FAQs
Why Most Tech Employees Have Concentration Risk (and How/Why to Diversify)
As a tech professional, it's almost a guarantee that you have too much investment exposure to your company according to modern financial theory. Here's why:
You have explicit ownership via vested stock options or RSUs (or stock, if you purchased your options)
You also have a lot of implicit ownership via your unvested stock options or RSUs. Most individuals are not planning to leave their job in the next few months (or likely years), then while this may be taxed different, the value of your unvested equity comp is 100% tied to the company stock value. Most individuals don't factor in this "ownership", but your definitely should
Outside of stock/equity ownership, your company is also your employer and pays your salary (e.g. if the company were to struggle financially, that frequently both (i) negatively impacts the stock price, as well as (ii) increases employment risk (via an increase in risk of being laid off)
Holistically, the combination of 1, 2, and 3 above result in a high amount of concentration risk for most tech workers. That doesn't mean you absolutely should be selling, but it's very important that you consider all three of the items above when you think about your overall exposure to your company.
As you consider, if you want/need help developing your selling plan, make sure to read: Divestment/Sale Planning
How Are the Number of Shares in an RSU Grant Determined for a Publicly Traded Company?
RSU grants specify a number of shares you will vest into over time (e.g. 100,000 shares over 4 years). That said, most companies target a dollar amount when issuing a new RSU grants (e.g. $400,000 vesting over 4 years). To bridge the two, what happens is (1) The company targets a dollar amount for the grant; and (2) they use the "current market price" to determine how many RSU shares that will be, and then (3) they issue the RSU grant with the requisite calculated shares.
What can surprise people however is how the "price" is determined. Rather than being the closing price of a specific date, most companies use the average of the last 20-40 trading days. Their logic being that the trailing average is likely a better representation of a "fair" price vs one given day (especially if its a day where the price changed significantly).
This can work in individuals favor or detriment however in certain circumstances. If the stock price has increased significantly in the last couple of weeks (e.g. 5,6,7,8,9,10,11,12,13,14 as the last 10 days), a trailing average (9.5 in the example above) will give you a stock price materially below the market price (14 in the example above) --> resulting in a larger RSU grant vs. the current market price
And if the opposite has occurred (14,13,12,11,10,9,8,7,6,5 as the last 10 days), a trailing average (9.5 in the example above) will give you a stock price materially above the market price (5 in the example above) --> resulting in a smaller RSU grant vs. the current market price
What is VC Liquidation Preference? And How Can it Impact My Stock-Comp?
Liquidation preference is a benefit of the preferred stock that many VCs get when they invest in a company. There are multiple types, but in general, it specifies that the investor has a right to be paid back (typically their initial investment amount, though it can be higher) before other shareholders receive any distribution proceeds (e.g. from the sale of the company via acquisition).
In certain scenarios, VC liquidation preference can have a large impact on your stock comp. For example, let's assume all of the below funding rounds occurred for SuperCo each with a 1.0x liquidation preference:
Seed: $2m VC investment
Series A: $6m VC investment
Series B: $20m VC investment
Series C: $50m VC investment
Series D: $175m VC investment (valued at $750 million)
Note: Post Series D, 100 million VC preferred shares existed and 100 million common shares (and vested options/RSUs)
Scenario: SuperCo is eventually sold for $250 million.
Let's assume the Series D above occurred in 2021, after which the tech market (public and private) declined notably. SuperCo eventually had a decent exit (albeit down 66% from its prior raise), and was acquired for $250 million in cash. Post Series D, 200 million diluted shares were outstanding (100m VC preferred and 100m common).
Without VC preference, the $250 million may have been divided 50:50 between the VCs and common holders (given they both owned 100 million shares, or half the total). Said another way, each common shareholder may have gotten $1.25 per share ($125m cash divided by 100 million common shares)
With VC preference, the first $253 million of proceeds goes to paying back the VCs. That exceeds the $250 million cash buyout price, so 100% of the proceeds would go to VCs and common shareholders would get nothing
Can You Exercise an Option when FMV is Less Than Strike Price? Should You?
A stock option is considered to be "underwater" when the fair market value (FMV) of the option (the stock price if publicly traded; the 409a price if pre-IPO) is less than the strike price of the option. If a company is not doing well (or if the overall market has repriced, which occurred in 2022), it's not uncommon for stock options granted a few years ago to now be underwater.
To the crux of the question however, if you have an underwater stock option: (1) are you allowed to exercise the options; and (2) if yes, should you?
