In this blog post, we'll walk you through the basics of understanding and exercising your stock options. Here are some questions we get asked fairly often:
Why do I have them?
The reason companies offer stock options in their employee contracts is to attract talent, retain talent, and incentivize good work ethic. Offering options gives employees the ability to buy ownership in the company at a discount, with the hopes that those shares may eventually hold more value than the agreed upon price given by their employer at the date of signing.
How do I go about exercising my stock options?
In order to exercise your options, you must be able to pay your exercise price per share, which was the price agreed upon at the initiation date of your contract. Along with this, you may also have to pay taxes on the spread (the difference between your exercise price and the price per share at the time you sell), given the company has gone public or has been acquired by another company.
How can ECP help me with my stock option exercise and what benefits will I receive by partnering?
ECP gives you the cash to exercise your stock options and pay the associated taxes while also limiting your risk if the stock ends up worthless. ECP does this by offering you a non-recourse cash advance, which means the money that we give you to exercise your options is not owed back to us unless the company goes public or gets acquired.
The cash we give you is not tied to any of your own personal assets and if your shares do end up worthless, you don’t owe us a penny of the money that we gave to you. Instead, we take the loss, which covers your downside risk.
By offering this product to employees at high growth companies like yourself, we give you the ability to retain your personal savings or spend it on what is most important to you. At the same time, you keep the ability to capitalize on your hard work by turning the late nights and long hours into a real ownership stake in the company you worked so hard to build..
What should I know and what questions should I be asking if I am offered stock options by my employer?
1) How many shares will be granted to me?
The number of shares granted to you should be stated in your offer letter, as well as in a separate document known as a stock option agreement.
2) How many additional options will be authorized/offered to other investors?
Authorized options are that those have not been granted yet. To estimate the company’s potential future dilution (AKA, how your current number of options will look once they’ve all been issued), calculate the number of additional options that will be authorized and added to the option pool.
If an option pool is significantly below 15% to 20% of its total capitalization, it may mean that either: 1) the company is sparing with its options, or 2) substantial future dilution may transpire, once the option pool is increased to make room for future option grants.
It is common for companies to increase their option pool over time and a company that is well managed will administer a capital budget from the beginning in order to help estimate its future option grants.
3) What does the company believe it will be valued at upon exit?
Your potential employer should be able to give you a company valuation estimate that would be verifiable by the internal management team, even though this valuation will be, at best, an educated guess based on prior performance.
4) What will it cost to exercise my options?
Your exercise cost will be based on the number of grants you have, the number of shares per grant, along with the agreed upon price for those shares at the time of signing.
In order to calculate your exercise cost, you can multiply the number of shares granted by the agreed upon associated price for those shares.
Once you calculate this number, you will have to add and consider the associated taxes. These are based on the spread between your original strike price and the price that you sell your shares at once/if the company goes public.
Note: There are also different scenarios that may occur if the company is acquired. Make sure to ask what your scenario would look like in the event of an acquisition.
5) What is the market rate for my position?
Every job has a market rate for salary and equity.
Market rates are normally estimated by your job role and seniority while also considering the number of existing employees and the location of the firm. It’s okay to ask your future employer what they think the market rate is for your position. It’s not a good sign if they have trouble answering this question.
6) What is the difference between NSO and ISO stock options?
Check out the article we wrote on this here but to summarize quickly:
Incentive Stock Options (ISOs): ISOs are stock options that, if held for at least two years after the grant date and at least one year after the exercise date, you qualify for long-term capital gains tax treatment on the spread between the sale price and your exercise price.
Nonqualified Stock Options (NSOs): NSOs are stock options that, if held for at least one year after the exercise date, you qualify for long-term capital gains tax treatment on the spread between the sale price and the fair market value (FMV) at the time of exercise.
7) Does your potential future company allow you to early exercise your stock options?
We have a post covering early exercise, check it out here. Early exercising your stock options means you are allowed to exercise your options before they have vested (i.e. before you’ve earned them). This can be a benefit to employees, because they have the opportunity to have their gains associated with long-term capital gains tax treatment.
- Options are awarded to employees to attract talent and incentivize good work ethic
- In order to exercise your stock options, you must be able to pay your exercise price per share and cover associated taxes
- By partnering with ECP, you transfer the entirety of your downside risk to us, while still having equity participation in the company. We become a partner and participate-- partially-- alongside you. Our interests are aligned: by taking care of your bottom line, ours takes care of itself.