What you need to know about stock options, restricted stock grants, and exercising

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Getting equity in a company can have life-changing consequences, but it can also be confusing. Before you can start evaluating your compensation package, it’s crucial to understand how equity works.

Below, we’re breaking down what stock options and grants are—and explaining how you actually make money from them. First, let’s start with a refresher on the basics.

What is equity?

Equity represents ownership in a company, and a share of stock is a piece of that ownership. When a company offers you equity, they’re giving you a chance to own a portion of their company—and potentially make money off of that ownership if the company does well.

There are two classes of stock. Common stock generally goes to employees and founders, while preferred stock is for investors. Investors choose preferred stock because it offers regular dividends (payouts) if a company performs well financially. However, common stock is usually cheaper to purchase than preferred stock, and also typically comes with the right to vote on important company decisions.

Most equity offers come in the form of stock options or restricted stock grants.

What are stock options?

Stock options aren’t shares of stock; they’re options to buy stock. A stock option gives you the right to purchase a set number of company shares at a fixed price. If the value of the stock—and therefore, the price per share—goes up over time, you can potentially make money by selling them.

There are two main types of stock options:

  1. Incentive stock options (ISOs): ISOs are stock options that offer tax advantages. With ISOs, you generally don’t have to pay taxes when you buy shares of stock (however, you may have to pay what’s called the alternative minimum tax (AMT) in certain instances). You might also qualify for special tax incentives if you follow certain rules when selling your shares (and depending on your company’s size). In most cases, ISOs expire 10 years after they’re granted to you.
  2. Non-qualified stock options (NSOs): Like ISOs, NSOs usually expire 10 years after their grant date. However, with NSOs you have to pay taxes when you buy and sell your shares of stock (more on that later).

What are restricted stock grants?

In lieu of stock options, a company might offer you restricted stock grants. Restricted stock grants give you automatic shares in a company—as long as certain conditions are met. These conditions can be specific to you as an employee or to the company (or both). Unlike a stock option, you don’t have to buy the shares of stock when you receive a restricted stock grant. However, you do have to pay taxes on the shares you receive.

The most common type of restricted stock grant is a restricted stock unit (RSU). If a company offers you RSUs, that means they’re promising to give you shares of stock in the future once the conditions are met (in other words, once the restrictions are lifted).

Companies often apply double-trigger conditions, meaning that there are two triggers that have to be released before you can receive your RSUs. The first trigger usually requires you to work at the company for a certain amount of time before receiving your stock grants. The second trigger is generally performance based, which means your company might have to hit a particular milestone before granting you your shares (i.e: an IPO or successful exit). In practice, this usually means you aren’t taxed on your RSU until the company exits and you can sell your shares.

Receiving stock options or units puts you one step closer to owning stock, but you still have a couple more hurdles to cross, including vesting.

What is vesting?

Vesting refers to the period of time you have to work at your company before you own your stock options or stock grants outright. Until your options or grants vest, they’re not technically yours. While there are many different vesting schedules, most companies operate with what’s called a cliff, which typically lasts one year.

That means you’ll get zero options or restricted stock units for the first year you work at your company, then you’ll receive your first chunk at the one-year mark. From there, you’ll usually get a small percentage every month or quarter (determined by the vesting schedule) over a handful of years until they’re 100% yours.

Once your RSUs vest—and any other conditions are met—you own your shares of stock. However, it’s different with ISOs and NSOs. Even when your ISOs or NSOs vest, you still don’t own stock—you just own the option to buy the stock at a predetermined (usually low) price.

To own the stock, you have to spend your own money to buy shares. This is called exercising your options.

Exercising your options (aka buying shares)

Once your stock options are vested, you can exercise them. To do that, you buy shares of stock at the exercise price, also called the strike price.

The strike price is a fixed price based on the stock’s fair market value (FMV). The FMV is determined by a 409A valuation, which is when a third party assesses your company to estimate its worth.

The strike price is set when the company’s board of directors approves the stock option grants for employees. Since grants can be approved months after your start date, your strike price typically cannot be guaranteed when you receive an offer (if the FMV goes up in the meantime).

However, the price is typically low, and much lower than the preferred price investors pay. To give you an idea, our initial strike price at Agora was $0.006. As the company grows and matures, the difference between the strike price for common and preferred stock typically gets smaller.

