As a financial advisor who specializes in equity compensation, I’ve noticed that many startup employees have something in common: they don’t understand equity compensation. This often leads them to undervalue it, ignore it, make decisions they later regret, or all of the above.
Equity compensation (which is often in the form of stock options for early-stage and pre-IPO startups) is about offering your employees an ownership stake in return for joining your company. But equity is also a form of deferred compensation, the value of which is likely not realized for years down the line. It’s also an investment decision on the part of the employee because they still need to buy into their company. They have the option to buy stock, typically at an attractive price—for a company that may or may not succeed.
Like any investment decision, equity is about weighing risks and rewards and making decisions based on personal financial details. But most people you’re hiring aren’t financial experts. This stuff is complex, it’s personal, and it can be tough to make rational, unbiased decisions about the company you’re building.
Many companies and their leaders shy away from providing recommendations or advice, and for good reason. They don’t want to be seen as influencing employees’ decisions because that’s a legal no-no. Still, there are ways to help candidates understand the offers you’re sending as well as help those you currently employ.
I get many questions from clients about their current equity compensation packages, and I also work with many who are transitioning jobs to help them review and compare job offers they receive.
Based on the most common questions I get from employees who are considering accepting a job that includes equity, as well as questions from employees who are trying to understand their current equity package, below are five key topics employers should consider communicating in a job offer.
1. The type of equity they’re receiving
Many clients I’ve worked with don’t understand the very basics of equity, including that they may need to exercise (or buy) their options, and that doing so is generally a taxable event.
As an employer, there are four main types of equity you’re most likely to grant employees. Here’s a breakdown of each, the differences between them, and what information you could provide to help your employees (or prospective employees) understand what’s offered:
- Incentive Stock Options (ISOs): An ISO is a tax-preferential form of equity that is issued to employees. It is common for early-stage companies to offer this type of equity. ISOs give employees the option to purchase shares of the company at the price at which they were granted. The difference between the 409A and the grant price is considered a “bargain element” and is what triggers the tax element. A key difference, however, is that when you exercise an ISO the bargain element is added to the employee’s Alternative Minimum Tax (AMT) equation. It’s important to understand this. As mentioned above, ISOs have beneficial tax properties to them if certain conditions are met. If an employee exercises ISOs and holds them for two years from when they were granted and one year from the date of exercise, the employee will receive long-term capital gains rate tax treatment upon a post-exit sale.
- Non-qualified Stock Options (NSOs): Non-qualified stock options (NSOs, also referred to as NSQOs) are the option to purchase stock in the company at a predetermined price, as stated in the grant (generally known as the “strike price”). When an employee is issued an NSO, they should understand that the current 409A valuation minus their strike price creates an ordinary income taxable event for them, rather than AMT as in the case of ISOs.
NSOs are common when a departing employee with ISOs receives an extended exercise window. Their ISOs automatically convert to NSOs after 90 days, so it’s important to communicate this if your company has an extended window policy.
- Restricted Stock Units (RSUs): A restricted stock unit is an unfunded promise that a company will issue an employee a certain number of shares or cash payment once future vesting conditions are met. RSUs can come in the form of cash-based or stock-based grants, with stock-based grants being the most commonly issued.
RSUs can either be issued as single-trigger or double-trigger. Single-trigger RSUs are shares issued when a single triggering event takes place. The most common trigger situation is time-based vesting, but it can also be tied to performance-related vesting. On the other hand, double-trigger RSUs require two triggers to happen for the shares to be released to an employee. The first trigger tends to be vesting-related, while the second trigger is an exit event. A key tax difference between single and double-trigger RSUs is that upon vesting of single-trigger RSUs the employee will have a taxable event, while a double-trigger RSU taxable event doesn’t happen until the liquidity event takes place.
RSUs in private companies can create a complex tax situation for the employee as ordinary income can be credited to them, but there may not be liquidity to sell shares to cover the associated tax. Lastly, since an employee does not own RSUs until vesting occurs, they are ineligible for 83(b) elections.
- Restricted Stock Award (RSAs): A restricted stock award has many of the same features that come along with RSUs except for one key differentiator: RSAs are issued to the employee when granted, and are held in an escrow account until the vesting terms are met. This is important for employees to know because this unique feature allows an employee to file an 83(b) election if desired. If an employee does file an 83(b) they are opening up the ability to receive capital gains treatment upon sale. This could be tax-beneficial to certain employees if capital gains taxes are lower than their ordinary income rate.
As you can see, there are some pretty major differences between different types of equity, especially relating to how they are taxed. That’s why it’s important to tell your employees the type of equity they’re receiving, ideally in their offer and in any onboarding documents you provide.
Additionally, the type of equity employees receive may change during their tenure at a company. For example, many companies grant ISOs early on but switch to RSUs as the company’s value increases because the cost to exercise ISOs can become burdensome. So, as much as possible, it’s critical for employers to provide clear messaging about the type of equity employees can expect to receive. It is also helpful if employers can provide appropriate resources for the employee to learn more about the implications of their equity type when exercising or, later, selling.
2. The current value of their equity and the future potential
Oftentimes, employees only know the number of stock options they’re being granted and equate that with value. But 10 shares out of 20 is worth more than 100,000 out of 10 million.
