When joining or building a company, it is imperative that you understand the laws around equity. As an employee, not understanding how stock options work may leave you with expensive tax bills for worthless stock. As a founder, doling out equity too liberally will leave you with a sliver of the company by the time you exit through an IPO or acquisition.
Stock options 101
Typically, when you get hired at a large firm you are given access to an HR department that explains your 401k package options. You may even receive a workshop to help you learn about the various investment strategies and mutual fund options. This is not always the case when working for a startup.
Perhaps you’ve heard stories about employees who did not understand their options and ended up with a sizable tax bill for stock that was worth a fraction of the intended price. When it comes to stock options, timing and taxation are everything.
When you receive stock options, your shares will vest over a set time schedule. This is called your vesting schedule. The shares that are vested are available to you and those that are not vested are considered restricted shares. The company has the right to buy restricted shares back from you since you didn’t earn them.
At any time you can exercise your options to convert them into shares, yielding a mix of both common shares and restricted shares. Entrepreneurs exercise early to benefit from the small variance between the strike price and the current market price. This is why timing is important. You will be taxed at conversion, so convert when with the lowest possible tax event.
Exercise if you believe the stock will appreciate in value. Be certain to research your company’s industry to understand positioning. Is this company Uber or Sidecar? Facebook or MySpace? Exercising shares of worthless stock will leave you with a net loss. Do your homework to understand the company’s outlook.
Taxation and the IRS
Of course, there is always paperwork. You must understand the proper documents – Section 83 (b) election — that are filed in each event to remain in compliance.
Section 83(b) election is a letter you send to the IRS letting them know you’d like to be taxed on your equity, even shares of restricted stock, on the date the equity was granted to you rather than on the date the equity vests. Failing to file this one document will cause taxation at the vesting date, not the grant date.
Tip: Always consult an attorney when you receive equity or stock options. Your specific taxation will vary based on your country of origin.
Equity as an infinite currency
Another common mistake that founders make is giving away too much equity and to the wrong people. It’s a common misperception that equity is free and limitless. Actually, all shares have value and limits.
When deciding whom to give equity and stock options, ask yourself this question: Is there value creation and duration? In other words, is this person creating value and for a long period of time?
Example: A branding team creates a logo and graphics during a two-week period. This type of service should be paid in cash.
Example: A developer signs on to build your prototype and your future platform. This type of service should be paid in equity.
Whether you’re a founder or early employee, your equity and stock options should be handled with care. Treat them like gold. In some scenarios, they are worth more than gold.
This article was originally published in Entrepreneur.com
Image credit: encrop.net