EquityZen Knowledge Center

EquityZen has curated this list of quality resources for secondary investors, shareholders and company representatives.
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Not So Obvious: Here's What To Know Between NSO and ISO Stock Options

EquityEmployeeStock Option

Nat Disston   May 18, 2017

The world of startup stock options can be pretty opaque. To outsiders, its seems all one does is join a small company, and, if it works, everyone becomes millionaires. For new employees, they often don’t know what they don’t know and are faced with piles of new documents and more questions once they join their budding business. Core to our mission is to help educate employees, companies, and their founders about their stock options and what they can do with their resulting shares.

We’ve had the good fortune of an engaged community of readers and this post is a direct response to a reader request. If you have anything you’d like to see discussed on these pages, please let us know! Here, we dive into a common point of confusion around ISOs (Incentive Stock Options) and NSOs (Non-Qualified Stock Options). But first…

What the heck is a stock option?

A stock option is a right to purchase a share of stock at a specific price within a specified period. Stock options are often used as long term incentive compensation for management and employees at high-growth companies. Once an employee exercises (buys) their stock options, they become stock in the underlying company. More on that here.

So back to the ISOs and NSOs. What drives the main point of confusion? You may have heard some discussion at the watercooler/ping-pong table that “ISOs have better tax treatment.” But with the labyrinthine American tax code, let’s circle above this topic at a few thousand feet.

Do ISOs really have better tax treatment? Maybe, but it’s not so black and white. ISOs are complicated because they can only be issued to employees (and not to contractors, lawyers, or outside vendors), must be priced at Fair Market Value (FMV, which is the same as a 409A valuation), and there are limits on how they vest and how much can vest in a given year (up to $100K). NSOs can be granted to anyone with no limit on volume or exercise price.

But Nat…which ones do I want???

(Disclaimer: I’m no tax expert and must advise you to speak to an accountant or financial advisor regarding your own situation.) NSOs are straight forward in that you must pay ordinary income tax on any gains at the time of exercise. If the current FMV is now $5 and your exercise price is $1 (FMV at time of grant), you pay ordinary income on the $4 paper gain. Furthermore, this tax event is withheld by your employer and may be tax deductible for them: another win for your employer. ISOs, on the other hand, don’t have any required tax at the time of exercise, which sounds nice but can be misleading. The fact is that exercising ISOs may make you subject to the AMT (Alternative Minimum Tax), which for most startup employees will be the case, and can lead to quite a surprise come tax season. Kind of like a club that has no cover charge at the door, but sells you $20 beers.

Still with me? We’re almost done! Remember: taxes are boring, but your taxes are important.

A commonality between NSOs and ISOs is that you will owe taxes when you exercise either type of options. Once the options are exercised, however, they are perfectly equal – stock in your company. This is important to note for EquityZen’s business, because they are treated the same way on the secondary market.

Conclusion

NSOs and ISOs differ in how they are taxed. And while there may be instances that ISOs have better tax treatment, each case is a little bit different. Fun Fact: a large part of EquityZen’s business is helping employees cover their exercise cost and subsequent tax bill, regardless of whether they’ve exercised ISOs or NSOs.
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Shareholder's Playbook: What to Know About Selling Your Shares

EquityEmployeeSellShareholderLiquidity

Sharmila Achari   February 04, 2016

So you’re working at the pre-IPO company of your dreams….but you need some immediate liquidity. You’ve heard of platforms like EquityZen that help private company shareholders get liquidity for their shares, and you want to understand more about how the process works. Then this is the blog post for you!

It’s All About the Documents, Baby

The first step is understanding the documents related to your shares. For anyone looking to sell their shares, it is very important to understand the rights that the issuing company has with respect to those shares and what steps are necessary before the shares can be officially transferred.

