Your Guide to Private Company Stock Options
- Working for a private company and being paid with stock options can be lucrative, but careful cash flow planning, managing taxes, and monitoring concentration risk are all crucial. Different types of employee stock options have different rules, so working with an experienced financial planner is often needed.
- A private company going public or being acquired presents another host of decisions and risks
Equity compensation is an effective way for private companies, particularly in the tech sector, to pay employees. Stock options are some of the most common ways workers are paid, but with that comes added risk and complexity for the employees. High-growth startups can better retain key talent as it often takes many quarters—even years—for options to turn in the money.
Should the company for whom you work succeed, options earned early in your tenure likely become highly valuable as you share in the firm’s success. You will soon be faced with the decision to exercise the options and hold or sell the stock. This problem is made all the more complicated when you work at a private venture rather than a publicly traded company. Often, you cannot sell company shares when you want, which adds risk to your financial situation.
Employees and executives at private companies commonly look forward to a so-called liquidity event in which the firm is acquired by a larger enterprise or the company goes public through an IPO. Those are opportunities to sell stock at much higher valuations. Another possibility, however, is if the private company offers a secondary market to allow current stockholders to sell, but there are usually strings attached.
As you can see, there are complications when managing risk around your employer stock if you work for a private company. Diversifying assets is part of a sound financial plan, but so too are managing taxes and timing stock sales. For workers at tech startups, there’s stress in weighing the pros and cons of exercising stock options now or waiting it out. Let’s run through key considerations to help you make the best decision.
1. Knowing what you own.
First, read your company’s plan documents to understand your equity compensation to the best of your ability. That might mean checking with your Human Resources department. Specifically, you want a firm grasp of the options you were awarded – are they incentive stock options (ISOs) or non-qualified stock options (NQSOs)? What’s the strike price (the price at which you can buy shares upon exercise)? What’s the expiration date on the options?
Another key piece of information is the vesting schedule on private company options; which is how long you must wait after you are granted options before they become yours. Many people are curious about the current fair market value of the options, which can be determined simply by comparing the stock price to your options’ strike price (called the bargain element).
Knowing these fundamentals of employee stock options helps you make better decisions when you have opportunities to exercise and sell stock.
2. Keeping a cash buffer for taxes.
A low strike price on your stock options is ideal as it means you will pay less to acquire shares of stock. But that’s not the only cash outlay you will encounter. Taxes are generally owed when you exercise and simply hold shares since exercising employee stock options is a reportable event to the IRS – that goes for both public and private companies.
This stage is where cash flow planning is so critical. You do not want to be faced with selling other assets or taking retirement plan distributions just to meet a high tax bill resulting from exercising employee stock options.
3. Recognizing that you might not be able to sell shares when you want.
With private firms, there isn’t a liquid trading market like you would have with a public company. There is no exchange to offload shares at a prevailing market-determined valuation. One possibility, though, is that your employer might provide a secondary market in which to sell the stock, but not all firms do this. Even if there is an arena to offload shares after you have exercised the options, it’s normal for other restrictions to exist, such as the right of first refusal.
If you do not see reasonable selling opportunities for your stock, then you must assess whether to exercise employee stock options. You might be better off just holding them and waiting for a liquidity event.
4. Understanding the Differences between ISOs and NQSOs.
For ISOs, you can face Alternative Minimum Tax (AMT) liability if you exercise and hold the stock beyond the end of a calendar year. The bargain element, defined earlier, is a reportable event for determining AMT. The good news is we can strategize around this and avoid AMT risk, but that requires careful financial planning.
For NQSOs, you are simply faced with paying ordinary income tax when you exercise – that goes for public and private companies. While it’s less complicated, NQSOs usually feature a bigger tax bullet to bite.
5. Exercising private-company stock options is sometimes the best action, even with all its possible challenges.
Nobody likes paying taxes. We get it. When it comes to private-company stock options, however, there is considerable risk in continuing to hold so much equity in an early-stage firm. A positive feature is that there are some advantages to exercising employee stock options.
For one thing, exercising ISOs sooner rather than later can mean a lower AMT impact today. The higher the shares are valued, the greater the bargain element is on your options. In general, we expect the company’s valuation to rise over time, so locking in a lower price today could be a good move to reduce your long-term taxes owed. An 83(b) election is another planning strategy to be considered along with a cashless exercise.
One more positive aspect of exercising ISOs in the near term is that you potentially secure a lower overall tax rate when you eventually go to sell. A qualifying disposition entails meeting timing requirements so that you owe favorable long-term capital gains tax treatment rather than owing at ordinary income tax rates.
6. Beware of the IPO lock-up period and other sale timing rules around liquidity events.
IPO Day is commonly a dream scenario for a startup tech enterprise. Indeed, it is common to see the stock price soar beyond what it was priced at while it was a private company. Moreover, your equity stake can make you seemingly instantly wealthy.
But it’s not all rainbows and unicorns. While it’s great that your options and shares are worth more and that you have a liquid secondary market in which to sell, there is commonly a six-month lock-up window. That is a stressful time for workers. And the company could have additional selling restrictions.
Other stock-sale timing rules are usually attached to other liquidity events, such as a takeover through an acquisition. In an M&A deal, your options might be converted into options of the new company. That event could be an opportunity to cash out, but the decision might also be out of your control. Knowing what you own and the rules around exercising options and selling shares at all times is critical. Finally, you should plan for what to do with stock options should you leave a company.
The Bottom Line
Owning stock options is exciting when working for a private company. ISOs and NQSOs can be very valuable, but knowing the correct times to exercise the options and when to sell shares is often stressful. You must perform diligent cash flow and tax planning while being cognizant of important tax rules and company policies, all while being aware of concentration risk. Sitting down with an experienced financial planner well-versed in helping people who work at startups is wise.