I have to admit: as a self-professed right-brained, creative type, I can occasionally tune out when I hear about topics like company equity. It’s not that I don’t care — I know how important it is — but the truth is, I’m intimidated. When people talk about strike price and valuation, I almost automatically assume I won’t understand — or at least I did at one point in my life.
Luckily, since then, I’ve been able to talk to a handful of people who translate complex financial concepts into terms I can understand. And one of those people is Brad Serwin, Glassdoor’s General Counsel. Besides being our resident legal guru, Serwin is well-versed in company equity, having worked at a variety of companies both private and public over 25 years where he assisted in mergers, acquisitions, and IPOs. Whether you’re completely new to the topic or just need a refresher on Equity 101, check out some of Serwin’s insights below.
The Basics: Equity, Stocks, and Vesting
There are two common types of equity grants made to employees: restricted stock units (RSUs) and stock options. “RSUs promise to give employees a share of a stock,” Serwin says, whereas stock options “promise the employee a chance to buy stock at a fixed price.”
From this definition, it might sound like RSUs are a “better” type of equity grant as it’s more of a sure thing, but it’s not quite that simple.
“When a company’s value is more volatile — that is, it could go up or down by a lot — stock options give you a better chance of a big upside. Private company values are more volatile than public company values. Private companies either go public or get sold, or they go out of business. So private companies typically like to give stock options so employees benefit from that volatility — it’s high risk, high reward,” Serwin says. And because of that, “companies will usually give around three times as many stock options to an employee as they will give RSUs.”
Regardless of which type of equity grant a company offers, though, you typically have to first earn it by remaining an employee of the company for a certain period of time, Serwin says. This is called a vesting period. Usually, there’s an initial employment period before anything accrues (or vests) at all, but after that, it typically vests monthly until you’ve earned the full amount that was promised to you.
To Exercise, or Not to Exercise?
If your company has issued you stock options, you have the ability to exercise (or purchase) them once you’ve vested. The question is: Should you?
“Every company and every employee’s situation is different, so there’s no one right answer,” Serwin says. However, there are certain instances in which you are more or less likely to benefit from it.
Reasons why you might want to exercise your stock options include that you believe your company will continue to increase in value, you believe your company is approaching a liquidity event (going public or being sold), and you can afford to do so — because exercising your stock options means you’ll a) have to pay the exercise price to your company and b) possibly pay taxes on your investment.
Conversely, if you don’t have the cash on hand to pay the exercise price and any associated taxes, or you’re not fully optimistic about your company’s financial future, you may not want to exercise your options for the time being.
“It’s important to remember that as long as you’re staying at your job, you continue to have the right to exercise when you want to — an option has value all by itself,” Serwin advises. “A stock option is just that — an option. It’s a choice.”
The Post-Exercise Process
So what happens if you decide to take that leap of faith and exercise your options?
“Once you exercise, you are a stockholder, and you have the same rights as any other common stockholder, such as the rights to vote for who becomes a director, get dividends if your company pays dividends,” and eventually, sell your stock, Serwin says.
But while “some companies will let their stockholders sell their stock before they go public if they can find a buyer either privately or through a private company stock brokerage firm, some companies don’t let their stockholders sell at all before they go public”, Serwin points out.
And remember also that, “most pre-IPO companies require all stockholders to agree not to sell stock for a period of time after the company goes public in order to make the public offering smoother — usually six months,” Serwin shares.
Once your company goes public, you can choose to exercise your stock options and sell the stock you receive, or you can continue to hold onto your shares in the hopes that they’ll increase in value over time.
Don’t Forget Taxes
It may not be the most glamorous part of equity, but taxes are important to keep in mind when you think about exercising your options.
“Gains from options are either taxed just like wages, or like capital gains taxes from buying and selling stock on a public stock market, but there are always taxes. The tax code gives preferential tax treatment to employees for “incentive stock options” if the employees follow certain rules,” Serwin says. “The rules to follow to get favorable tax treatment require an employee to hold their stock for at least a year after they buy it, and at least two years after the option was granted to them — and those periods can run simultaneously.”
“But employees need to know there’s a separate kind of tax called the AMT [alternative minimum tax] that frequently takes away the special option tax treatment. So anyone thinking about exercising a lot of options should talk to an accountant/tax advisor to understand what will happen if they exercise,” Serwin recommends.
Hopefully this brief introduction proved useful, but remember — it just scratches the surface of the topic of equity and how to make the most of it. If you want to learn more, consider doing some additional research online, talking to your HR and benefits team, or even setting up a meeting with a financial advisor. With a little bit of self-advocacy and knowledge gathering, you’ll set yourself up for success.