Should you accept ESOs?
- The company will survive an IPO
- The company will succeed
- You won’t be laid off
- You will have a way of exercising your ESOs
- Having a large number of ESOs or company stock aligns with your risk profile
- You will stay with the company for the long term
- Exercise & Sell
In this case, Shane won’t need to cough up 50k to purchase the shares. The options will essentially ‘convert’ to shares and be sold right away on the open market. An exercise & sell strategy is highly recommended as it eliminates market risk immediately – but beware of the high tax tag.
- Exercise to Cover
Here, Shane wants to buy and hold as many shares as possible, but he doesn’t have $50,000 lying around. He exercises and sells the amount necessary to cover the purchase of the remaining shares.
- Exercise & Hold
Shane wants all 5,000 shares, so he needs the funds to do so. Some agencies will fund the exercise – for a price. Otherwise, he will need to raise the funds himself.
The share value of a stock can dip below the original Fair Market Value and never return. You’re looking at an inevitable loss if the stock doesn’t pay dividends. Also, many start-up companies are growth stocks, meaning they don’t pay dividends. Instead, they reinvest all profits into the company. By owning a large portion of shares of the company, your sole hope is that the company grows so you can sell for a higher price later. All too often, that simply doesn’t happen. In the worst case scenario of a company failing, you’ve lost 100% of your original principal.
ESO Vesting Schedules
End of Year 1: Shane receives 1,000 of his promised ESOs. Depending on the type of ESO, he can exercise right away or must wait for a year (more on that later).
End of Year 2: Shane receives another 1,000 ESOs.
Years 3-5: Rinse and repeat
After six years, Shane has finally received all of his employee stock options. Hopefully, it was worth the wait. By the way, if you ever feel the grass is greener on the other side and jump ship to a competitor, your former company may have the right to take back any profits you made through their ESO compensation plan.
Two Types of Employee Stock Options
ESO #1: Incentive Stock Options (ISOs)
- The Bargain Element
This is the difference between the Fair Market Value (strike price) and the market price at exercise. This difference is subject to ordinary income tax if not all conditions are met. However, if all requirements are met, no tax is owed on it at all.
- The Capital Gain
This is the difference between the market price at exercise and the market price at the time of sale. If you sell at least two years after the grant date and observe the one-year holding period, you owe only the long-term capital gains tax.