Tech Stock Compensation Guide: Part 1
If you’ve ever wondered about the best way to manage tech stock compensation, you’ve come to the right place. In this guide, I will teach you how to get the most out of your ISOs, RSUs, ESPP or whatever acronym lines your bank account.
I’ve personally been compensated with almost every flavor of stock options during my 15 years in the industry. At my first company, we “paid” ourselves shares in a privately-held Ohio LLC. At my second startup, I created an ISO compensation plan for employees. These days, I receive restricted stock units from Google. So, let’s dive in and figure out how best to manage your tech stock compensation.
For those that don’t have time to read a 4,000+ word blog series on the topic, here’s the TLDR:
- Read the fine print in your stock plan carefully.
- In most cases, it makes sense to sell ISOs, RSUs, ESPP shares, and other more exotic company shares as soon as they vest at the prevailing market price.
A Stock Compensation Primer
In the tech industry, offering stock as part of an employee’s total compensation is very common. But not all stock is created equal. Below, I’ve outlined 4 broad categories of stock that you could receive as an employee.
Incentive Stock Options (ISOs)
Most startups give their employees shares in the company, but they do so using incentive stock options, or ISOs. An ISO isn’t technically stock in the company, but the right to purchase stock at a reduced price. Here’s how it works:
- You join a hot new startup right after they raised their series-A round. Series A rounds are typically a “priced round.” That means that a bunch of grown ups analyzed the company and agreed on a share price.
- The startup gives you an ISO grant when you start your employment.
- If all goes well, the company will grow and the share price will increase. At some point, the company will get acquired or go public, both of which are referred to as “liquidity events.”
- A liquidity event is one way to trigger the right to purchase your shares in the company. Let’s say that you were hired when the stock was worth $10. The company IPOs at $100 per share. In this example, your “compensation” would be the difference between those two prices, or $90 per share.
You cannot sell your ISOs if the startup never gets acquired or goes public. Even if you could, they probably aren’t worth anything.
There are also real complications (tax and otherwise) to exercising your ISOs, so read on to learn more about that.
Restricted Stock Units (RSUs)
Public companies tend to issue stock as restricted stock units, or RSUs. You can sell RSUs as soon as they vest because there is a market for the shares: the stock market.
RSUs are also great because vesting schedules tend to be pretty short. As a result, the tax implications are straight-forward. Most of the time, you can treat RSUs as nothing more than a more complicated cash payment for your labor. You have to log into a brokerage and click “sell” on a regular basis, but it’s basically just cash.
Employee Stock Purchase Plans (ESPPs)
Companies offer employee stock purchase plans (ESPPs) as a way for employees to share in the company’s market success. Most plans give employees a discount on the share price and set an upper limit on the number of shares an employee can purchase.
Salesforce used to permit full-time employees to buy up to $10,000 of Salesforce stock every year at a 10% discount. It was more risky than cash (after all, the stock price could go up or down at any time), but if it remained flat, minus brokerage transaction fees, you could expect to earn ~$1,000 for clicking a couple of buttons. I’m happy to earn $2,000/hr to spend 30 minutes clicking a few buttons.
Of course, ESPPs can be much more or less lucrative. Companies have wide discretion to implement their plans as they see fit. Your plan might be worth a lot more or a lot less than $1,000 per year.
Other Forms of Tech Stock Compensation
Tech stock compensation is chock full of acronyms. ISOs, RSUs, and ESPPs oh my! But companies have invented still more way to distribute shares. They range from the simple (issuing founder shares in a new tech company) to the complex (executive golden parachute plans).
This series will mostly focus on ISOs and RSUs, but I do include a very quick primer on these other tech stock compensation types at the end of part 2.
You just joined a startup and your hiring manager told you that you are now the proud owner of $1M worth of company ISOs. Holy cow, Batman, you’re a millionaire! Let’s dive into how I would manage this asset.
Understanding ISO Vesting
Just because you don’t actually own the stock, doesn’t mean you aren’t still subject to stock vesting. Most companies issue their ISO stock plans over 4 years with a 1 year cliff. You are given the opportunity to buy the stock in batches over 4 years, but the first share is only issued after 1 year of employment.
ISO grants are denominated in shares, not dollars, based upon the share price at the most recent valuation. Here’s how a $1M ISO stock award vests:
If your vesting schedule is monthly or quarterly, you’ll get the option to exercise your shares earlier, but at the end of 4 years, you’ll still have 50,000 shares.
