Employee Stock Options as Explained By an English Major

Part One of a three-part series wherein I, an English Major, explain incentive stock options and how they work for employees at startups.

In 2009 the economy was tanking, and I had my first real job at an internet startup, though I wouldn’t have known to call it that. I was an aspiring writer who desperately needed a job and was thrilled by the prospect of getting paid to hang out on the internet all day. I’d heard about stock options before, but really just that back in the day even the secretaries at Google got rich.

When I signed my contract and went full-time, I got my stock agreement in an email. Along with it came an offer from my boss to sit down over coffee so he could explain how all of it worked. I was so grateful to be employed, so ashamed of my luck, so afraid of jinxing myself, and so perfectly 24 that I never replied, just signed the paperwork without reading it and ignored the whole thing.

One day in the elevator on the way to lunch, my same boss mentioned that if things went as planned, those stock options would buy me my very first apartment in New York. When I left this job a year later, the apartment line was edited to reflect my short tenure: “One day these stock options will help you buy your very own studio apartment in New York.”

In between then and now I’ve scoured Wikipedia, filled out hypothetical tax forms, had phone calls with an accountant that cost me more than a month’s rent, sent late night emails to the fathers and husbands of people I call friends, and have tried but mostly failed to explain what I’ve learned over drinks with former coworkers, many times over.

Most of them, I found, hadn’t given it much thought.

In fact, stock options at startups seem to be the one very relevant topic the “community” doesn’t have meta-conversations about. There are no panels. No posts on Medium (okay a few posts on Medium). Not even a years-late trend piece in the Times.

Which I get because 1) This kind of money, and this kind of privilege, is uncomfortable to talk about. You sound like an asshole, and you basically are. 2) People are afraid of getting sued.

So, disclaimer: please don’t sue me or think I’m an asshole, but I’m going to tell you what I’ve learned. I’m no expert but I already went to the trouble of writing all this out so off we go.

While getting stock options at your internet job is totally hypothetical and could mean nothing, if it does end up meaning something you’re really going to want to have looked it up ahead of time. They are not a gift. They are not a perk. They are an opportunity. The decisions you’ll make regarding them will affect, if not the rest of your life, then at least your retirement fund. You don’t want to have to make them on a tight deadline.

So as much as you want to dismiss it, or avoid it, or say it’s not your thing, if you find yourself in the ridiculously, embarrassingly lucky position of working at a startup and having this paperwork crammed into a tote bag somewhere, get your act together and start Googling the shit out of Incentive Stock Options. Or at least read this article.

First things first:

Stock options are just that: an option to buy shares in your (“your”) company’s stock. You don’t have the stock yet, someone is just setting it aside for you — kind of like layaway for horribly privileged people.

And yes, stock is a tiny bit of ownership in a company.

Owning shares in a company is like owning a square inch of a house. If they sell the house, you get your little share of the profit. If the house starts turning a profit, you might start getting your share of the money they make (dividends!). And, if you get sick of your square inch or really want to pay off your student loans or something, you can sell off your little square inch, or a part of it.

I’m sure there are better, more accurate ways of saying this (all of this!) but it’s how I’ve wrapped my head around it.

The value of stock, and therefore also the “valuation” of a company, is kind of fake and based on projections and human error and just general “hunches.” However, this is not an excuse to say “it’s not even real” and throw your option grant in the bottom of your metaphorical adult book-bag and forget about it. Because rich people will give you real money for this imaginary shit! And money is real. Okay money is symbolic and fake, too. But student loan debt is real. Madewell Industries is real. Your electric bill is real. Credit is not that real but broker fees are, though they shouldn’t be, real.

Most employees of startups get this stock option “agreement” which explains your option grant. That means what they are giving you (“grant”, it’s kind of obvious, c’mon) — the type of options, the number, the vesting schedule, the strike price, and any other picky rules and stipulations. It behooves you to read this contract, or better, have someone familiar with contracts read this contract. Remember that contracts are open to interpretation, and built only on language, which is flimsy and often misunderstood. Read it on a Saturday morning just after you’ve had your coffee. Or on a quiet train ride. Send emails to whoever sent it to you with lots of questions asking for clarification. It’s almost weird if you don’t.

