Evaluating equity compensation
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:
Equity value: This can be estimated by the value the company may have in the future, and the number of shares you may own.
- Percentage ownership: As we’ve mentioned, knowing how many shares of stock or stock options you have is meaningless unless you know the number of outstanding shares. What matters is the percentage ownership of the company the shares represent, including the details of how the total is counted.
- Risk: It is critical to understand risk in the business and dilution to ascertain the possible future value of equity. This article from Leo Polovets provides some additional thoughts.
- Vesting: Understand when you will receive the equity, as well as whether you’re able to exercise stock options (and pay the associated costs and taxes), and whether you can do all this before your exercise window expires.
- Liquidity: Determine when you will be able to sell your shares, and if that is likely to be for a profit at that time. (We talk about liquidity of private stock next.)
- Tax: Tax concerns are inseparable from the value of equity. Know the tax implications of your possible grant, exercise, vesting, and sale, in terms of ordinary income tax, employment tax, long-term capital gains, and alternative minimum tax.
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?
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:
- How well the company is doing now—that is, how profitable it is, or how many customers it is attracting.
- How well the company will perform in the future.
- 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?
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.
🔸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:
- SharesPost, Equidate, and EquityZen have sought to establish a market around secondary sales, particularly for well-known pre-IPO companies.
- A few other secondary firms have emerged that have interest in certain purchases, especially for larger secondary sales from founders, early employees, or executives. A company can work with a firm to facilitate multiple transactions. These firms include 137 Ventures, ESO Fund, Akkadian Ventures, Industry Ventures, Atlas Peak, and Founders Circle.
- In some cases, an employee may have luck selling stock privately to an individual, like a board member or former executive, who wishes to increase their ownership. Further discussion can be found on Quora.
Stock option scenarios
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:
- 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.
🚧incomplete Infographic: Possible visualization of these exercise options. A flowmap? “If this, then this” (with arrows).
Summary of dangers
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.