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A Guide to Private Company Equity Compensation

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Technology company start-ups or private companies oftentimes use potentially extremely valuable equity compensation as a way to attract a talented workforce away from their “less risky” larger public company counterparts. If you’re considering a job offer or currently work for a private company that provides Incentive Stock options or Restricted stock/stock units as part of their overall compensation package, read on to ensure you’re maximizing your financial decisions around them!


Overview of Incentive Stock Options (ISO’s)

 

ISO’s are primarily offered by private companies today and typically provide “the right to purchase shares of the company at a set price” within a 10 year period from the date they are granted. Essentially, the grant of ISO’s will outline 1) how many shares the employee has the right to purchase 2) the purchase/exercise price of those shares 3) how often the shares vest (meaning when you can purchase the shares) 4) the expiry date of unpurchased/exercised shares, which is typically 120 months or 10 years from the grant date. 

All these pieces of information are critical in making decisions around your ISO’s and when to exercise. The first step to inquire with your company’s CFO or whoever oversees the equity plan, as to whether the plan allows “early exercises”. Early exercises are the ability to purchase/exercise shares PRIOR to their vesting date. Essentially, allowing you to purchase them all upfront. If this is an option within your company’s equity plan, it can potentially save a great deal on taxes, in the long run, assuming the company’s value grows over time and there is an eventual liquidity event. If an early exercise is used, keep in mind, that the vesting dates will still impact your ownership over the underlying shares of company stock. Typically, if you were to leave the company prior to all the early exercised shares vesting, the company will repurchase the unvested shares from you. The other imperative piece to early exercised shares is that you MUST file an 83(b) election with the IRS within 30 days of the early exercise. This will ensure that the shares are taxed accordingly in the future and failure to do so could result in significantly greater tax liability. 

Whether or not you decide to early exercise shares, another key component to inquire about with your equity team prior to any exercise of ISO’s is what the most recent 409(a) valuation or fair market value of the company’s shares are. The valuation of the shares at the time of exercise is what helps determine whether there will be any tax consequences for you in the year of exercise. For example, let’s say your ISOs have an exercise price of $1 per share and you have 10,000 shares ready to exercise. The current fair market value of the company’s shares has risen to $5. If you were to exercise the full 10,000 shares it would cost you $10,000 (10,000 shares x $1 per share exercise price) and the potential AMT tax liability exposure would be $40,000 ($50,000 fair market value – $10,000 exercise price). This is often referred to as the bargain element. As you can see, the large the gap between the exercise price and the current fair market value at the time of exercise, the larger the potential tax liability, whence why the early exercise option can be so powerful for a fast-growing, valuable private company. 

 

Overview of Restricted Stock Units (RSU’s) and Restricted Stock

 

It’s not uncommon for “mature” private companies to switch from offering ISOs to RSU’s the closer they approach a potential liquidity event such as an IPO or acquisition. RSU’s and restricted stock are much more straightforward than ISO’s and don’t require as in-depth tax planning. Generally, RSU’s will be granted to an employee with 1) the number of shares and 2) vesting period. As the RSU’s vest, they become “restricted stock”, since they can’t be sold until a liquidity event. They will also not trigger any tax consequences UNTIL said liquidity event. For example, if you’ve got 10,000 shares of RSUs that have vested while working at the private company and they’ve just IPO’d, the vested RSUs will automatically be reported as income on your paystub. If the value per share was $10 at the time of IPO, that’s an additional $100,000 in income that will be reported for tax purposes. Generally, the company will allow you to sell/withhold shares to satisfy that tax liability. 

An 83(b) election may also come in handy if allowed with your particular equity compensation plan. It can allow employees to pay the tax upfront on the value of the restricted stock using today’s valuation. The primary risk is you’ll pay taxes before recognizing any liquidity in the shares and if you were to leave prior to the full vest of the shares, you paid taxes on an asset that you’re forfeiting. The main benefit being you’ll potentially pay significantly less in taxes should the valuation of your shares increase prior to and at IPO (remember you pay the taxes on the value of the restricted stock at the time of the IPO or liquidity event).

The other potential pitfall (albeit a net positive for most people) is if you’ve accumulated thousands of shares of restricted stock and your company has an extremely successful IPO, they may not withhold enough taxes on the value of your shares and other income for the year, leading to large, unforeseen tax liability when you file taxes. It’s important to run a tax withholding projection in the year the IPO occurs to ensure you’re not caught off guard by a potentially large tax bill. Especially, if the lock-up period overlaps tax filing time, in which case, you’re unable to actually sell the shares yet but you’re required to pay any additional tax liability. 

 

The Bottom Line

 

Equity compensation, especially at private companies, can be extremely valuable, yet also very complicated. Every equity compensation plan is unique with its own wrinkles. This guide is meant to provide a general overview, however, keep in mind your plan may work differently. It’s always important to consult a financial planner or tax advisor prior to exercising any stock options or utilizing unique strategies such as the 83(b) election if there’s any uncertainty as to what the implications will be. 

We’ve helped many clients work through private/public company equity compensation, and enjoy learning the nuances of each particular plan. If you’re looking for an advisor that specializes in equity compensation, schedule a free consultation today!

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Levi Sanchez, CFP®, CPWA®, BFA™
Levi Sanchez, CFP®, CPWA®, BFA™
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, CERTIFIED PRIVATE WEALTH ADVISOR®, BEHAVIORAL FINANCIAL ADVISOR™ designee and Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. Levi’s been quoted in the New York Times, Business Insider, Forbes, and is a frequent contributor to Investopedia. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!

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