 

Incentive Stock Options, or ISO’s, are probably what you’re getting — the incentive being you don’t quit when they start hiring people over you in approximately a year. These are what I’ll be talking about and referring to throughout.

If you’re an early employee and the company is new, your options are pretty much worthless for now. If the company succeeds later on, though, this is to your advantage. This is why people shittier than you always want to “get in on the ground floor.” Getting in on the ground floor just means you paid less to get more. Your “strike price” is way lower, and maybe you got your option grant before they hired a lawyer who advised them to stop giving people so much stock, you newbs, you’re giving away the farm.

 

TIP: Always join a company before the lawyers do.

 

Your strike price is just a really cool (“cool”) way to say how much the stock will cost you when you buy it. It’s the price you’ll pay per share of stock, and it is set when you get hired and sign the grant. For better or worse, it never effectually changes. I say “effectually” because in the event of a “stock split” a company can decide they didn’t originally cut enough pieces in the pie, and magically cut everyone’s piece smaller. Still, you’ll get your same fraction, your stock will just be cheaper and you’ll have a higher number of options — e.g. 100 shares at $1/share becomes 1,000 shares for $0.10/share.

Your option grant will also tell you how many shares you’ll potentially be eligible to buy. Barring firing you before you vest, they can add to this but they can’t take it away. (NB: If they try to, this is a problem. Email a lawyer or business-y person about it. Don’t worry, when the time comes, desperation will drive you to get over your hesitation and fear of these types of people.)

This means that one day in 10 years when this company you work for is wildly successful, and worth $100 a share, you still pay only the 60 cents they quoted you when you signed the stock agreement (or much less, if the company has gone down in value). It means all the investment banker husbands of your former roommates would wonder how you got so lucky, if only they knew.

If you join the company later, your strike price will probably be higher. That’s not because someone is trying to screw you (well, always a possibility). It’s because of the IRS, mostly. You pay the “fair market value” of the options at the time you are granted them. This sets your strike price, which rarely changes, stock splits aside, even as the fair market value rises, or falls.

If you come in later, the company is (if they’re lucky) presumably worth a little more, so you have to pay a little more. You are marginally less lucky but still you can’t complain.

 

TIP: Complaining about this shit, overall, is frowned upon. Only do it to the most trusted friends who will wear their potential annoyance with you on their sleeve. Learn to change the subject quickly, and without apologizing. “I’m so sorry I’m complaining about all this MONEY,” does not help your case.

 

The fair market value, or FMV (money people love an acronym), is pretty hypothetical but it’s usually more conservative (ie, cheaper) than what the stock is bought and sold for. Why? Because 1) all of this is fake, and 2) it’s kind of like the difference of wholesale and retail. Or not at all. But the third parties who are hired to establish a fair market value of stock shares are just being super realistic. They look at money in the bank and graphs and crap like that — tax shit. But when you buy or sell shares on the market — when investors invest in your company, for instance — you mark that shit up. You say, “One day this will be worth a billion dollars!” And because it’s all kind of fake and everyone is making educated guesses about the future, the investor is sometimes like, “Okay sure! Here’s a ton of money!”

When they do that, provided it’s a good round, it ups the value of everyone’s shares.

Apparently (per the hours I have wasted having bourgeois fantasies on Trulia) this is like the difference in “property value” of a house, which determines what you pay in property tax, and the actual price you pay for a house, determined by the “market,” i.e. what people are willing to pay for it.

 

NEXT WEEK: vesting, exercising, and the dreaded AMT tax, which I won’t even try to explain other than tell you to watch out for it. You can read it here.

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23 Comments / Post A Comment

Olivia2.0 (#260)

You sure are terrified of someone thinking…something…about you having stock options. You don’t have to throw it in everyone’s face, but you also probably don’t have to apologize for it 100 times in one post. It’s a personal finance blog. It’s okay to talk about money here.