When providing a job offer that includes equity compensation, you may include information on how to value their options today and in the future. An offer can include the value based on the most recent 409A valuation, as well as valuations at possible future valuations (i.e. if the company were to grow to $1 billion). Of course, this would be hypothetical, but it helps illustrate how the value of their equity rises as the company’s valuation does. This can help them gain a grasp on how to value their equity.
But be sure to make it clear that these are estimations and are subject to change, even before they receive their equity grants, and that strike prices aren’t determined until the date they are officially granted.
At Secfi, we’ve also built a tool to help employees evaluate the value of their equity compensation in a job offer.
3. Proactive communication about 409A updates
Legally, all private companies need to work with a third party to evaluate their 409A valuation at least once a year. It’s helpful for employees to know ahead of time when that will be happening for two reasons:
- There is often a blackout during any evaluation when employees are not able to exercise.
- If employees believe the new 409A valuation could be higher, they may want to exercise any vested stock before it changes.
409A valuations will also change during any other material event, like a funding round. This, of course, could make it harder to communicate in real time. While you may communicate with your employees that the company is exploring new funding, it may be tough to tell them the exact timing. And there may be other reasons, including legal ones, why you can’t provide real-time updates about funding rounds.
But, you can educate your employees about the implications of a funding round, or at other times when there is an annual 409A update that is not related to funding.
4. Whether the company allows early exercising
If you allow early exercising, let your employees know during the offer stage and during onboarding. Early exercising means that employees are able to exercise their stock options before they vest. Most vesting schedules have a 1-year cliff, with a 4-year vesting period, so they would need to wait a year before they’re eligible to exercise anything.
Exercising early can be beneficial because the strike price will be based on the 409A valuation at the time the employee’s equity was granted. If they exercise when the strike price and 409A valuation are still the same, they may not owe any taxes. Additionally, if they do early exercise in this type of situation, they may consider filing an 83(b) election form, which they must file with the IRS within 30 days of early exercising. This form may allow them to save even more on taxes when they are later able to sell their stock upon an exit event.
That said, early exercising does not mean their vesting schedule is accelerated. The employee must still allow their equity to vest for them to own the early exercised shares. The difference is that when those shares vest, they have already been exercised and now the employee owns those shares.
There are downsides to early exercising to consider, too, like if the employee leaves before vesting or if the company’s valuation declines. It’s important to provide employees with the necessary information and resources so they can make an informed decision.
5. Clear guidelines for liquidity options, including secondary sales and tender offers
To the extent possible, inform your employees and prospective employees if the company allows or provides liquidity options before an exit event. Knowing they may have the option for liquidity in the near term may impact a candidate’s decision to take on the risk of startup life.
For example, secondary markets can provide liquidity for equity an employee has exercised. Of course, secondary market dynamics will dictate if there is appetite from buyers, but if your company becomes valuable enough, it’s possible. That’s why you should communicate with your employees if you allow secondary sales and the related policies. Many companies have different policies as it pertains to secondary sales, like needing the approval of the Board of Directors, among others. It’s possible your company may not allow secondary sales at all, so the employees should be aware of that before they look to sell.
Similarly, some later-stage companies may conduct tender offers. These are, essentially, company-sanctioned secondary sales. Usually, current or outside investors have agreed to buy a certain amount of shares from employees. And, tenders often occur around funding rounds. When a tender is happening, it’s important to communicate:
- Who is eligible (for example: do employees need to have exercised already?)
- The dates of the tender (what is the deadline for their decision?)
- How much are they eligible to sell?
- What is the sale price?
Those buying in a tender may have agreed to purchase a specific amount of shares. This may translate to employees only being allowed to sell 25% of their equity. Or, some details may depend on the amount of interest from employees. Communicating this upfront can help employees decide whether or not they want to sell, and if they need to make an exercise decision beforehand.
Of course, your policies regarding secondary sales, tenders, or other forms of early liquidity, could change over time as your company grows. Provide employees updates if, and when, those policies change.
6. Recommendations for financial advice
Many companies shy away from providing education about equity compensation because they don’t want to be seen as influencing their employees to make certain decisions. But equity compensation is also complicated, involves tax considerations, and is, oftentimes, based on an employee’s personal financials—so many employees are likely looking for help. More commonly though, they are not even aware that they can get help and guidance on these matters. Basically, they don’t know what they don’t know.
It’s not uncommon for employees to discuss equity decisions at the office or via Slack. But what may apply to one employee may not apply to another. Because, like any investment decision, it’s dependent on the person’s financial goals and their financial situation. An employee with only ISOs will not have the same factors to weigh as another employee who has only RSUs.
But many talk to each other because they don’t know where else to look for help. And, even if they want help from a professional, not all financial advisors have experience with stock options or equity compensation. If you’re able to point employees in the direction of advisors who do know, they can consult with them to make their own decisions separate from the company. Plus, establishing a partnership with a financial advisory firm that specializes in equity could be a company benefit that potential employees view positively.
At the very least, when providing the above information, you can strongly recommend that they seek out professional advice from a financial advisor and/or tax specialist to help them make decisions regarding their equity.