April is financial literacy month. As an organization committed to creating solutions to the financial challenges posed by stock option compensation, we’d like to address some of the common misconceptions we’ve come across in our line of work. Among the numerous financial structures that employees can benefit from, we acknowledge that many employees do not fully understand their stock options (even if they think they do).
Stock options can be an extremely valuable benefit usually offered by pre-IPO companies that incentivize employees to work for their share of the company’s increase in value. The main goal in granting stock options is to tie pay to performance and incentivize the company’s success; the higher your company’s share price increases, the more your options will be worth. Sounds simple, right? Not necessarily. Here are 3 key concepts employees should understand if they hold stock options as a form of compensation.
- It’s not a gift, but an opportunity…
Not all option plans are the same: different agreements provide diverse incentives under unique circumstances. For example, an employer might offer more shares based on seniority in the company, or special skills. Stock options agreements can also vary based on the grant date (when your shares begin to vest) and the vesting period, which is when employees are eligible to exercise a specific number of options. Many employers also use agreements as a means of retaining employees by requiring them to remain with the company in order to exercise their options.
It’s important to remember that you’re not gifted these shares but rather have an opportunity to buy shares in your company. That opportunity changes if you leave your company or are unable to exercise during a blackout or lock-up period. Option exercising does not occur automatically. Unless you actually exercise your options, you may never see real value.
- How you use them is up to you
Leaving your options unexercised until a liquidity event (e.g. tender, IPO or acquisition) is a reasonable strategy, but you may be leaving real dollars on the table. Why? Because the difference between the option exercise price and its fair market value at exercise is typically taxed at ordinary income rates once the shares are sold unless the you meet certain holding periods, whereas shares from an option exercise that are held for at least 1 year are eligible for lower long-term capital gains rates. The difference in these rates can make a significant difference in the financial outcome for the option-holder.
There are potential tax benefits to exercising your stock options before IPO, but it can become more difficult over time if your company rapidly increases in value due to the resulting tax burden. And if you do exercise your options and the shares decrease in value, there can be tax consequences. To make the most of your shares you should understand the tax advantages and disadvantages of exercising your options in different scenarios. We always recommend working with financial and tax advisors to help you make the right choice for your equity opportunities.
- If you don’t use it, you lose it.
It’s important to keep in mind that your stock options usually won’t last forever. You have a set amount of time to exercise your options before they expire. Once expired, the employee no longer has the right to purchase company stock under the terms of the agreement. If left unexercised, most options expire after 10 years and typically expire 90 days after leaving a company. Although your options can be reissued or amended, it can be difficult to recreate the economic benefits of an early grant. Think carefully before letting your options become worthless! If you can exercise your options early and your company continues to appreciate in value, the benefits may be substantial.
Stock options can be a complex financial instrument, but are a common part of employee compensation at private companies. At Liquid Stock, our solutions can help you realize your full equity potential. Why wait to achieve lifelong goals and ambitions? By removing the financial burden and simplifying a complex issue, we can help you exercise your options and reap the potential benefits of your equity opportunities.About the Author:
Shane Larkin, Founding Team Member at Liquid Stock, is an investment professional with an engineering background and MBA.
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