‍Private Company Stock Options: How Stock Options Work in Pre-IPO Companies

Casey Fenton

|

November 1, 2023

Remember when Airbnb went public in December 2020? The home-sharing giant's IPO turned many early employees into millionaires overnight, showcasing the transformative power of stock options. 

If you're steering the helm of a private company with aspirations to follow in such illustrious footsteps, understanding the intricacies of stock options is important. Not just for you, but also for your team, who could be sitting on a goldmine without even knowing it. Read on to learn how stock options work in a pre-IPO setting and how you can guide your employees to maximize their gains from these often misunderstood assets.

Read More:

Stock Options vs. RSU: Which is Better For Your Company?

Restricted Stock Units (RSUs) are the best worker equity

Stock Options in the Context of Private Companies

Firstly, you should differentiate between public and private companies. Public companies are those that have gone through an initial public offering or an IPO, and their shares are traded on a stock exchange. Private companies, on the other hand, haven't yet gone public. In this context, stock options allow your employees to buy shares of your company at a predetermined price, also known as the exercise price.

Why would you offer stock options? They can act as a powerful incentive. You're not just offering a salary; you're offering ownership and a slice of the future success of your company. It's an emotional and financial investment that can yield significant returns for your team if done correctly.

Components of Private Company Stock Options

When structuring a stock options package for your employees, you're essentially creating a mini-contract that spells out the terms under which your employees can buy shares of your company. To get this right, you'll need to understand and carefully consider the following key components:

1. Grant Date

The grant date is the day you officially offer stock options to your employees. It's a foundational moment that sets the terms of the options. It is also the starting point from which other time-sensitive elements like vesting schedules and expiration dates are calculated. Make sure your employees understand the significance of the grant date as it will impact their decision-making process regarding the options.

2. Vesting Schedule

A vesting schedule specifies how and when your employees will gain the rights to exercise the stock options. Typically, you may use a 4-year vesting schedule with a 1-year cliff. What this means is that an employee must stay with the company for at least one year to begin vesting and will be fully vested after four years. Some companies may also have milestone-based vesting schedules tied to performance goals. Ensure that your vesting schedule aligns with your long-term business plans and employee retention strategies.

3. Exercise Price

Also known as the "strike price," this is the price your employees will pay to convert their stock options into actual shares. This price is often determined based on the fair market value (FMV) of the shares at the time of the grant date. Setting an exercise price that is too high may demotivate employees, while a price that is too low could have tax implications and also dilute existing shares. Seek advice from financial experts to find a balanced exercise price.

4. Expiration Date

Stock options don't last forever. Each option has an expiration date, after which the option is no longer valid. Typical expiration dates range from 5 to 10 years from the grant date. Make it a point to remind your employees of this expiration period so they can make informed decisions about when to exercise their options.

5. Cliff Period

Many vesting schedules come with a cliff period, typically lasting for one year from the grant date. During this time, no options vest. If an employee leaves the company before reaching the end of the cliff period, they walk away with zero options. This serves as an initial commitment period that ensures employees have a strong incentive to contribute to the company's growth.

Additional Provisions

Sometimes, stock options come with additional conditions like acceleration clauses, which could speed up the vesting schedule if specific events occur, such as a company sale. Likewise, you might include a provision for double-trigger acceleration, where vesting accelerates if the company is sold and the employee is subsequently terminated.

Knowing the Value of Pre-IPO Stock Options from Private Companies

As a startup founder or private company owner, you'll often find yourself in the position of offering stock options as a way to attract, incentivize, and retain talent. While these options can serve as an excellent motivational tool, their abstract nature can be confusing. Understanding the value of these stock options is critical, not just for your team but also for you as a company leader. 

1. The Role of Valuation Metrics

Stock options in a private company are only as valuable as the company itself. Therefore, keeping tabs on your company's valuation is imperative. You'll often go through funding rounds, each of which will determine the value of your company and, by extension, the worth of stock options. Transparently sharing these valuation metrics with your team can be an effective way to keep them aligned and motivated.

2. Leveraging Future Growth Prospects

Another factor that influences the value of stock options is the future growth potential of your company. If the roadmap is promising and there's a solid business plan, the odds are that the company will increase in value, making those stock options more attractive. Do you have an upcoming product launch or expansion into new markets? This potential for growth directly correlates to the rising value of your stock options.

3. Exit Scenarios and Financial Upsides

Lastly, discussing potential exit scenarios can provide a tangible framework for understanding value. Whether it's an IPO or an acquisition, each path offers a unique set of opportunities and challenges. If your company is aiming for an IPO, for instance, stock options could potentially turn into publicly traded shares that can be easily liquidated. In the case of an acquisition, there may be immediate financial gains if the deal terms are favorable.

4. The Importance of Financial Planning

While stock options can serve as a pathway to significant financial gains, it's necessary for your team to consider these as part of a diversified financial plan. Unlike a salary, the value of stock options is neither fixed nor guaranteed. Therefore, financial planning is essential to make the most of these complex but potentially rewarding assets.

Taxes on Private Company Stock Options 

When it comes to offering stock options, tax implications aren't just a concern for your employees. As an employer, understanding how different types of stock options are taxed can significantly impact both your company's finances and your ability to offer attractive compensation packages. Here are the two most common types of stock options in the United States, their tax treatment, and the ramifications for you as an employer.

