The most lucrative part of startup compensation is often in the form of equity grants, however, misunderstandings about ESOPs can result in you facing a large tax bill. A few key concepts will help you become better informed about your equity compensation.
Why do startups offer stock options?
As a part of job offers and retention packages, many startups include stock options in the form of an ESOP (“Employee Stock Option Program”).
Companies offer stock options as a long-term financial incentive to their employees for their work to make the company more valuable. Equity compensation helps in retaining and hiring talented employees as it provides them with a sense of ownership. The idea of being a part-owner of something is appealing because of the life-changing outcomes equity can provide.
Take for instance, early employees of companies like Uber, WhatsApp, Hewlett-Packard and many more ended up making buckets of money when their companies went public (or in the case of WhatsApp — bought by Facebook). The first 3,000 employees of Facebook made roughly $23 billion at the time the company went public thanks to a variety of equity compensation schemes (Financial Times). On average, that’s roughly $7.7 million each, which is certainly a life-changing sum.
The options provide a way for employees to participate with the upside and are a way for early-stage companies to provide an offer to the best talent that is competitive with larger, established companies.
With the possibility of high reward, there is some risk involved with exercising stock options as well. The value of equity ownership is dependent on the value and terms of the company at its Exit, when the company going public or is acquired by another company. If the terms are unfavorable, shareholders risk getting less (or nothing) than they expected. The risk that’s why it’s important to understand the terms and when to exercise.
Types of equity being offered
When you are offered Stock Options, you are not being offered shares of stock directly, instead, you are offered the rights to purchase shares at a later date and at a lower price known as the Exercise or Strike Price rather than their actual market value known as the Fair Market Value or FMV.
In some cases, companies also offer Restricted Stock Units or Stock Appreciation Rights, which do not directly offer stocks to the employees but are basically agreements to pay the employees cash value of the allocated stocks on a future date, generally a liquidation event like fundraising or IPO. We’ll cover these in detail in another post.
If your company is using EquityList for ESOP management, the online dashboard helps you stay up to date on the current value of the options and the cost involved in exercising your options (in the case of ESOPs) so that you are able to make informed decisions.
Another important difference that you need to understand is the one between Preferred and Common Shares. All the founders and employees are allocated Common shares while the investors are generally allocated Preferred Stock.
Preferred stock owners have certain “privileges and preferences” which the common stock owners don’t. Preferred stock owners are paid before the common stock owners when certain liquidity events occurs such as if the company is sold. This is known as Liquidation Preference.
Most investors retain a 1x liquidation preference when investing (meaning that they retain the option of getting exactly the money out first in the case of an acquisition), however, some investors insist on even higher preference levels.
If your company does well and grows to become very valuable, you should not need to worry about being in a queue to get paid for your equity. In a successful outcome, an investor's ownership of the company should mean that that they get a larger amount of money by simply accepting their share of the proceeds compared to the amount they'd get from invoking their liquidation preferences. However, in a scenario like above where the company exits at a valuation lower the amount of money originally invested in it, then all the money from the exit is first used to pay back the preferred stockholders. This scenario is known as Liquidation Overhang.
Scenario 1: An investor invests $2 million in a company at a pre-investment valuation of $8 million in exchange for 20% equity comprising of preferred shares with 1x liquidation preference. So when a few years later the company is sold at a valuation of $9 million, the investor either gets to take the liquidity preference of $2 million paid back first and the founders and employees split the remaining $7 million.
Scenario 2: An investor invests $2 million in the same company at the same pre-investment valuation of $8 million in exchange for 20% equity comprising of preferred shares with 3x liquidity preferences. If the company does no more financings and is sold at a valuation of $8 million, the investor gets $6 million paid back first and the founders and employees split the remaining $2 million.
The Option Lifecycle
Now that you understand a few basic terms involved in equity compensation, let’s move on to understanding the lifecycle of stock options.
1. The company creates an option pool
During the initial days of the company, generally before the first employees are hired, a number of shares are reserved for an employee option pool (or employee pool). A typical size for the option pool is 20% of the stock of the company, but, especially for earlier stage companies, the option pool can be 10%, 15%, or other sizes.
Once the pool is established, the company grants stock from the pool to employees as they join the company or in some cases, mostly during the second stage of hiring (Year 2 and onwards) and the options may not directly be offered to every new hire. Options are then selectively offered by some companies during their bi-annual or annual performance appraisal process as a reward considering the contributions made by the employee and the employee’s willingness to go the extra mile for the company.
2. You are offered unvested options
As we mentioned in the previous section, you are not offered shares directly but the opportunity or the option to buy the shares of your company, however, even that “option to buy” is not immediately available to you.
You are given what are called the “unvested” options which basically imply that your company would like you to have options through which you can eventually opt to buy shares of the company in the future if you continue working there for a while. Your options vest over the following years.
The number of years over which your options vest is known as the vesting period, which is decided by the founders and other board members of the company. The most common vesting period is four years and has a one-year cliff. That cliff means you have no options during the first year from the start date of your vesting. After the cliff period ends, the options allocated during that cliff period become yours, and then the vesting schedule is followed as specified (usually Monthly, Quarterly, or Bi-annually).
The cliff is a way of incentivizing your continued stay at the company for the next year at the minimum.
3. Your options vest over the years
Once your vesting period gets over (in the most common configuration, at the end of the 4th year), you end up owning all of the options, which are again just the right to buy shares of your company.
When you decide to buy the shares, that’s called exercising your options. The price per share you pay to exercise your options is known as the Strike or Exercise price which is pre-decided and is mentioned in your Grant Letter. Along with the strike price you also incur income tax on the profits yielded.