(1) Are you allowed to exercise the options? Yes, you are allowed to exercise a stock option that is underwater. The stock option grant provides you with the right to purchased a specified number of shares at a specified price. How the FMV of the company's changes after the grant does not change this right.
(2) Should you exercise options that are underwater? Like so many things in stock-based compensation, the answer to this question is "it depends."
If your company is publicly traded, we know of no circumstances where it makes sense to exercise an underwater stock option (as you can just go and buy those shares at a lower price on the public market)
If your company is pre-IPO, in most circumstances it will not make sense to exercise an underwater stock option; but there can be a few circumstances where it does (especially considering that the 409a valuation of a company differs from the VC preferred valuation). For example:
(1) If you're leaving the company and need to exercise your vested options or let them expire, and despite the underwater nature of your options you very strongly believe in the company and believe exercising will be a good investment
(2) If you anticipate a liquidity event in the near future at an attractive price. For example, you have an option with a $1.00 strike price when the 409a value of the company is $0.75 (and the VC preferred value is around $3.00). There is speculation that your company may be acquired for around $5.00 per share. (note: we strongly advise against making investment decisions based on speculation; this example is provided purely for illustrative purposes)
We strongly recommend seeking professional financial and tax advice in this scenario. The tax implications of exercising underwater stock options can be nuanced, and the financial motivations for doing so are rare.
Where Can I Find Out What Vesting Schedule My Grant Has?
The vesting schedule is detailed in/on the formal equity grant document you received. If your company uses one of the popular stock comp tracking tools (e.g. Carta; Shareworks; Pulley), logging into the platform and viewing your grant should allow you to access your vesting schedule
Should I Sell Some of My Vested NSOs to Finance the Purchase of Vested NSOs?
The answer depends on the situation. If your NSO options are not expiring, we almost always recommend against this. If your NSO options are expiring however, this strategy can be considered to balance how much (if any) cash you pay out of pocket.
If your NSOs are not expiring, this likely isnt a good idea
With equity compensation, you have both explicit stock ownership (shares you own), and implicit stock ownership (shares you have economic benefit from due to vested stock options. Taken together, we call this your "holistic exposure."
The reason this "sell some NSOs to buy other NSOs" question is typically asked is individuals are very bullish on the company, and seeking to improve the taxation of future appreciation to be long-term capital gains versus income (for more details see: Exercise NSOs Earlier). In this case however, one would actually end up worse off economically by selling some vested NSOs and using the proceeds to buy other vested NSOs. For example:
ZoomZoomZoom Corp. is currently trading at $50 per share
Anita has 10,000 NSO options with a $5 strike price and is very bullish on the company
Let's assume that the NSOs will not expire for another 5 years, and 2 years from now ZoomZoomZoom increases in value to $100 per share
If Anita did nothing today, her value in 2 years would be:
In two years the pretax value of her NSOs would be $950,000 (10,000 options with $100-$5 = $95 in value per unit)
Assume the applicable tax rate on this would be 39.35% (37% federal + 2.35% Medicare; no social security; no state tax)
In two years the after tax value of her ZoomZoomZoom exposure is $576,175
If Anita sold NSOs today to exercise other NSOs, her value in 2 years would be:
Today, Anita exercises all 10,000 NSOs
Assume the applicable tax rate on this would be 39.35% (37% federal + 2.35% Medicare; no social security; no state tax)
Anita sells 3,935 shares to cover the tax bill today ($177,075), and retains 6,065 shares for long term
In two years the after tax value of her ZoomZoomZoom exposure is $462,153 (6,065 shares, less a 23.8% long-term capital gain and NIIT tax on the $50 gain per share post exercise)
What is an 83(i) Election
An 83(i) election was introduced in 2017 as part of the Tax Cuts and Jobs Act. When requirements are met, an employee at a privately held company with an NSO or RSU may elect to defer federal income tax on the NSO exercise or RSU settlement for up to 5 years.
While attractive in theory, due to the restrictions and limitations it is very rarely utilized in practice. For more details we recommend visiting: Pillsbury Law: IRS Issues 83(i) Guidance
What Is My Pre-IPO Company Stock Worth? There Multiple Answers To This Question
As detailed in 409a Valuations, there are multiple ways a company's value is determined. Beyond the typically discussed VC/Preferred Stock Valuation, and 409a Valuation, there are also potentially Secondary Market Transactions that provide a price datapoint. Ultimately, At the end of the day, it's tricky to determine or know what the value of your Pre-IPO company stock is truly worth. Only when a liquidity event occurs, or is offered, do you have more insight
What Matters? The Number of Shares I'm Granted or the Percent Ownership of the Company
The percentage ownership of a company is what matters. Company's authorize and issue shares for a variety of reasons. A billion dollar company could have 10 shares each valued at $100 million each, 10 billion shares valued at $0.10 each, or an near infinite number of other combinations. The percent of the company that your shares (or equity grants) comprise relative to the fully diluted share count of the company is what allows you to better understand and compare your grant/ownership.
