the company's financing (how much of that X the company's investors take off the top before the common stock is valued). These are the numbers that differ most wildly from job to job, and the ones most likely to impact your personal upside.

Remember that as a line employee in a 100 person startup, your stock grant is not going to be a life-changing event unless the company is CNN-level spectacularly successful. If the company does quite well, it'll probably amount to the equivalent of a 5-figure bonus per year, paid in a lump sum when the company is bought.

> When you leave the company, you'll be required to shell out some cash to keep your exposure to the company's upside

I'm not sure what that means. He has to purchase the options in order to exercise them later? I thought once something "vested" it was yours to keep.

As I understand it, with ISO's, the options generally need to expire within a small number of months after an employee leaves. Regardless of the particulars, in every case I'm familiar with (myself and friends), leaving the company requires you to exercise options or walk.

Vesting gives you the right to exercise. It doesn't do anything else for you.

I think I get it, so when you said "shell out some cash to keep your exposure to the company's upside" you mean buy the options for the value you were granted them (the "strike price" I think). Is that right?

Well, you own the options after they vest; you exercise options in order to purchase shares. In other words, you own the right to buy shares at a specific price (that's the option), and exercising that right means actually buying those shares (generally for a price far below the current share price). You can then hold on to the shares, or turn around and sell them for an immediate profit (depending on the terms of various agreements).

Careful: you probably own the options only for a very limited time after you leave the company. You cannot generally hold on to your options until the company is (say) certain to be acquired; you generally have to exercise them almost immediately after leaving.

Unrestricted common stock you can keep long-term. Options, not so much.

Another thing to be careful with, if you leave the company pre-IPO or purchase, you need to exercise those options, but the money you are spending is still very much a pie-in-the-sky bet. Until the shares become publicly traded, you can't do anything with those shares, sell them, trade them, etc. You can only hang on to them in the hopes they become worth something someday.

Right. If you don't give the company (say) a couple thousand bucks when you leave, you're going to be walking away from your equity grant forever.

Nope. Vesting gives you the ability to purchase the shares. Once you leave a company, you typically have 30 days to purchase what you vested, else you surrender them back to the company.

Options are an opportunity to buy stock at a set price (the strike price). So if you're granted 10,000 options at $1 each, and when you sell them the company is valued at $2 a share, you'll make $10,000 off your options. If you go through a company like e-trade you don't have to actually have the $10,000 to sell them. You can do the trade without the $10,000 initial investment to buy the shares specified by your option grant(at least in my case with a previous employer this was true).

Since the option grant is just an offer to buy stock (vs. a stock grant which is an actual share and doesn't cost anything to sell), once you leave the company that offer to buy stock is typically rescinded after a certain period of time.

Does this mean I have to buy into my own stock?

Yes, but most people don't exercise their options until a liquidity event (company gets sold, goes public, etc). When this happens, you hope the shares are worth more than your option price. If so, you can exercise your options and make profit between your option price and the current price. This is the zero risk way to do it.

Also it looks like it will take five years to vest, so what happens if the company is acquired/goes public between now and then?

You should have some sort of vesting schedule in your packet. I'm guessing that within 5 years all your options will be vested, but between now until then, your options vest as you work. This is because your startup doesn't want to just give out boatloads of options to people who are going to leave. They want you to stick around and earn them and the vesting schedule is how they accomplish that.

This is great, thanks for the insight jbail. I want to clarify using an example (not using real numbers):

I am granted 100k options at exercise price of $0.10, so the total amount it would cost me would be $10k to purchase them. The company is sold with shares being valued at $10 each.

I spend $10,000 purchasing the shares, which then I would see a return of $990,000?

But AFAI understand before the IPO you can't buy anything, even if the shares are valued some value in some company to company transaction. AFAIK it's not about company being sold, it's only once it's on the market (and other conditions you have are met) that you can execute your options. Then you don't have to worry to even have the mentioned 10K USD, you'll be able to get the difference between the real price of that number of shares and the strike price of your options.

http://en.wikipedia.org/wiki/Strike_price

You can buy before the IPO, but you won't have anywhere to sell them. Buying before IPO is risky because you may face taxes on the difference between the strike price and fair market value, but not be able to turn any of the paper profit into actual cash to pay the taxes.