1. Non-qualified Stock Options (NSOs)

Non-qualified Stock Options, often abbreviated as NSOs, are the more straightforward of the two types when it comes to taxes. When an employee exercises NSOs, the difference between the exercise price and the fair market value of the stock at the time of exercise is considered ordinary income. As an employer, you are required to withhold income and employment taxes at this time. This could involve withholding shares to cover the tax liability or requiring the employee to provide cash for this purpose.

The good news is that the amount recognized as ordinary income by the employee is also deductible as a business expense for your company. However, this deduction is subject to limitations and might not align with the company's financial year, so it requires careful planning.

2. Incentive Stock Options (ISOs)

Incentive Stock Options, or ISOs, offer more favorable tax treatment for employees but come with more stringent rules and restrictions. Unlike NSOs, there is no income to report, and therefore no withholding requirements, at the time of exercise. Instead, employees may be subject to Alternative Minimum Tax (AMT).

While ISOs offer tax advantages to your employees, there's a trade-off for you as an employer. Specifically, the spread between the exercise price and fair market value at the time of exercise is not deductible as a business expense. This can impact your company's taxable income, especially if a large number of employees exercise ISOs in a given year.

Reporting Requirements

Both types of options require specific forms and reporting measures. Failing to adhere to these can result in financial penalties. For NSOs, you'll typically be required to file forms such as W-2 for the employees. For ISOs, you'll need to provide employees with Form 3921 detailing specific information about the stock option exercised.

Strategic Considerations

When you're determining which type of stock options to offer, consider both the financial impact on your company and the attractiveness of the options to potential or current employees. ISOs might make your company more enticing to potential hires due to their favorable tax treatment, but they come at the cost of a lost business expense deduction. NSOs, on the other hand, offer you a tax deduction but may result in higher tax liability for your employees.

Exercising Private Company Stock Options Before IPO 

Employees often have the option to exercise their vested shares before your company goes public, commonly known as "early exercising." They need to understand that this is a financial risk, as the shares may never become liquid if your company does not go public or get acquired. However, early exercise might offer tax benefits under certain conditions.

Exercising Private Company Stock Options Post-IPO

After an IPO, the exercise process becomes easier but also comes with new considerations. The shares can be sold on the public market, but employees may face lock-up periods, during which they can't sell their shares. This is important information for them to understand to plan their financial future.

Can Your Employees Trade Private Company Stock Options?

Stock options are often touted as a long-term incentive for employees to stay with your company and contribute to its growth. But what happens if an employee wants to capitalize on those stock options before your company goes public or gets acquired? The ability to trade or sell stock options is a nuanced area that's heavily influenced by your company's policies, securities laws, and the terms of the options themselves.

1. Transfer Restrictions

The first thing you need to know is that stock options granted by private companies are usually non-transferable, as specified in the stock option agreement. This means your employees can't sell or transfer them to a third party without your consent. These restrictions aim to protect the company's ownership structure and often include exceptions only for specific situations, such as transferring options to a trust or to immediate family members under estate planning.

2. Secondary Markets

In some instances, a private company may allow its stock options to be sold on a secondary market. These markets are platforms where private securities can be bought and sold, often with the company's approval. While this offers liquidity to your employees, it also introduces a host of complexities, including valuation challenges and compliance with securities laws. If your company permits this, make sure to provide clear guidelines and consult legal advisors to navigate the regulatory landscape.

3. Company Buyback Programs

Another option for liquidity is offering a company-led stock buyback program. Under such a program, you as the company can buy back shares from employees at a price determined by a recent valuation. While this provides an exit opportunity for your employees, it also demands substantial cash reserves on the company's part.

4. Legal and Regulatory Considerations

Allowing the trading of stock options isn't merely a matter of company policy—it's also a matter governed by federal securities laws. Securities and Exchange Commission (SEC) regulations require that any trading of securities, which includes stock options, adhere to specific rules regarding disclosure and compliance. If you are considering allowing your employees to trade their stock options, consult with legal experts to ensure that you are abiding by all relevant laws.

5. Impact on Company Culture

Last but not least, consider the impact on company culture. Allowing stock options to be traded can affect employee morale and retention in various ways. Some may view it as a positive sign of the company’s growth and financial stability. Others might interpret it as a red flag, signaling that long-term commitments are less valued. Therefore, weigh the pros and cons carefully and ensure you communicate clearly with your team to mitigate any negative impacts.

Private Company Stock Options vs. Public Company Stock Options

In public companies, stock options often have less upside potential because the company is already established and its stock price may be more stable. However, they offer more liquidity and are generally considered less risky than private company options. Make sure your employees understand the difference so they can make informed decisions about their financial futures.

Why RSUs Can Be Your "Flexible Option" for Equity Compensation

Unlike stock options, Restricted Stock Units (RSUs) are shares that are given, not purchased, once they vest. They offer more flexibility for you and less financial risk for your employees. RSUs can be particularly beneficial for later-stage startups preparing for an IPO as they can be less dilutive than stock options.

Bottomline

Private company stock options offer a way to incentivize your employees by granting them a piece of the company's future. The landscape can be complex, both for you and your employees, but the rewards can be substantial. Understanding the intricacies of stock options in a pre-IPO setting can be vital in maximizing their potential. Take the time to educate yourself and your team to make the most out of this opportunity.

Did we catch your attention on RSUs? To know more about how they can be tailored to your private company’s needs, book a demo with Upstock today.

Retain your key employees

Ensure your team is awarded based on contributions and results with Upstock’s KPI inegration feature.

Learn More
ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

Previous: Portfolio Diversification: Investment Strategies for Better Returns‍ Next: Comparative Analysis: Profit Participation Units at OpenAI vs. Other Equity Models