Some of my friends are considering transitioning from government to private industry as a programmer. In order to assist them in evaluating companies and offers, I’m starting a new series “Finance For Programmers” that will cover some of the terms and ideas you’ll be hit with when getting an offer. If there’s anything you want me to cover in subsequent posts please drop me a line at ben@follis.net.
Now, on to Stock and Stock Options for programmers.
What is Stock and how do I make money from it?
To begin we must first describe what stock is. A stock share, as you might surmise from it’s name, is a share in the ownership of the company. If there are 100 shares in existence and you own 50 of them, you own half the company.
In order to raise funds a company will sell shares to investors. If they are offered to a limited set of people under specific terms they are a private company, and if they offer them to the general public and sell them on the open market they are a public company.
The distinction between a public and private company is of critical importance when evaluating an offer. Because there exists no public distribution of shares, it is typically very difficult to sell shares in private companies. Additionally, most private companies have restrictions on who can buy, or how their shares can be sold. This means you will very likely be unable to exchange your equity for actual money unless a few very specific events, called liquidity events, occur. (E.g. The company makes an initial public offering and goes public, or gets bought out).
Shares of public companies on the other hand may be bought and sold on the open market and are typically listed on an exchange you can access with your broker such as NYSE or NASDAQ.
In short: if you take a position with a private company you will not be able to immediately cash out shares released to you, while you can cash out as soon as the shares are released to you in a public company.
Wait, “released to me”? What does that mean? What’s vesting?
Companies award stock to their employees for a few reasons. First, (and this is especially true for private small companies like startups) is that if they can convince you to take stock they don’t have to pay you cold hard cash. Second is employee retention. In order for retention to work there are usually some restrictions on when and how you get your shares, and in order of importance they are
- Value (Quantity x Price)
- Vesting Schedule
- Lock up Period (private companies only)
Valuation
The immediate value of a share in a public company is trivial to determine. It’s the market price on the day your offer arrives.
Valuing a share in private companies can be quite complex because there is no public benchmark. However there will usually be a valuation computed at the last investment event (called rounds) or liquidity event of the company, and that will usually be the value the company says the shares are worth. You must take this with a healthy grain of salt, however, as there’s no saying the shares will be worth that valuation when you are able to sell.
Vesting Period
In order to enable employee retention stock awards are not all available to you to sell on the first day of work. They are typically released to you on a fixed vesting schedule that requires you to be with the company a set period of time to receive the shares. That vesting schedule starts on your grant date, which usually is your start date or very close to it.
There may be particularly unfriendly terms on that schedule such as a “cliff” that specifies that you get no shares before you’ve been with the company for at least a given time period (your equity falls off a cliff).
A typical silicon valley vesting schedule is the entire award vests monthly over four(4) years, with a one(1) year cliff. The four year vest means you nominally have 1/48th of your shares released to you every month. Unfortunately, the 1 year cliff means that you get NO shares released in the first year, and furthermore get NO equity if you leave the company before 1 year has passed from your grant date.
Companies can and do mess with the vesting schedule to screw you over. Notoriously, Amazon’s vesting schedule gives you 5% of your shares in the first year, 15% of them in your second, 40% in your third, and 40% in your 4th. As most Amazon employees do not make it to 4 years, you should assume the vast majority of your equity “award” is valueless.
Lock Up Period
To prevent all of their best employees leaving as soon as a liquidity event occurs many private companies will place a further restriction and not let you sell your shares until a fixed amount of time after the event. This period is called a lockup period (or lockout period) and has caused many a heartache. If you have a lockup period of six(6) months, your company goes public at $100 a share, and the market tanks the stock three(3) months later, you are NOT going to be able to sell at the $100 price.
Stock Taxes
Taxes on stock shares are fairly straightforward. The IRS wants their cut when your shares are released to you. In public companies they’ll usually take the taxes out of the award before you get it. In private companies they don’t. Even worse, you are now on the hook to pay the taxes on the value of the shares in the year you got them, but unfortunately cannot sell them. All is not lost, as there are some tricks such as 83b elections you can take on your grant date to reduce that burden when you hold shares in a company who’s value is growing quickly.
Employees hate paying taxes on shares they can’t sell, so in order to better retain them private companies (especially startups) will often give you stock options instead.
What is a Stock Option?
A stock option in the context of employment compensation is a contract that allows you to buy a given number of shares for a given strike price on or before a given expiry date. They differ in normal options in that you don’t have to pay for them and the expiry date is usually years in the future instead of months, unless you leave the company(then it’s 90 days from your leave date). The common term for employment related stock options is incentive stock options (ISOs).
In most respects the ISO awards work exactly like stock awards with a vesting schedule, cliff and whatnot. The difference is you really do need to pony up the cash at the strike price to buy the shares. Buying the shares with the options contract is called exercising the option.
ISOs however have very different tax treatment from stock awards in that you only pay the taxes on them when you exercise. The taxable value of the option contract is the current value of the shares covered by the contract minus the cost to you to buy them at the strike price. This means that as long as your options haven’t expired you can pick and chose when to take the tax hit, as well as chose what percentage of your award you want subject to tax right now.
Because of this very favorable tax treatment public companies usually only give ISOs to executives or very highly placed employees.
Startups however frequently give them to everyone because it allows their employees to avoid taxes until they cash out.
Common Gotchas with Options
The biggest problem with ISOs from an employee perspective is the strike price and expiry. It is entirely possible for your strike price to be higher than the current value of the share. If that happens your options are worthless, or more accurately, have negative value to you. This is called being underwater. You will hear many programmers complaining about their options being underwater when a company isn’t doing well or the share price tanks.
The second biggest problem is the expiry shortening to 90 days after you leave the company. All your options go away if you haven’t exercised them by the expiry date, so if you want to get the shares the options entitle you to, you have to pay for them at the strike price. As most people do not leave companies that are doing really well, that can be a tough decision.
Conclusion
I’ve covered the basics of the basics here. I’d encourage you to look into the following areas
- 83b elections
- ISO Grant/Vest dates and Long Term Capital Gains
- Restrictions on your granted shares (usually voting) in which case they become Restricted Stock Units (RSUs)
- ISOs and Alternative Minimum Tax
If you’ve any questions drop me a line at ben@follis.net