when you join a startup, a common piece of the compensation package is equity, which grants you partial ownership the company
knowing that, choosing where to work is very much an investment decision. like not only your time but also money. your startup’s equity becomes a part of your investment portfolio.
the SEC tries to structurally protect people from the increased risk of investing in private securities by requiring you to become an accredited investor. because employees are not required to have this designation to accept equity, there is nothing really protecting them from not understanding the full extent/nuance of how their equity package works
stock options
most startups do not issue outright shares, but rather stock options, which grant you the right to acquire shares of the company, usually at a later date
defining some vocabulary
grant
when a company gives you options, which is the right to buy a set number of shares at a fixed price later
at this point, you do not own any stock in the company & you have not paid anyone any money
the strike price is the agreed upon price that you’ll later be able to buy 1 share of stock. this value is based on the most recent 409A valuation
granting is not a taxable event
vest
your options likely will not be granted to you on day 1 of joining. instead, a more common structure is that the company will disperse your options to you over the course of four years, giving you 25% of your equity each year. if you were granted 100 options, you’d receive 25 of them when you reach a year of being at the company.
vesting is not a taxable event
exercise
the moment when you convert your vested stock options into actual shares of the company.
this IS a taxable event. you pay income tax on the “spread” which is calculated by taking the (fair market value - your strike price)
kinda twisted because now you owe tax on “paper money”. these shares cannot be sold since the company is still private, but you still need to pay uncle sam to obtain them. if the company goes to zero, you still the owe taxes.
sell
when you dispose of the shares for cash
this is also a taxable event. you pay tax on any gains (sale price - cost basis))
long term/short term capital gains tax applies here
you can’t sell whenever you want. sells happen when there is some sort of liquidation event such as an IPO, acquisition, or company permitted tender offer
if you leave a company, you typically have 90 days to exercise vested options or they are given back to the company. this time window is negotiable, but extending the window forces ISOs to convert to NSOs, which have worse tax terms
409A valuation is an independent appraisal of the fair market value of a private company’s common stock. usually startups get one after funding rounds and/or annually. so a low 409A is good for employees who want to exercise options since taxable spread will be smaller
to get around the ‘i can’t afford to exercise’ or ‘i’d owe tax on illquid stock’ problem of stock options, you can shift the downside risk onto a lender by taking out a non-recourse loan. that is, you take out a loan to pay the strike price + taxes and use the shares themselves as collateral. if the stock goes to zero, the bank holds them & you are not personally on the hook for the loan.