3 Things Startup Employees Should Know About Stock Options and Risk Mitigation
Stock options have made millionaires out of startup employees. So, why are employees opting out of exercising their stock options?
Stock options became common parlance in venture-funded startups in the mid-70s when struggling startups succeeded in attracting the talent and interest of their employees by offering them stock options. Founders started to give away part of the ownership of the company to all employees, instead of high salaries for real talent in the form of cash payments, making it a life-saver for many companies.
Many employees have hit gold with stock options. There’s a rising trend of startups — especially tech startups — making millionaires out of employees. Stupendous success stories like Facebook and Twitter announcing a percentage of their company to their equity pool have made equity an attractive option.
Compensation packages with stock options built into them can be a win-win for both sides and a viable way to align talent with purpose and vision.
However, not all employees can cash in on the opportunity to create wealth from stock options offered to them.
What’s making them relinquish the advantage of having stock options in a company? What pushes employees to leave money on the table while leaving the company? What do they need to know to turn their stock options into real wealth?
Here are three things about stock options every employee should know:
1. There’s a clock ticking.
Stock options are agreements between a company and its employees that allow the employees the right to buy a certain number of company shares at a set price — also called the strike price — within a set period of time, usually for a period of 90 days. When an employee decides to leave the company, they can only exercise their options by putting down substantial capital, within the deemed time.
Scott Chou, the founder of ESO Fund, a company that helps employees exercise and liquidate their stock options with ease, notes that the cost of exercising stock options for employees can exceed a year’s salary considering taxes. Most employees tap out and leave money on the table.
2. They can turn into the proverbial golden handcuffs.
The executive team doesn’t have to — and often isn’t motivated to — share everything with a broader audience. The general policy is to not tell people too much — especially departing employees, a trend apparent in Silicon Valley and other states with high-performing, high-capital businesses. In the case of a round of investment or merger, employees usually get disclosure packages known as the Schedule of Exceptions handed to them, which tend to be dominated by canceled stock option agreements, to avoid lawsuits by employees.
The general counsel and CEO get to decide how much communication can actually flow to the employees, making it hard for employees to decide whether or not to spend cash to exercise their stock options. This is particularly hard-hitting in a time-sensitive environment.
3. Taxes can be a huge impediment.
The option grant is a wonderful financial tool that is clever and tax-efficient, but it can be the proverbial golden handcuffs for an employee. The potential value of the stock makes it seem golden, but the high cost of purchasing options can be limiting.
If the employee opts to exercise the options when the price is higher than the stock price, they are also left to deal with huge taxes. With a typical vesting period of four years for the standard stock option to fully vest, the increase in the share value leads to onerous taxes, and a decrease in share value means a direct loss for the employee.
Founders and board members use options as an incentive for retention, but the asymmetric information flow — be it a heads-up on mergers/acquisitions or the company’s financial health — facilitates gaining back the options for free if an employee decides to leave or gets fired.
Chou notes that the number of people who don’t exercise their stock options is staggering — 55%, 75%, and sometimes even 80% of stock options grants go unexercised. Poor company performance contributes to about half of these, but a major contributor to employees forgoing their stock options is the lack of funds and access to timely information.
Risk mitigation for employees
With companies scaling faster than ever, employees should be in a position to exercise their options with access to the right information. Companies like ESO Fund offer to mitigate employees’ risk in three ways:
- Mitigate employees’ risk by funding the exercise of stock options
- Helping employees to manage their taxes
- Offering to absorb the loss if the option price went down from the strike price
With a risk-free option to liquidate their stock options, employees can look forward to a solid foundation for wealth-building.
Entrepreneur Leadership Network Contributor