ISO Strike Prices
In the above example, we assumed a price per share of $20. That’s the strike price. If, after 4 years, the price per share rises to $40, you stand to gain $1M. If the price goes down, you don’t lose any money, but that $1M in stock becomes worth exactly $0. People often refer to this situation as your shares being “underwater.”
One final point about strike prices: although it may make you feel great to have a $1M ISO plan, remember that you have to actually spend your hard-earned post-tax dollars to buy the shares. If you don’t think you’ll have $1M of liquid assets (very few people do), then to some extent, it doesn’t matter whether you have $1M worth of ISOs or not – you could never afford to exercise them in the first place!
For that reason, it might be hard on your ego, but you should alway strictly prefer to have an ISO plan that you can easily afford to exercise. Whether that means having fewer shares or a lower strike price, you want to make sure you can actually realize the gains if you get lucky.
Watch Out for Short PTEPs
Carefully read your ISO agreement for the post-termination exercise period (PTEP). Industry practice is to give employees 90 days from the date of termination to exercise their ISO shares. As a two-time cofounder, I think 90 days is predatory, and at CodeCombat, we extended the PTEP to 1 year. Some companies let employees buy shares at any time after leaving. This is an infinite PTEP.
Let’s say that you decide to leave a startup after having worked there for 3 years to get a graduate degree. If your ISO plan is the typical 4/1, you will have vested 75% of your ISOs. That’s a lot of potential value for you.
Even if you have a standard-length PTEP, things are about to get hectic. You will only have 3 months to manage your life transition, figure out the paperwork, and find the capital to buy the shares. And you will have to do all this while also moving your life, getting registered for coursework, complete pre-reqs, and starting courses.
Most startup employees don’t even know if the company will ever have a liquidity event. If you buy the shares and the company goes bust (like most startups do), there’s no refund policy. Your money just disappears.
For this reason, I always encourage new startup employees to read the fine print of their ISO offer carefully. A 90-day PTEP may be acceptable for you, but just go in with your eyes open.
Potential ISO Tax Problems
Remember that with ISOs, you have to actually buy the shares from the company at the established strike price before you can sell them. If you’ve held your ISOs for at least 2 years, you can record that income as long-term capital gains. So far, so good.
But, if you don’t maintain a large cash cushion and don’t know a lot about the US tax code, you could find yourself in a world of hurt due to under-reported income. Here’s how that could happen:
Let’s say you regularly earn $100,000 a year working at a silicon valley startup. The company gave you a $250,000 ISO compensation plan when you joined the company. Four years after joining, the company goes public, and the share price doubles. You now own $500,000 of the company’s stock.
Even if you’re a top 1% wealthy American, it’s unlikely that you have $500,000 lying around in a savings account. So, you borrow the necessary funds to buy all $500,000 of the shares, quickly sell them and repay the loan.
You will have a realized, long-term capital gain of $250,000 for the year. That means your taxable income for the year will be $350,000, but you have only withheld taxes for a $100,000 / year income. Uh oh.
Even though your ISO gains will be taxed as long term capital gains at 25%, you’ll still owe $62,500 to the IRS above and beyond your ordinary taxes. And here’s the clincher: the brokerage that you use to transact the sale probably won’t know that. They will sell your shares and deposit the $500,000 into your bank account and let you figure out the tax implications.
If you don’t adequately prepare, you could have a very unpleasant tax season.
The OverthingMoney Approach to Managing ISO Tech Stock Compensation
I have 4 simple rules for managing ISO tech stock compensation:
- Negotiate the terms.
- Round to $0.
- Figure out liquidity.
- Exercise immediately.
Negotiate the Terms
Everyone from solo founders to 1,000 person Series-F companies issue ISO compensation plans. As companies become more established, your negotiating leverage falls dramatically. Here’s how I would illustrate the relationship between company size and your negotiating leverage:
If you work for a small company, you have negotiating leverage. ISO plans are complex, but to keep things simple, I would focus on the following variables:
More money is always better, and many early-stage companies haven’t figured out their leveling and stock plan particulars. So it’s always worth asking to increase the total size of the offer. Remember that it’s very cheap for founders to grant this request. Some founders actually see this as positive signal from employees since it indicates you want to bet big on the success of the company.
Vesting schedules tend to be more flexible than grant sizes, strike prices, and PTEP. You could, for instance, ask for a 3 or 6 month vesting cliff (the date on which you can first exercise the shares) if you think the company is particularly risky or a liquidity event is coming up.
You could also ask to weight the ISO vesting schedule up: basically get more of the shares sooner. Google does this with their RSUs, so there is industry precedent to do it.
