Equity has become a popular addition to an employee’s compensation package, offering a chance to share in the company’s success, as well as the opportunity to grow an individual’s personal long term wealth. According to the 2018 General Social Survey (a longstanding national survey), 11 million people participate in their company’s Employee Stock Ownership Plans and 25 million people have other variations of stock-based compensation. This equates to 20 percent of workers in the private sector in the United States.
If your employer offers equity as part of your hiring package, you’ll also receive a stock option agreement or option grant with your offer letter. Understanding the contents of that agreement and how it can impact your total compensation is important before you sign on the dotted line. Below, we’re breaking down the terms you need to know, common types of stock to expect, and the potential equity differences based on the stage of the company.
Equity 101: Basic Definitions
Let’s start with the fundamentals of equity. Here are some common terms you will want to get familiar with as you go through your stock option agreement:
- Stock vs. Share vs. Option: The terms “share” and “stock” are frequently used interchangeably, but they do have distinct definitions. A share is an individual unit of a stock, while stock refers to your amount of ownership in a company. (Think of shares as atoms, the building blocks of a molecule, or in this case, stock.) Lastly, a stock option is the opportunity to purchase shares of the company at a set price.
- Strike Price: The strike price—also known as the exercise or grant price—is the cost of each individual share on the date that it’s offered. This will be the price you pay if you choose to purchase the shares, even if the value of those shares changes over time.
- Fair Market Value (FMV): The FMV dictates what the strike price will be and is based on the value of the shares if they were publicly traded. It’s determined via a 409A valuation by either the market for public companies or by an independent third party if the company is privately owned.
- Exercise: This term refers to the action of purchasing the shares that were granted to you as part of the option agreement. Typically, you can exercise (or buy) your shares once they have vested.
- Vest/Vesting Schedule: A vesting schedule, or vesting period, is how long it will take for you to actually accumulate the full amount of shares that are offered in your package. Most companies require that you work for them for a set period of time before you’re eligible to purchase your stock options. This part of your compensation package rewards your loyalty over time with a growing ownership stake in the company.
Types of Employee Stocks
While there are a few different types of equity options—which can vary depending on the company’s specific employee stock option plans—the most common options are called Non-Qualified Stocks Options (NSOs) and Incentive Stock Options (ISOs). The core difference between the two types of stocks is how they’re taxed and when those taxes are withheld. (Yes, you not only need to exercise your options, but you’ll also have to pay taxes on them as they are considered part of your income.) Generally speaking, for NSOs you’ll be taxed both when you exercise and sell your shares. ISOs are not taxed upon exercise, but do incur capital gains taxes when you sell the shares.
There are also less common, alternative types of stock called Restricted Stock Units (RSUs) and Restricted Stock Awards (RSAs). These stock types may have different tax obligations, and the shares do not need to be exercised. Instead, after a vesting period set by the company, you’ll automatically own your shares.
Accepting, Vesting, and Exercising
So, you’ve accepted your stock option agreement. Now what? It’s important to note that accepting your options is not the same as exercising them. You’re simply accepting the offer that gives you the option to buy them. Exercising means you’ve purchased the options at the designated strike price, and you become the owner of those shares. Once you purchase your shares, the difference, or “spread” between the FMV and strike price is how your equity grows in value. The more that spread grows, the more you can gain on your investment.
Typically, you’ll need to wait until your shares have vested before you can exercise them. (Some companies will allow you to exercise your options early). The vesting schedule is determined by the company and should be broken down in your option agreement. Often, these vesting schedules include a large amount of shares after the first year, otherwise known as a “cliff.” The rest of the shares then vest equally over quarters, months, or years.
Here is an example of a common vesting schedule:
- You receive an option grant for 2,000 shares that fully vest after four years at the company.
- The first 25 percent (500) are vested after the first year.
- The remaining 75 percent (1,500) shares are gradually vested in equal groups of 125 shares every quarter for the remaining three years.
ISO and NSO options generally expire (meaning you can’t exercise them) 10 years from when they were granted, so it’s a good idea to confirm any expiration dates when receiving your offer letter.
If you end up leaving the company down the road, your shares will stop vesting immediately. If you have vested any shares during your time at the company, you’ll have a set amount of time after leaving the company to exercise these vested shares. This is referred to as the Post-Termination Exercise (PTE) period. The PTE period is generally 90 days, though it can vary by company.
Variations of an Equity Package
Your equity package can also heavily rely on the stage of the company when you join. As a company grows, it may choose to offer different types of stocks. In addition, the actual percentage of ownership in the company will change depending on the total amount of shares that are available.
For example, an engineer at an early stage startup with fewer than 25 employees and an engineer at a Series C company with 500+ employees may both be offered 2,000 stock options. Let’s say the early stage startup has 400,000 outstanding shares for the whole company—that would mean the employee’s options are worth 0.5 percent of the company. At the later-stage company, let’s say there are 20 million outstanding shares—that would equate to a 0.01 percent ownership stake in the company. While the amount of shares remains the same, your options are likely to be more diluted at a larger company. To simplify the equation, you can calculate the value of your equity package by using a free equity calculator. Keep in mind, though, that if the company is private (i.e. not publicly traded), you may not be able to know the true value of your shares.
When you evaluate your offer, be sure to note not only the type of stock and how many shares are being offered, but also the vesting schedule, the strike price, and any notable expiration dates. You can also ask your employer if they allow early exercise and how the number of shares being offered relates to your actual percentage of ownership of the company, though some employers may not be willing to share this information.
The option for equity in a company is an opportunity to not only be interwoven into the success of your employer, but it can also help to build your own personal investment portfolio.