Remember: Exercising doesn’t apply to restricted stock units, only stock options.

How long do you have to exercise your options?

If you own ISOs and NSOs, you have a certain amount of time to exercise your vested options after you leave the company. This is called the post-termination exercise (PTE) window. If you don’t buy your shares of stock within your company’s PTE window, you forfeit them and lose out on the potential to make money.

The PTE window varies from company to company, but the industry standard is 90 days. However, some companies (like us at Agora) are extending their PTE windows to cover the entire 10-year lifetime of a stock option. If that’s the case, you’ll have a good chunk of time to observe your company’s growth, save money, and decide whether or not exercising is the right move for you. Make sure you ask your company what PTE window they use (or ask them to use Agora!).

When should you exercise?

You can generally exercise your options after they’re vested (and before they expire). Some companies (like us) even offer an early exercise period, which gives you the opportunity to buy shares of stock before your options have vested. Exercising early may help you save money on taxes.

Of course, you need to have enough money to exercise your options and pay for the potential AMT tax associated with early exercise (if it applies). That’s why exercising is a high risk, high reward decision. You may have to dip into your personal savings to buy your shares of stock—and there’s no guarantee of when (or if) you’ll be able to replenish your savings.

If you don’t want to put your money on the line, though, you could always wait to exercise your shares until they’re liquid (meaning you can cash in on them). At that point, you could buy your shares then sell them immediately to cover the purchase cost—and hopefully recoup some money.

The question is how.

How do you actually make money?

Once you exercise your vested options or receive your grants after the double trigger, you own shares of stock in your company. Congrats! But how do you make money on that equity? There are four common ways:

  1. Initial public offering (IPO): An IPO is when a private company decides to open its stock to the public market for sale. In this case, everyone from investors to average joes can purchase shares of your company’s stock. If your company has a high exit value, your stock could be worth a lot.
  2. Acquisition: If another company buys your company, the new company will generally pay you cash for your shares. Keep in mind that investors get paid out before employees (who are common shareholders), so you may not make money if your company has a bad exit.
  3. Tender offer: If your company decides to hold a tender offer, you can potentially liquidate your shares by selling them back to the company or to outside investors. In that case, your company sets the price of stock and facilitates the sale.
  4. Secondary transaction: You might be able to sell your private stock to investors through a secondary transaction site if your company allows it, but the process can be tedious and expensive.

Here at Agora we believe liquidity should be part of the journey, not just the destination. We believe companies should allow secondary transactions and regularly help employees sell their shares through tender offers throughout the company’s lifespan.

What about taxes?

The amount of taxes you pay on your stock depends on the type of stock options or units you have and when you decide to exercise and sell them.

NSOs

When you exercise your NSOs, you’ll pay ordinary income tax on the difference between your strike price and the FMV at the time of the sale. If you hold onto your shares for less than a year before selling them, you’ll pay short-term capital gains taxes on the profit you make (the sale price minus the FMV). If you keep your shares for more than a year before selling them, you’ll pay long-term capital gains taxes on your profit.

ISOs

ISOs are a bit different. If you sell your ISO shares right after you exercise them, you’ll pay ordinary income tax on the difference between the strike price and the FMV at the time of the sale. But if you keep your stock for more than one year after exercising your options, you get a tax advantage (which means paying a lower long-term capital gains rate).

Depending on how many options you exercise and when you sell them, you could end up paying a steep tax fee. And if you’re not able to cash in on your shares for a while, you may have to use your personal savings to cover the tax costs. That’s why it’s important to be strategic about when you decide to exercise.

RSUs

Taxes are a bit simpler for stock units. On the date that your shares vest, you’ll pay ordinary income tax on the FMV of those shares for the year. Once you sell your shares, you’ll owe either short or long-term capital gains taxes on the profits you make from the sale.

The equity journey

Equity is something you earn through years of work experience and smart decision making (and lots of luck). There are countless factors that are out of your control, but you can take charge of your choices along the way. That starts with understanding your options.

Nothing in the article constitutes professional and/or financial advice, nor does any information on the Site constitute a comprehensive or complete statement of the matters discussed or the law relating thereto.

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