Wouldn't a website like secondmarket.com allow you to unload stock before a liquidity event? That assumes that someone would want to buy the stock from you.

No, it's a private company, and part of the ownership contract will prevent you from selling your shares to people outside the company. You might even be precluded from selling them period. That's why most people don't buy until the company's exit.

See my mainline comment for more details

If all your options are ISOs, yes.

You'll very likely have to execute your options when you leave the company, or give up your exposure to the company's upside.

To add to the vesting discussion, there's typically a cliff. What this means is that you have access to none of your options until that time, a 1 year cliff is pretty common. If you see in your packet something about a 1 year cliff this means that on you're 1 year anniversary you have access to 20% of your available options. Typically you'll then vest the additional amount each month following until you've fully vested after 5 years.

In addition to exercising your options during a liquidity event it's common that a company requires you to either exercise or expire your options when you leave the company. There's typically a time period allowing you to decide to exercise these or not, often it's 30 days after you leave that you have available to decide to purchase your options or not.

What happens if a liquidity event occurs within the first year, before the cliff? Do I still have my options, and am just unable to exercise them?

It depends on the event. You would still have the options, but might not be able exercise any of them until a cliff is reached. The event might also include a trigger of some sort that accelerate the cliff/vesting schedule, but I think this is usually just a mechanism for founders & early employees.

You should spend some time reading about what ISOs are, how they are taxed, and in particular, if an 83 (b) election is an option, it is probably something you want to do. There are pretty good explanations at http://fairmark.com/execcomp/index.htm

I've been through this a few times. Three times the startup went under before exit, and the options wound up being pure fiction.

Once I left the company with some vested options, bought them for about 500 bucks, and then got washed out in their next round of investing.

Once (like you I was employee 65 in a 70 person company) we got bought for a nice sum, and the employees all got retention packages worth, as tptacek noted, 5 figures per year served, give or take. Most of the early-in employees, who put in very long hours at the beginning, felt a bit screwed. They worked out their hourly rate for overtime spent on the company, and it came out... okay. Not great. Late arrivals like me felt just fine.

The main point I've taken from these experiences is this: when grunts like us own shares in a private company (or options to buy shares), we don't own anything real. What we own is a small piece of a partnership contract, in which we are a very underprivileged partner. If you look carefully in the partnership agreement, you will see that not all shares are created equal. There are A class, B class, C class, and so on. Each class of shares enjoys different privileges w/r to the money that comes into the company. Grunts like us get C class shares that place us at the mercy of the other two classes.

Investors and founders are senior partners in the company, and they can pretty much do what they want with your part of the contract. Your only remedy is to quit the company.

Some things companies commonly do with shares of this class:

- Take a new round of investment, and rip them up. Often this happens after a down round of fund raising. With layoffs in advance. The laid off employees lose all interest in the company (even if they bought their shares!), and the remaining employees get issued new options in the new agreement.

- See them replaced with some other incentive plan. This usually happens after a medium sized exit. Basically the buyer puts a certain amount of money on the table. The board of the company splits up the pie in some way that sort of relates to the current share agreement. Then they wash out all of the existing shares and hand out retention packages to employees and founders. The size of the packages typically relates to the size of your grant, but few people get cheques cut on the day of the sale. Most have to work for a year or two to see the payout.

Let me sum up with this: I'm not bitter! I've got way less risk in the game than investors and founders, especially as a late arrival. This is the reality of the game, and my eyes are wide open. So equity participation in a small company for me is icing on the cake. Far more important is base salary, benefits, HR policies, company culture, technology, co-workers, all that stuff. I've never chosen one company over another based on the options package. For grunts like us it rarely matters anyway.

This is a great comment (note that while I'm a total cynic about the prospects of holding private company common stock as a non-employee, I did just lose out on a high-multiple investment opportunity by walking away from my last employer's options).

I just want to add though, presaging some people's thoughts that "they really trust the founders" and whatnot, that oftentimes the founders have little say in the outcome for non-employee stock holders. The VCs are usually calling the plays with regards to exits and valuations.

It's also worth noting that at some point during the life of many successful companies, the founders incentives are going to begin radically mismatching those of the employees; their outcome on a modest-but-successful exit will be life-changing, and the utility of the extra money they make on an exit large enough to change early employee lives won't be worth the risk. They'll want to exit as soon as they can.

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