WayDownSouth (#3,431)

@Olivia2.0 yes, I agree, Share options are often provided by start-ups, as compensation for the relative lack of job security and the general odds against the company being successful. I am confused by the references to share options being a privilege or a person being an arse for talking about them. At start-ups, I’ve found that people talk about options constantly, since that’s the gold at the rainbow that they’re looking for (and why they’re working such large amounts of overtime for free).

heavyrotation (#4,261)

@Olivia2.0 Probably because it’s Tumblr, and not just some random startup. To which I say, good on Meaghan!

I think a lot of the writers here are bashful about money in all contexts, (the haves, the have-nots) and frankly given the fact that a lot of the content is aimed at a younger not quite with-it demographic, not totally unexpected.

Olivia2.0 (#260)

@heavyrotation I don’t know what the company that the stock options are from has to do with it, and also I didn’t know it was Tumblr until you told me so…so what?

There’s no reason to apologize for stock options in a post detailing the who/what/when of stock options. I get that it was probably supposed to be for effect, but, it just came off as immature and a bad look for ladies in general. (to me)

highjump (#39)

@Olivia2.0 @Olivia2.0 If you beat the odds and got some life changing amount of money because you were an original employee of a what is now a well-known brand then please don’t bitch about it. Yes, I’m sure that does present a more complicated tax arrangement, but I appreciated Meghan’s tone here. This is a privileged opportunity that is great to have and important to understand, but a very ‘my diamond shoes are too tight’ thing to complain about.

@fo (#839)

@Olivia2.0 I’m with you 100%. I think the apologies are OTT. Yes, a clear disclaimer of “however it may sound, I ain’t complaining” fits, but it’s soooo much more than that.

It’s not like any of the actual content is “what *will* I do with all this money?”–it’s more “I dunno exactly how much “money” I have, and I dunno how to (1) turn it into something I can use, and (2) avoid an OMG tax liability; so I figured it out and here’s what I learned”. Which is pretty neutral, and applicable if the options are worth $10,000 or $1,000,000 (not so applicable if they’re worth $10,000,000, bc then the answer is: professional financial and tax advisers, as they will certainly save more than they cost).

OllyOlly (#669)

All I know about the AMT is my parents complain about it every year, but I think it just means they are rich and should probably get over it.

@OllyOlly That was one of the problems of the AMT. It was not traditionally adjusted for inflation so it started to affect many more people than originally intended.

Meaghano (#529)

@OllyOlly Ha. In their defense it is an attempt to close a tax loophole that ends up inordinately affecting the sorta-rich more than the super rich. And a lot of people have problems with it.

And when it comes to stock options, triggering AMT means you end up having to pay taxes on money you haven’t actually gotten yet — and may never get — (shares in a private company you’ve bought but aren’t allowed to sell yet, or that end up tanking) so it can REALLY suck. Esp. for say, 24 year olds who don’t talk to someone about this and suddenly owe more in taxes than they make in a year.

grog (#2,222)

@Meaghano Bummer. This might be asking too much, but I hope you write about the specifics of your situation in the next installment. I understand if you don’t though, since it’s not exactly anonymous.

And I agree with comments at the top – you don’t need to apologize or feel like an asshole for writing about receiving stock options. Especially on the Billfold.

@fo (#839)

@Meaghano: “AMT is an attempt to close a tax loophole that ends up inordinately affecting the sorta-rich more than the super rich.”

It was to prevent “rich” people from coming up with BS deductions to zero out their tax liability. It originated in ’69, when there were a LOT more deductions available (for example, you used to be able to deduct *any* interest you paid–car loan, credit card, whatever–as an individual), and 155 people with ‘high’ income paid $0 in income tax.

Yes, it hadn’t been indexed to inflation, but even now that it is, the threshold for *possible* application ain’t anything close to “rich” or even “sorta-rich”–you can get hit with AMT with an income of ~$52,000 if you are single, or $80,800 if married. Granted, it’s *unlikely* to hit you at that level, but that’s the threshold where it starts to be an issue, particularly if you live in a high tax state, bc state/local taxes are “bad” under AMT.

