Avoid the 7 most common employee stock option mistakes
9 min
San Francisco native (yes, really). @uw and Lowell High alum. I like to nerd out on fintech, stock options and taxes.
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San Francisco native (yes, really). @uw and Lowell High alum. I like to nerd out on fintech, stock options and taxes.
Even if you understand how stock options work, you might still find yourself making a mistake with serious consequences — like paying too much in taxes, taking on too much personal risk, or even losing your stock options entirely. Your startup may be on the path to go public, but you still want to make sure you’re setting yourself up for success with your stock options.
Good news, we’re here to help. Here are the seven most common mistakes people make around their employee stock options, in rough chronological order:
You’re offered a job with an impressive number of stock options — over the next 4 years, you’ll vest 100,000 shares in the company. You’ll need more information to fully understand what you’re actually earning:
Ideally, the answers to these questions should be contained in your onboarding paperwork. If not, ask your HR rep to point you toward the answers.
A common mistake we hear from employees is that they don’t realize they own a far riskier type of share in the company than (venture) investors do. The difference lies in the type of stock being issued by companies.
- Common stock: generally issued for employees, advisors and founders
- Preferred stock: issued for investors when they invest money into the company
Understanding how much preferred stock is issued is important. Because when a company is liquidated at a value lower than the amount of money raised as an employee owning stock you receive no money at all.
How does this work? Well preferred stock is a tricky type of stock because it can come with all kinds of preferred rights and clauses. The most common ones you should understand is the Liquidation Preference. A liquidation preference effectively means that investors get to choose whatever is best for them in case of making money out of their investor. The choices are:
1) On liquidation of the company the investor chooses to take their preferred stock rights and redeems their money back before anyone else gets paid. The proceeds of the company sale are used to pay for this (meaning there is left for stock holders). Investors would do this if the share price of the stock they own is lower than what they invested in.
2) On liquidation of the company the investor chooses to convert their preferred stock to common stock. They forego their ability to get their money back, but they would generally do this when the stock is worth (way) more than what they paid for it. Meaning they make the return they hoped to make when investing.
In some (rare) cases investors have Participating Preferred stock. This means they get their money back PLUS they get to convert to common stock. This is a very punitive clause. In other cases investors have a 2x or 3x liquidation preference. This means they can always at least get 2x or 3x their money back (meaning they have a guaranteed return assuming the companies exit is high enough).
Understanding how much your company has raised compared to the expected exit of the company is very important. It’s also key to understand what rights and preferences other investors received before exercising your stock options. You might end up buying stock that is very risky.
- Read this NY Times Article
- Read this article on how an exit went wrong
Stock options are easy to ignore: After your one-year cliff, they just exist in the background, quietly accumulating in a benefits administration portal somewhere.
For most people, they don’t really think about their stock options until it’s time to leave their company.
However, by ignoring your stock options, you may be inadvertently racking up an alternative minimum tax liability that will be difficult to handle on your own. Let’s take a look at a real-world scenario:
If you decide to exercise your stock options immediately, you’ll pay $25,000 to the company to purchase shares that have a hypothetical fair market value of $50,000.
When it comes time to file your taxes, your accountant will note that you experienced gains (on paper) of $25,000. Given your salary, exercising your stock options will trigger a comparatively small alternative minimum tax bill that year. You pay the AMT, which is still manageably small.
If you decide not to exercise your stock options immediately, you’ll continue to work at the company, and automatically vest shares each month. On your 2-year work anniversary, you decide to quit your job and learn you have 90 days to exercise your stock options or lose them permanently.
In the meantime, your company has raised a fresh round of funding that bumps up the fair market value of your stock options to $5 each.
Now, when you go to exercise your stock options, you’ll pay $50,000 (50,000 shares x $1 strike price per share) on stock that has a hypothetical fair market value of $250,000 (50,000 shares x $5 fair market value).
When it comes time to file your taxes, your accountant will note that you earned a gain — on paper — of $200,000, which triggers a significant AMT tax bill.
