The Beginner’s Guide Part 3 – Your ESOP and Why it Matters

When you’re a startup employee, getting stock options can be a major part of your employee compensation. But an employee stock option plan is far more complicated than receiving your salary each month. That’s why we prepared this employee stock options guide to help you along.

If you’re confused by phrases like ‘exercise periods’ and ‘vesting,’ have a look at Employee Stock Options Part 1. Otherwise, keep reading. It’s time to consider some of the employee stock options benefits and pitfalls so that you can make an informed decision about your ESOP.

What is an ESOP?

ESOP stands for Employee Stock Options Plan – sometimes also called Employee Stock Ownership Plan. It’s part of your compensation package. Your ESOP contract covers all the details of your opportunity to acquire shares in your company.

What to think about when you’re offered an ESOP

Here are some of the most important areas to look for in your ESOP:

• Type of options. Are you offered ISOs or NSOs? The difference is important because it affects the amount of tax you might have to pay when you exercise your stock options.
• Exercise period. When you leave your job, you’ll only have a certain amount of time in which to exercise your stock options. Pay careful attention to this, because it would be a shame to miss out on the opportunity to exercise your stock options just because you lost track of the time when you moved jobs.
• Exercise price. The amount that you’ll need to pay for your stock options makes a big difference to the amount you can hope to gain by exercising them. The exercise price, multiplied by the number of stock options in your package, determines your final exercise cost.
• Number of stock options. The number of stock options you are granted represents the percentage of company shares that you will own after you exercise them.
• Vesting period. This is the amount of time you’ll have to wait until your stock options are ‘vested,’ meaning that you can exercise your options to buy shares. Your options might vest gradually over a few years, or there could be a vesting ‘cliff’ where 100% of your options all vest at the same time. If you’re only intending to stay in this company for a few years, it’s important to check how many options will vest by the time you’re ready to leave.
• Preferred shares. Major investors and executives have ‘preferred shares,’ which mean that they get paid first when the company exits, and/or gives them a higher guaranteed return on their investment. If there are too many preferred shares already issued, there might not be enough left after exit to cover your initial investment. To read more about preferred shares, see our blog post ‘What is a liquidation preference?’.

Employee stock options benefits

If you have an ESOP, at some point you’ll need to decide whether or not to exercise those options. The sooner you begin to think about the benefits and pitfalls of your ESOP, the better informed you’ll be when it’s time to make a decision.

You could become a millionaire

Let’s begin with the positive. When receiving your employee stock options, your hope is that your company will grow, and its value will increase. If your company has a good outlook, you’d be well advised to exercise your stock options to get in on the ground floor, and then enjoy the income as the share price rises. Over time, the amount that you’ll make from your employee stock options could add up to far more than a year’s base salary. This was how many employees at startups like Waze, Facebook, and many more became bona fide millionaires.

You could build a rewarding investment portfolio

Even if your company doesn’t turn out to be a unicorn or make you an overnight millionaire, the stock options you get as a startup employee could still turn into a sizable savings cushion. Continuing our imaginary startup called FuzzyBear Inc., consider this scenario:

• In 2017, you exercised your employee stock options to purchase 20,000 shares in FuzzyBear Inc., at $2.00 per share.
• Two years after you invested, FuzzyBear Inc. is acquired by the much larger consortium of HeavyBears Inc. and common share prices doubled.
• As a result, you now own shares worth $80,000.

You might find that FuzzyBear’s stock continues to grow in value over the next few years, giving you sizable dividends every year, as well as a nice nest egg when you choose to sell your stock. Alternatively, you might decide to sell off most of your FuzzyBear shares at this point, and reinvest them in a range of different stocks to diversify your portfolio.

Employee stock options pitfalls

Now let’s turn to consider the employee stock option pitfalls. They aren’t as pleasant to consider, but they can’t be ignored.

First of all, stock options are not as liquid as cash. You’ll usually need to wait for your options to vest before you can exercise them, acquire your shares, and then exchange them into cash upon a liquidity event.

You could lose money

There’s a chance that the company share price will drop instead of rise. For example:

• In 2017, you exercised your employee stock options to purchase 20,000 shares in FuzzyBear Inc., at $2.00 per share.
• Two years later, FuzzyBear Inc. is acquired by the much larger consortium of HeavyBears Inc. and common share prices doubled, so that you now own $80,000 worth of shares. You hang on to them, hoping that the market will carry on rising.
• You don’t expect a sudden recession, which causes the value of your shares to drop to just $1 per share. Your shares are only worth $20,000.
• You decide to hold on to them, hoping that the market will rally and that the share price will rise again. Unfortunately, 6 months later your company declares bankruptcy. You get back only $0.20 for every share, losing all the value you gained as well as your acquisition cost.

It’s not a scenario anyone wants to consider, but the sad truth is that 90% of startups fail.

You might not have enough money to exercise your options

Don’t forget that you have to pay the exercise price when you exercise your options. Depending on your income tax bracket and the type of options you’ve been awarded, you might also have to pay a significant amount in income tax and capital gains tax. If you don’t have the funds available to cover this cost, you might need assistance to fund it. That’s where EquityBee can help.

Your equity could be diluted

If FuzzyBear issues 1 million shares, and you acquire 20,000 of them, then you should own 2% of the company and get 2% of the profits when it exits. But if the company issues another 1 million shares a year later, you’ll only get 1% of the shares. It’s important to think about how many more shares your company might issue in the future, and how much your equity could be worth.

Moving forward

Ultimately, whether your ESOP is a blessing or a burden depends on your precise situation. Your life circumstances, the terms of your ESOP, how long you intend to continue working at this company, the company’s expected growth – they all affect the choices you make regarding your stock options. That’s why you need to educate yourself about the terms of your ESOP and make an informed decision for yourself.

All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.

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