Here is a short list of the most common documents you will encounter as a shareholder and what each document means (a more detailed list can be found here https://equityzen.com/blog/key-equity-documents-to-keep-on-file/): 

Option Documents
  • Stock Option Grant Agreement: This document sets out: (a) the number of options being granted to the employee, (b) the type of options (incentive stock options (ISOs) or non-qualified stock options (NSOs), (c) the exercise price, and (d) the vesting schedule for these options.  
  • Stock Option Plan: This is the governing document that describes the terms and conditions of your grant and is the same for each optionee. This document often contains the restrictions around selling or transferring your shares.
  • Notice of Stock Option Grant: A one page document describing the material terms of the stock option grant (It is not always included). 
Option Exercise and Stock Purchase Documents
  • Notice of Exercise: This document is filled out when you are ready to convert vested stock options into shares of the company (a.k.a. “exercise” the options). This document represents proof that you have exercised a specific number of options and shows the exercise price.
  • Stockholders Agreement: The governing document that contains the terms and conditions for owning shares in the company. Importantly, this document often contains the restrictions around selling/transferring shares in the company. The Stockholders Agreement will often set forth whether the company retains a “right of first refusal” (ROFR), the length of the ROFR period, and any other conditions that must be met before the company will permit the share transfer.
  • Confirmation of Exercise: This document is often provided by the company to a shareholder once the exercise of options is complete and you are now a shareholder. 
  • Stock Certificate/Stock Ledger: This one might seem obvious, but the stock certificate is the document issued by the company that evidences legal ownership of shares. However, since many companies do not issue physical certificates, such companies also maintain an internal stock ledger, which lists the names of all stockholders and the number of shares owned.  

Company Documents
  • By-laws: By-laws set out the day-to-day rules for the company’s organization and governance. By-laws can be important for startup employees because many companies have started including provisions in the by-laws that can materially affect your rights as a shareholder. Such provisions include restrictions on transferring your shares and any requirements that must be met before you can do so.  
Knowledge of the documents involved is an important tool for you when looking to sell your shares. In order for a platform like EquityZen to assist, we will need to: (1) establish that you legally own your shares and (2) understand what restrictions are imposed by the company before you can sell those shares.  Understanding the distinctions and information in the documents above can allow you to more effectively provide us with the information that we need and help get your shares sold faster.

Who You Gonna Call? 

Now that you have all your paperwork in order, the question becomes who can help you find a buyer and guide you through the share transfer process. In recent years, several platforms (including EquityZen) have arisen to meet the needs of startup employees in need of liquidity.  There are a variety of options out there from traditional brokerages to platforms like EquityZen. When considering selling your shares, it is important that the firm conducts share transfers in a manner that complies with the company’s stated policies as well as applicable securities laws. Platforms may also differ based on their minimum transaction size, the fees involved, as well as the level of service and professionalism offered. 

What are the Transfer Restrictions?

One of the key questions that we help you figure out is: “What needs to happen before I can sell my shares?” By reviewing your option and share ownership paperwork, we can guide you through the steps involved in the share transfer process and manage your expectations around timing of the sale.  Here are some common transfer restrictions that may be applicable to your sale:

  • Right of First Refusal (ROFR): Most private companies retain a “right of first refusal” (ROFR) over shares, which means that if a shareholder seeks to sell shares to a third-party, the company has the right to buy those shares back from the seller at the same price and terms that the seller offered to the third-party. Typically, when a seller submits a Transfer Notice stating their intent to sell a certain number of shares, this starts the ROFR Period, during which the company can decide whether or not it wants to buy back the shares. Typically the ROFR period will last between 30-60 days. If the company does not respond to the request within the ROFR period, or if it states that it will “waive the ROFR,” then you can proceed with your sale. Alternatively, if the company decides to “exercise the ROFR” and buy the shares back from you, then you still get your money. It’s a win-win!
  • Board Approval: In addition to a ROFR, some companies require approval from the Board of Directors before they will permit you to sell your shares to a third-party.  This restriction is usually contained in the By-laws or the Stockholders Agreement, if it is required by your company. Transfers requiring Board approval will often take a longer to complete because Board of Directors meetings only occur once a month or once a quarter. 
  • Legal Opinion: Some companies will also require you to provide an independent legal opinion stating that the sale of your shares will not violate any state or federal securities laws. If you don’t have an attorney you trust, a secondary marketplace can usually provide you a referral to an attorney who can provide this opinion for you. 
  • Transfer Fee: Some companies may require you to pay a transfer fee at the time that you sell your shares. This requirement is usually contained in the By-laws or Stockholders Agreement. 

So…What Will this Cost Me?