Squeezed and without the money to exercise their stock options or pay the resulting taxes, hundreds of thousands of people collectively abandon billions of dollars worth of stock options when they leave their jobs every year.
If you’re earning ISOs or NSOs, you’ll have a limited amount of time to exercise your stock options once you leave your company. The prevailing industry standard is 90 days, but you’ll want to check your stock option paperwork to know for sure.
One thing to note: Even if your startup is one of the few that has voluntarily extended its post-employment stock options exercise window — in some cases by as much as 10 years — ISOs automatically convert to NSOs after 90 days of you leaving the company (NSOs are taxed less favorably than ISOs).
If you fail to exercise your stock options in that window, you’ll forfeit them and lose them forever.
For those who haven’t made a plan for their stock options, they’re usually surprised to learn they have to come up with tens of thousands of dollars — and in some cases, hundreds of thousands of dollars — in just 3 months. If they can’t, they can lose their stock options forever.
If you’ve managed to get in early at a startup and stay there for a decade (but fail to exercise any of your stock options in that decade), you should know that all unexercised stock options automatically expire after 10 years.
It’s rare, but we have helped early employees at unicorns exercise their stock options as they get close to their 10-year work anniversary.
If you neglect to exercise your stock options until it’s nearly too late, you’ll likely face trivial exercise costs but a large AMT bill, as the value of your stock options will have likely grown considerably over the past decade.
The majority of startup employees end up waiting until after an exit — either an IPO or an acquisition — to exercise their stock options, using a same-day transaction called a cashless exercise.
With a cashless exercise, you’ll exercise your shares and immediately sell them, setting aside a portion of the gain to pay for your taxes.
Cashless exercises are simultaneously the easiest option, and the most expensive. Cashless exercises are taxed at the short-term capital gains rate, which can result in hundreds of thousands of dollars in value lost to the IRS.
On paper, cashless exercises make sense — by waiting to exercise until a company exits, you’ll reduce your risk (nobody wants to buy stock options early, only to see the company fail), and you won’t have to put up any cash to exercise your shares.
Instead of a cashless exercise, you may want to consider non-recourse financing from Secfi. With non-recourse financing, Secfi puts up the money you need to exercise your stock options before an exit (starting the clock on the long-term capital gains rate), and gives you enough cash to cover your alternative minimum tax bill (if applicable). If the company fails to exit, Secfi will take on the downside risk.
Depending on your specific situation, you might end up saving more money in taxes with non-recourse financing than a cashless exercise. We’ve built a handy Stock Option Tax Calculator to help you run the numbers yourself, or feel free to reach out to one of our equity advisors to talk about your specific situation.
You’ve managed to avoid the most common mistakes people make around stock options: You understood your stock options, made a plan, exercised your stock options early using non-recourse financing, and your company successfully exited. Now what?
It’s tempting to hold off on selling your stock as it continues to climb. And, it’s understandable that you feel a personal connection to your company’s stock — hoping, or believing, that it will always go up.
The general rule of thumb is not to hold more than 10 percent of your net worth in a single stock, and to diversify your net worth across multiple types of investments. Of course, it’s always best to make an informed decision with the help of a licensed financial advisor.
We can point to rare examples like the collapse of Enron or Lehman Brothers, where employees collectively lost billions of dollars due to over-concentration of net worth in their company’s stock.
What happens far more often is that Wall Street enters a bear market that impacts certain companies harder than others, leading to a lot of volatility in individual stocks. Watching your net worth swing wildly from month to month can make it difficult to plan your financial future.
A major partnership falls through, or an unexpected competitor enters the market and begins eating up market share. Worst-case scenario, your company experiences a sharp drop in stock value, and decides to cut your job as part of a mass layoff. Now, you’re out of work and your stock is trading at its 52-week low.
It can be hard knowing you sold only to see that price increase, but it’s a far easier pill to swallow than not selling any and watching its value get wiped out.
No one can foresee the future, but usually the worst choice is not making any choice at all.
Feel free to reach out if you have questions about your unique situation, or check out our Stock Option Exit Calculator to better understand the cost to own your stock options.