Meaghano (#529)

@grog It’s not in there now but I will see if I can cover it a bit without you know, publicly auditing myself. I was lucky in that back in the day someone looked me in the eye and was like, “Seriously, have an accountant look into this,” but I have seen friends who I thought were aware of it get totally screwed.

And it’s funny, I wrote this piece last summer before I wrote for the Billfold, I’m sure the frame/tone would be a little different now, but my intention was/is more to say, “I have hang-ups about this stuff, I handled it immaturely, I felt weird about it — but still this is important and if you are in my situation and feeling this way, be smarter than me about it than I was and educate yourself.” Hopefully that will come through a bit better in the other two parts of this.

I think it’s that weird line between acknowledging that hang-ups are common and normalizing/glorifying them. No I don’t think you should feel guilty about this stuff, even if I did. But don’t feel guilty about feeling guilty! Just get over it and educate yourself.

And @fo knows a lot more about AMT than I do. I primarily just learned how it works for ISO’s.

@fo (#839)

@Meaghano “@fo knows a lot more about AMT than I do”

Had to look up the deets; we are on the intertubez after all.

But the primary ‘average person’ hit with AMT is someone with several kids, and a high state/local (including property) tax bill, and maybe a big medical bill year (so that a part is deductible) who has family income of ~$150k–definitely on the upper side of MC, even in the higher tax states, but not ‘rich’ in Cali or NY/CT/NJ.

honey cowl (#1,510)

I may never have stock options but I sure will know all about them. Thanks Meaghan!

antheridia (#2,995)

Meaghan, thank you SO much for this fantastic article! This is perfect timing, because my husband works for a tech start-up and has options, and we only just realized a couple of months ago that this could be big for us. I look forward to the rest of the series!

sarahsayssoo (#4,237)

I have a cousin of stock options at my current job, carried interest in projects. Taxes haven’t been a problem as of yet, although I think I’ll hit AMT if/when it pays out. Past that, it just feels like pretend money right now

@fo (#839)

@sarahsayssoo “although I think I’ll hit AMT”

If it’s bona fide, private equity style, carried interest, it should be treated as capital gains, which won’t get hit with AMT. Make sure you get professional (no, not HRBlock, or your cousin the CPA who doesn’t do tax work) tax advice.

sarahsayssoo (#4,237)

@fo it is bona fide private equity, and I will when there is actually money. right now I have filed 83(b) on them and will again this year which in my understanding means I’m okay for now

I hope that is still not wrong. it could be.

@fo (#839)

@sarahsayssoo I dunno enough to know. I do know enough to know that (1) you’ll want a real pro at some point, and (2) if you are taking tax advice from anyone with a financial stake in the p’ship, then you’re taking a major risk–unless you’d trust them with $1,000,000 in cash, and a kill switch on your life. There are too many incidents of the p’ship acting in self-interest and against the interest of the minority partners, at least on tax matters. See, eg, http://www.ustaxcourt.gov/InOpHistoric/CrescentHoldingsDiv.Ruwe.TC.WPD.pdf which is (almost certainly) far off point for your circumstance, but shows how a p’ship will throw even the CEO under the tax bus.

WayDownSouth (#3,431)

@@fo yes, I absolutely agree with you about minority partners being hurt when there’s a lot of money on the table. I recall that when Anderson Consulting blew up several years ago, quite a few of the junior partners lost their houses.

During the dot-com burst, I also recall that some Microsoft employees lost quite a bit as a result of having borrowed money against share options. As the options tanked, the banks which lent them the money sold off the shares to pay for the loans and the employees ended up with not much. Borrowing money using collateral which can vary in value quite a bit is fraught with risk.

Eric18 (#4,486)

Start-ups are risky ventures. Stock options are a good way to recruit people who otherwise might be leery of joining such a risky enterprise. Nothing wrong with being richly rewarded if your company succeeds. After all, alot of start ups just fade away.

garysixpack (#4,263)

I can’t wait to see if Meaghan will take a moral stand against 83(b) election.

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