If your company permits it, you can start exercising your options as soon as they are vested. In this case, you become a stockholder sooner, after which the vesting applies to actual stock rather than options. This has tax implications, which we’ll discuss in a bit.
However, the company retains the right to repurchase the unvested shares, at the price paid or at the fair market value of the shares (whichever is lower), if you quit working for the company. The company will typically repurchase the unvested shares should you leave the company before the stock you’ve purchased vests.
4. You exercise the options
The day you exercise your options is the day you officially become a stakeholder in the company. This means that you own a part of the company, the percentage of which is known as your stake in it. However, owning the shares doesn’t necessarily ensure that you’ll get rich for sure nor does it mean that you’ll even get paid at the end of it. That still entirely depends on how your company is doing at the time of exit.
Now, since your company is private, that means you can’t trade your shares on the public stock market yet, which means that you have to wait for your company to either go public or to be bought by a bigger one for your big payday to arrive. However, some companies do offer Stock Repurchase Programmes (also known as “Buyback” or a “Secondary Sale”) which allows the employees to transfer or exercise their options and sell the shares back to the company or partnered investors before the exit. This is usually aligned with later funding rounds (Series C or D) to help other shareholders increase their stake in the company and acts as an opportunity for the employees to encash some of their shares.
Urban Company (formerly known as UrbanClap) is an on-demand home services platform founded in the year 2014. They organized their first-ever cashout in June 2017 during their Series C round of funding. At the time of the cashout, UrbanClap’s shares were valued at $337 (INR 24,000) per share.
In November 2018 they announced a second ESOP and share cashout worth $2 - $2.5 million (INR 14 - 18 Crore) at $871 (INR 62,000) per share during their $54 million Series D funding. Reportedly, around 50 of the 100 eligible employees exercised the option to sell their shares.
Flipkart, Ola, Razorpay, and Swiggy are a few other companies that have carried out buybacks in the past.
5. The company exits
When a company offers to sell its shares for the first time on the public stock market, that’s known as the Initial Public Offering or IPO.
When a company is bought by another company, that’s known as Acquisition. For Example: UberEats by Zomato, Whatsapp and Instagram by Facebook, etc.
Any of the above-mentioned events mark the arrival of the much-awaited payday for Founders, Investors, and Employees. If the acquiring company is a private company and the acquisition is mostly in stock of the private company, shareholders of the target company will now own private stock.
While you have the rights to exercise your options as soon as they have started vesting, however, most of the people prefer exercising the options at the time of exit (or at the time of “Secondary Sale” or Buyback if that is offered by the company) because in that way you often don’t have to bear the burden of taxes earlier than necessary. The cost and taxes involved in exercising the options is adjusted from the money that you make on the FMV of your shares at the time of exit. You can calculate your proceeds from this formula:
(Number of Options * (Price per share - Strike Price)) - Taxes
How to calculate taxes?
When you exercise options, you are receiving income in the form of shares, and are liable to pay taxes on that income.
It can be a little confusing to compute the taxes involved in this process and they vary based on when you decide to exercise your options i.e. during a liquidation event or before that.
If in doubt, you should consult your tax advisor to determine the best course of action for you.
Exercising before a liquidation event
You are liable to pay taxes in two parts if you decide to exercise your options before a liquidation event. Once at the time of exercising and once at the time of selling the acquired shares.
First, there are upfront costs involved if you decide to exercise your options before a liquidation event. You have to pay the exercise cost along with the tax on the difference between the current value of the shares and the strike price (FMV - Exercise Price) which you’ll have to pay from your existing savings and there are chances that you may end up losing the cost of exercises and taxation in case the company drops in value later.
Second, when you end up selling these acquired shares later, you are again liable to pay taxes on the difference between the value of shares at that time and the value of the shares at the time you acquired the shares.
For Example: You exercised 1000 stock options at Rs. 10 per share in the year 2018 while their value at that time actually had increased to be Rs. 100 per share. So, at that time you’d be liable to pay taxes on the difference i.e. on Rs. 90 per share. Now at the time of IPO in the year 2020 you decide to sell these shares at Rs. 500 per share, so you’ll again be liable to pay taxes on the earnings of Rs. 400 per share. In India, your tax rates may vary anywhere between 15 - 30% based on your earnings and the length of time you’ve held shares.
Exercising during a liquidation event
You incur costs only once if you decide to exercise your options at the time of a liquidation event and you may not even need any cash input from your end for the same. You pay the strike price to exercise the options and you sell the shares at the same time but on a higher valuation (FMV) so, the tax liability here is only on the difference between FMV and your strike price. This tax is levied like a normal income tax.
Your Profit = Payout - Exercise Cost - Taxes
The good thing is that you can always get the exact amount of expenses calculated before you make any decision. This post isn’t exhaustive or tailored for your tax situation, so you take advice from an expert whenever you’re planning to exercise your options.
If your company uses EquityList, the employee dashboard can provide you with tools to model the tax impacts based on inputs you provide.
When should you exercise your options?
You cannot predict what the valuation of your company is going to be at the time of a liquidation event nor can you be certain if you’re going to make money from ESOPs. If somebody (including company's executives) claims that they know for sure how a company’s stock is going to perform, you should consider not taking advice from them.
However, we hope after reading this you will have a lot more clarity on how ESOPs work, what are the various factors on which its value depends, and most importantly how you should evaluate your future job and/or performance appraisal offers.
Neither us, nor can anyone else, can claim to know the best time to exercise the options. You should reach out to a financial advisor if you need guidance to exercise your options. If your company uses EquityList, your dashboard provides you with all of the necessary information in one place in order to make this process easier for you.
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Image Credit: Photo by Dan Gold on Unsplash. EquityList cannot provide you with investment advice, instead consult your own investment, tax, and legal advisors.