Above, I used the example of joining a Series A company that went through a priced round. In that case, you almost certainly can’t negotiate the strike price. The price is the price. But most pre-seed and seed companies, as well as a select few Series A companies, haven’t yet gone through a priced round.
Unless you are the first employee, the company will have a sense of their share’s value, but before a formal valuation, the strike price is literally whatever they want it to be. Just be firm, polite, and ask if the company has already completed a 409A valuation. The hiring manager doesn’t have to tell you, but most will.
If there is no 409A, you can probably negotiate the strike price. Don’t be shy! Most founders price their shares at insanely low amounts like $.000001 to keep the exercise costs low. You can’t get a founder-sized discount, but there’s definitely wiggle room.
If your plan has a 90-day PTEP, ask for a longer period. You can start by proposing to eliminate the time period and making it infinite, but be willing to compromise. Even 1 year is a huge improvement over 90 days.
Negotiating is uncomfortable, and is fraught with all sorts of sexist double-standards for women, but I think it’s a valuable skill to cultivate. Even if you fail, you will gain experience at a very valuable skill.
Round to $0
From a risk-adjusted perspective, almost all startup equity is worth $0. That impressive offer letter is probably worth about as much as the sheet of paper it’s printed on.
I always encourage people thinking about working for a startup to completely ignore the value of their ISOs in their financial planning.
Let me repeat that again: your ISOs are probably worth nothing. You should never rely on ISOs for anything financially important like a home down payment. And never, under any circumstances assume that you’ll be able to access the value in the ISOs for normal expenses like your rent or groceries.
Figure Out Liquidity
Even if you get lucky and your ISOs turn out to be worth millions, it will probably cost you a sizable fraction of that total to exercise the shares. If you cannot figure out a way to get access to that kind of cash on relatively short notice and on reasonable terms, then you will never be able to actually benefit from the shares in the first place.
Normally, ISOs are priced to be reasonable. Hopefully, you only have to come up with, say, $50,000 to fully exercise your options, but make sure up front.
As a last-ditch option, you always sell some of the shares, use the profit from the sale to buy more shares, and keep doing that until you’ve exercised all of your options. If you decide that this will be how you exercise, keep in mind that most personal brokerage accounts execute trades and make funds available very slowly. It can take a couple of days to execute the trade, another couple of days for the funds to become available in your brokerage account, and another couple of days for the money to transfer from your brokerage to your bank.
With round trips into and out of your brokerage account measured in weeks, you will want to ensure you can at least afford to exercise a sizable fraction of your shares at once. If you can only afford to exercise 5% of the shares up front, it could potentially take months and lots of clicking to fully exercise. In that time, prices could change dramatically.
Finally, if you get lucky and your ISOs become worth something, exercise as quickly as you can. Don’t look at the price, just hold your breath, set a day order in your brokerage (a sell order that ignores the market price), and get your money.
Why not wait or try to time it? Two reasons: I think people should seek diversification and avoid active investing.
If you have ISOs that are worth a bunch of money, you’re already long on an asset that is very risky. Let’s assume you have a net worth of $1M and your ISOs are worth $250k. That means 25% of your entire net worth is tied up in startup stock. That’s crazy risky.
If you owned $250k worth of another highly speculative asset, say Dogecoin, and your net worth was $1M, would you hold it? Most people would reduce their exposure to that level of risk and I think that’s very prudent.
Avoid Active Investing
It’s tempting to think that you know a lot about the future performance of the company’s stock price, but it’s very risky.
If you are still an employee, you can’t trade your company’s stock if you have material information about the future performance of the stock price. That’s insider trading, and its illegal.
If you aren’t still working at the company, the minimum criteria to believe you can beat the market is to have a non-insider information advantage as well as a well-researched hypothesis about how you can be right twice. Those are pretty lofty criteria, so proceed with caution.
For most people, I think the obvious thing to do is sell your shares as quickly as you can and then reinvest the profits in a diversified asset like an index or mutual fund. If that is too painful to contemplate, at least reduce your risk by selling a sizable portion of your shares and then play with an amount of money that is small relative to the size of your portfolio.
In the above example, maybe you sell $200k of the $250k and allow yourself to play with the remaining $50k. Even if you do a terrible job and lose all $50k, that would only be 5% of your $1M portfolio. You can easily recover that loss and it wouldn’t impact your lifestyle. Losing 25%, on the other hand, would affect at least your medium-term financial planning and potentially your day-to-day lifestyle.
In part two, I cover how you should manage RSUs, ESPPs, and other more long-tail tech stock compensation. So for you bigco employees, stay tuned and happy overthinking!
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