What employees need to know about stock options
In the startup world, particularly when it comes to unicorns, options can be considered the holy grail. They have a bit of mystique and come with stories of early employees becoming millionaires post IPO. However, most people don’t fully understand the mechanics and choices that employees have when it comes to option compensation.
So, let’s break it down: Simply speaking, options are contracts — they aren’t shares. They’re contracts where an employer promises to sell the employee their shares in the future at today’s price. The employer isn’t actually giving the employee the stock as part of their compensation package. Instead, the employee is getting the option to buy the stock at today’s price even though the stock would be more expensive if it was purchased on the open market.
Some early employees of a startup may become millionaires overnight because they’ll be able to buy the stock for 15 cents a share after waiting until it starts trading for hundreds of dollars.
Employees Must Be Patient
Here’s the catch to employee equity: Employees must be patient to access the shares. The employer wants employees to stay and help transform the company into the next big success story.
Typically, companies make employees wait one year for an option grant to start vesting, and only then will a portion of the grant vest (i.e., become purchasable by the employee) on a monthly basis until the four-year anniversary of the grant date. This option compensation (like most equity comp) is a retention and incentive mechanism.
After waiting for options to vest, employees can “exercise” their options, which means buying the shares at the price from as far back as 10 years ago and then sell them at today’s price. Even after the options have vested, there are still costs to obtain shares beyond just the exercise price. For example, certain taxes might be owed at the time of exercise. Also, depending on the company, there may be no way to sell the newly acquired shares prior to a company’s IPO or acquisition. However, it’s possible to obtain liquidity from options in other ways through the secondary market.
What Happens When Employees Wait for Their Options to Vest?
When a company gives employees Incentive Stock Options (ISOs) or Nonqualified Stock Options (NSOs), the employee usually has to wait for the options to vest before they’re allowed to exercise them.Once the options have vested, employees have the opportunity to obtain shares, either all at once or periodically as they vest.
In some cases, employees are granted Restricted Stock Units (RSUs). With RSUs the shares are given to the employee at a schedule determined by the company, they do not have to buy them. But, keep in mind that taxable income will be recognized with each release of shares from an RSU.
How to Liquidate Shares Before Your Company IPOs
Some private companies allow employees to sell their shares directly — Forge can help with this process. First, there must be an agreement on price. From there, Forge works to connect a seller of the shares to an interested buyer.
Next, Forge will submit a notification to the company called a Stock Transfer Notice. The notice tells the company to switch ownership from the buyer to the seller. If a switch is approved, then they can make a direct transaction. However, the company usually has a Right of First Refusal (ROFR) to purchase the shares. If the company chooses to exercise its ROFR, then they’ll buy back the shares from the employee. So, the employee still gets liquidity but the original buyer is removed from the deal.
Some companies also require board approval for transfers. In this case, the company has an opportunity to block the transaction. With that said, Forge has standing relationships with several companies as a trusted buyer, and at others — the company’s approval will depend on price and number of shares.
Private Companies Need an Employee Liquidity Solution
With private companies beginning to find it more optimal to delay IPO, demand for employee liquidity may not be met. However, by using platforms like Forge, employees can use the secondary market to buy or sell shares in order to get the liquidity they need.