The total cost to complete a share transfer will depend on: (1) your company’s restrictions and (2) which secondary marketplace you use to complete the transaction. Typically, the secondary marketplace will not charge you to review your documents or list your shares for sale. If you complete a transaction through the marketplace, then the marketplace will charge you a fee based on a percentage of your sale price (usually 5%-10%). Additional costs may be incurred on account of a transfer fee charged by the company (typically between $1,000-$5,000) and a lawyer fee to prepare a legal opinion (typically between $1,000-$2,000).  

To Sum it All Up

While selling private shares is more complicated than selling publicly-traded shares, it is by no means impossible. Understanding the rights and restrictions attached to your private shares will help you considerably in determining whether you can sell your shares and what price you can command. In addition, partnering with the right secondary marketplace can be an invaluable resource in securing company approval and making the share transfer process as smooth and hassle-free as possible. 
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Revisiting the Vesting Schedule

EquityVestingOptionsCompensationEmployee

Nat Disston   July 17, 2015

Silicon Valley gave birth to (among many other things) the practice of granting employees equity as part of their compensation package. This practice began nearly fifty years ago with the spawn of companies like Hewlett-Packard. However, the terms of earning your equity over time have remained largely unchanged. Today we want to revisit the nearly universal “4 year vest with a 1 year cliff.” This common vesting schedule means that you earn your equity grant evenly over 4 years, except none of it is yours until you’ve passed your one year mark.

A lot has changed in Silicon Valley and beyond over the years. Let’s take a look at why this vesting schedule exists, what’s changed, and how it has been impacted.

Then

According to the National Venture Capital Association, the median time to IPO was 3.1 years in 2000. Employees were granted equity that would vest until the company would go public, or even beyond that date – 4 years from when the employee started. Employees’ incentives and timeline were tied to that of the company. There were no (or perhaps very limited) issues of employees struggling to afford their exercise or pay AMT taxes. Publicly traded stocks make a cashless exercise a no-brainer and lower valuations while companies were still private kept exercise costs within reason. This vesting schedule seemed to work pretty well.

Now

Venture backed companies are now waiting longer to go public. That median time to IPO of 3.1 years swelled to 7.5 years by 2013. A longer discussion on why that is the case here, but the data says a lot. Not only does the 4-year vesting schedule not line up with the time to exit but other problems have been created in the process:

- Companies now must give additional grants to retain employees after their initial 4 years are up. This can cause attrition if not handled properly.
- Equity vests over 4 years, but the options expire within just 90 days of leaving the company.
- As companies stay private longer, their valuations balloon in the private markets (ahem, Uber is worth $50 Billion?)
- The strike price on grants continues to increase as the private market valuation increases. In many late stage companies, employees simply can’t afford to exercise all of their options, let alone pay the subsequent tax bill.

So what should we do?

Firstly, companies' and employees' incentives need to be aligned. Employees are awarded equity as compensation so that they may work hard to build that into something meaningful. A four-year horizon doesn’t quite line up with that anymore. Company’s can offer new grants, but the employee who took a risk joining a smaller company 4 years ago is forced to pay significantly higher price to own those new options. Or by the time they receive a new grant they may be considering other paths. Some thoughts to consider: Should the vesting schedule be lengthened? Should one vest relative to how early on they joined? Should they be able to lock in a lower exercise price at the beginning?

Secondly, with private company valuations soaring as they stay private longer, many employees can’t afford the cost to exercise their options or pay their AMT Tax bill. This has forced many employees to leave their options on the table if they move to another company. Options they were given to reward and in exchange for their hard work. Things to consider: Should employees have the right to a cashless exercise? Should the expiration window be extended well beyond the current 90-day mark (such as Pinterest has done)? Should Options be worthless until they are sold and given value?

Companies are staying private much longer and are worth much more while private. More and more people are leaving high paying professions to help build small companies. I think we’ll start to see new alternatives as companies and employees navigate this changing landscape. There isn't yet one standard solution. What does need to be maintained on either side of the equation is:

1) Employee incentives should be tied to those of the company
2) Employees have the right to access the equity--and its underlying value--they are rewarded

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A few interesting opinions on the subject:
- Sam Altman of Y Combinator offers up some interesting ideas to this in his blog on Employee Equity. Among them are forward dating grants to obtain lower strike prices and weighting grants to vest more the longer you stay.
- Wealthfront takes a more conservative approach, opting to stick to the 4 year vest and 1 year cliff. More on their thoughts here and here.
- A VCs view to keep it simple and adapt the old model to today by lengthening the vesting period.
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