How Does Dilution Work?
The term dilution refers to the ownership percentage of a share of stock in a company declining over time due to the issuance of additional equity/shares in a company.
For example, lets say that GoingPlaces Corp. is raising capital. Before raising new funds, the company has 100,000 shares outstanding; so each share represents a 0.001% ownership in the company. Let's also assume the company has a pre-money valuation of $5 million (i.e. shares are worth $50 each)
If GoingPlaces raises $2 million at the existing valuation of $5 million, 40,000 new shares will need to be issued. After the transaction, the company will have a post-money valuation of $7 million ($5m pre-money valuation + $2m in cash), and have 140,000 shares outstanding with an estimated value of $50 each.
Post transaction, the ownership percentage of each share of stock declined (i.e. dilution). Pre-transaction, 100,000 shares existed and each share represented 0.001% ownership; post-transaction 140,000 shares exist and each share represents 0.000714% ownership. As you can tell by the example, the dollar value of each share did not decline. But due to the issuance of new shares, the percentage ownership of the company each share represents decreased (e.g. was diluted) due to the issuance/"sale" of new shares to the investor.
Note that this scenarios is overly simplistic for illustrative purposes. VC investors frequently invest in preferred shares versus common shares, which have preferential attributes to them and are in nearly all circumstances more valuable than common shares. Additionally, the example does not take into account existing stock option grants, which would effect the overall share count (known as fully diluted share count).
What is a Stock Swap? Should I Consider Doing One if My Company Allows It?
A stock swap allows employees to use company stock they already own to pay for the exercise of stock options in lieu of paying cash (e.g. its simply an alternate way to pay for the exercise of your options). Its most commonly available for publicly traded companies, but may be available in select scenarios for pre-IPO companies as well.
In our experience, the strategy is only applicable to consider in the event that your company (1) does not offer cashless exercise or shares, but (2) does allow for stock swaps. As most publicly traded companies have a cashless exercise plan in place for employees, we've found that the use of stock swaps is rare (because its more complex to implement, and has more complex tax dynamics, than simply using a cashless exercise for a portion of the transaction)
Stock Swap Example
XYZ Corp is currently trading at $50 per share
An employee has 10,000 shares of company stock purchased at $2 per share
They also have 5,000 NSO option with a $20 exercise price
To do a stock swap exercise, they swap 1,000 of their existing shares to "pay" the $100,000 exercise cost of the NSO option (5,000 shares at $20 per share strike price)
The stock swap allowed them to exercise the 5,000 options by paying with shares of stock instead of cash
After the transaction, they have 14,000 shares (10,000 starting shares, less 1,000 swapped shares, plus 5,000 shares via the NSO exercise)
Note: the tax treatment on these 14,000 owned shares is a bit unique:
9,000 shares at $2 per share tax basis (stock they owned and did not swap)
1,000 shares at $2 per share tax basis (swapped stock retains its basis)
4,000 shares at $50 per share tax basis (remaining options exercised in the stock swap after deducting the swapped shares that retain their tax basis)
The individual would also have recognized $150,000 of income on the bargain element of the NSO upon exercise [5,000 options with a $30 bargain element ($50 price less $20 strike)]
Will my Unvested RSUs Receive Dividends (if My Company Pays Them)
It depends (though its uncommon). Unvested RSUs are not stock that you own, and thus are entitled to dividend payments. That said, some companies that offer RSUs and pay dividends have corporate policies that provide cash bonus payments on unvested RSUs to approximate what a dividend payment would have been.
Should I Hire Someone to File My Taxes?
We recommend nearly all of our clients with stock compensation hire an accountant who is familiar with stock based compensation to file their taxes. Stock comp is annoyingly complex, and that carries forward into how they are taxed, and how one files taxes when stock comp transactions occur. We've seen countless individuals file their taxes incorrect due to stock comp (with the error being both "beneficial" and "detrimental").
Issues like double counting ISOs, not correctly calculating AMT tax, not claiming QSBS, incorrectly specifying an ISO disposition as qualified or disqualified, not recouping for past paid AMT, and not adjusting tax basis for stock comp have all occurred in the past tax returns of clients that we have reviewed
To be fair, we've also seen a number of CPAs get the above items incorrect as well. That's why we recommend you find an accountant who specifically has experience with stock comp.
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