Plans and Scenarios

12 minutes, 20 links

Plans and Scenarios

Common questions covered here
What are some common scenarios faced by people weighing offers that include equity compensation?
What factors should I consider when deciding if I should accept an equity compensation package?
What do I need to know to evaluate my offer of equity compensation?
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Evaluating Equity Compensation

Common questions covered here
What do I need to know to evaluate my offer of equity compensation?
What factors are most important when determining the value of an equity compensation package?

Once you understand the types of equity and their tax implications, you have many of the tools you need to evaluate an offer that includes equity compensation, or to evaluate equity you currently have in a company.

In summary, you have to determine or make educated guesses about several things:

That’s a lot, and even so, decisions are uncertain, but it is possible to make much more informed decisions once you have this information.

What Is Private Stock Worth?

Common questions covered here
What is private stock worth?
How can I estimate the cash value of my stock in a pre-IPO startup?
How much is my equity compensation package worth?

We now turn to the question of determining the value of private company stock. We’ve seen how stock in private companies often can’t be sold, so its value is difficult to estimate.

The value of equity you cannot yet sell is a reflection of three major concerns:

  1. How well the company is doing now—that is, how profitable it is, or how many customers it is attracting.

  2. How well the company will perform in the future.

  3. How likely it is the company will be valuable as part of another company—that is, whether it may be acquired.

The first concern is relatively clear, if you know the company’s financials. The second and third come down to predictions and are never certain. In fact, it’s important to understand just how uncertain all three of these estimations are, depending on the stage of the company.

In earlier stage private companies, there may be little or no profit, but the company may seem valuable because of high expectations that it can make future profit or be acquired. If a company like this takes money from investors, the investors determine the price they pay based on these educated guesses and market conditions.

In startups there tends to be a high degree of uncertainty about the future value of equity, while in later stage private companies financials are better understood (at least to investors and others with an inside view of the company), and these predictions are often more certain.

Can You Sell Private Stock?

Common questions covered here
Can you sell private stock?
Are there secondary markets for selling equity from startups and other private companies?

Ultimately, the value of your equity depends on whether and when you are able to convert it into stock that you sell for cash. With public companies, the answer is relatively easy to estimate—as long as there are no restrictions on your ability to sell, you know the current market value of the stock you own or might own. What about private companies?

A liquidity event is usually what makes it possible for shareholders in a private company to sell their stock. However, individuals may sometimes be able to gain liquidity while a company is still private.

Definition A secondary market (or secondary sale, or private sale) transaction is when private company stock is sold to another private party. This is in contrast to primary market transactions, where companies sell directly to investors. Secondary sales are not routine, but they can sometimes occur, such as when an employee sells to an accredited investor who wants to invest in the company.

Definition Shares held by an employee are typically subject to a right of first refusal (ROFR) in favor of the company, meaning the employee can’t sell their shares to a third party without offering to sell their shares to the company first.

caution Private sales generally require the agreement and cooperation of the company, for both contractual and practical reasons. While those who hold private stock may hope or expect they need only find a willing buyer, in practice secondary sales only work out in a few situations.

Unlike a transaction on a public exchange, the buyer and seller of private company stock are not in total control of the sale. There are a few reasons why companies may not support secondary sales:

  • Historically, startups have seen little purpose in letting current employees sell their stock, since they prefer employees hold their stock and work to make it more valuable by improving the value of the company as a whole.

  • Even if employee retention is not a concern, there are reasons private sales may not be in the company’s interest. Former employees and other shareholders often have difficulty initiating secondary transactions with a company.* Private buyers may ask for the company’s internal financials in order to estimate the current and future value of its stock; the company may not wish to share this confidential information.

  • Companies must consider whether sales could influence their 409A valuation.

  • Secondary sales are an administrative and legal burden that may not make it to the top of the list of priorities for busy startup CEOs and CFOs.

important However, participation in the secondary market has evolved in recent years,*** and a few options may be possible:

Stock Option Scenarios

Common questions covered here
How should I decide when to exercise my options?
How does a cashless exercise work?
What is the benefit of waiting until acquisition to exercise?

The key decisions around stock options are when to exercise and, if you can, when to sell. Here we lay out some common scenarios that might apply to you. Considering these scenarios and their outcomes can help you evaluate your position and decide what you should do.

  • Exercise and hold. You can write the company a check and pay any taxes on the spread. You are then a stockholder, with a stock certificate that may have value in the future. As discussed, you may exercise:

    • Early, even immediately upon grant.

    • Before vesting (if early exercise is available to you).

    • Sometime after vesting.

    • After leaving the company, as long as the exercise window is open.

      • caution Recall that the window is likely to close soon after you leave a company, often 90 days after termination.
  • Wait until acquisition. If the company is acquired for a large multiple of the exercise price, you may then use your options to buy valuable stock. However, as discussed, your shares could be worth next to nothing unless the sale price exceeds the liquidation overhang.

  • caution Secondary market. As discussed, in some cases it’s possible to exercise and sell the stock in a private company directly to a private party. But this generally requires some cooperation from the company and is not something you can always count on.

  • Cashless exercise. In the event of an IPO, a broker can allow you to exercise all of your vested options and immediately sell a portion of them into the public market, removing the need for cash up front to exercise and pay taxes.

important Note that some of these scenarios may require significant cash up front, so it makes sense to do the math early. If you are in a tight spot, where you may lose valuable options altogether because you don’t have the cash to exercise, it’s worth exploring each of the scenarios above, or combinations of them, such as exercising and then selling a portion to pay taxes. In addition, there are a few funds and individual investors who may be able to front you the cash to exercise or pay taxes in return for an agreement to share profits.

Author and programmer Alex MacCaw explores a few more detailed scenarios.

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Summary of Dangers

Common questions covered here
What risks and dangers associated with stock options do I need to be aware of?
What are the key dangers for an employee when it comes to equity compensation?
What are some disadvantages of equity compensation, including stock options?

Because of their importance, we’ll wind up with a recap of some of the key dangers we’ve discussed when thinking about equity compensation:

  • danger When it comes to equity compensation, details matter! You need to understand the type of stock grant or stock option in detail, as well as what it means for your taxes, to know what your equity is worth.

  • danger Because details are so important, professional advice from a tax advisor or lawyer familiar with equity compensation (or both) is often a good idea. Avoid doing everything yourself, but also avoid blindly trusting advisors without having them explain the details to you in a way you understand.

  • danger With stock options, high exercise costs or high taxes, including the AMT trap, may prevent you from exercising your options. If you can’t sell the stock and your exercise window is limited, you could effectively be forced to walk away from your stock options.

  • danger If a job offer includes equity, you need a lot of information to understand the value of the equity component. If the company trusts you enough to be making an offer but doesn’t want to answer questions about that offer, consider it a warning sign.

Next, we offer more details on what to ask about your offer, and how to negotiate to get the answers you want.

Offers and Negotiations

When a company offers any form of equity as part of its compensation package, there is a whole new set of factors for a prospective employee to consider. This chapter will help you prepare for negotiating a job offer that includes equity, covering negotiation tips and expectations, and specific reminders on what you can ask and what is negotiable when it comes to equity.

Why Negotiation Matters

Before accepting any job offer, you’ll want to negotiate firmly and fairly. You’re planning to devote a lot of your time and sanity to any full-time role; help yourself make sure that this is paidwhat you want.

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