The Overlooked Asset: Why Stock Options Deserve to be in the Spotlight

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The Overlooked Asset: Why Stock Options Deserve to be in the Spotlight

By Jordan Long, ESO Fund

What are the best employee benefits?

“Salary and Benefits” is the heading one typically cares about most in a job offer. While “Salary” may be the first thing you look at (it’s broken out on its own for a reason), a lot can be lumped into the “and Benefits” portion. Benefits like healthcare, sick days, PTO, and retirement planning play a large role in an employee’s decision-making process. Today’s workers place a premium on their work-life-balance, flexible working environments, with workers willing to take an average pay reduction of 18% for remote work.

However, the potentially most lucrative item in the benefits section is often the one that gets overlooked: Company Equity.

Stock options

In the startup world, equity is dangled as an important benefit at hiring, but due to lack of education on the subject, it is often disregarded when employees depart their company. Companies provide vague offers of “X number of shares”, without any real context, and employees don’t get to benefit from equity compensation in the same tangible way they can by taking a vacation, working from home, or going to the dentist for “free”.

Despite the lack of education and awareness surrounding employee stock options, startups still tout

these packages as major selling points for hiring. Equity is often used to compete with larger, public

companies that can offer more in the form of salary.

Given these circumstances, why does equity continue to take a back seat in the mind of the employee?

The answer is twofold. First, employees on average don’t fully understand their equity, and companies aren’t incentivized to educate them. Secondly, if your company does well, your equity can get quite expensive over time, and employees have a tough time justifying putting a large sum of cash into a single, illiquid, risky investment.

We will touch on both matters in more detail later.

So, what do employees do with this confusing, expensive benefit that helped sway them to take the job in the first place? According to Carta, more than half of employees simply let it expire, rendering it worthless.

Why do Stock options expire?

Stock options are awarded to employees to align their interests with the company’s. They give an

employee the chance to own a portion of the company, and as they work hard to make the company

more valuable, the value of their equity grows.

From the company’s perspective, stock options also act as an employee retention mechanism. For that reason, stock options are referred to as golden handcuffs: golden because they can be highly lucrative and handcuffs because they restrict career mobility.

The typical stock option grant features 2 characteristics that promote employee retention: vesting and expiration.

Stock option vesting

For stock options to become shares of the company’s stock, they must be exercised or purchased by the employee. Vesting is a mechanism that allows an option to be exercised once certain time-based requirements are met. Until a stock option is vested, the employee cannot exercise it.

The standard stock option grant requires 1 year of work at the company before any shares vest. In most cases, 4 years before the entire grant is vested. This means only 25% of the options vests each year. Compared to a salary where $50,000 means $50,000 per year, an equity grant of 1,000 options typically only means 250 options per year.

Stock option expiration

Options that have not vested when an employee leaves a company immediately expire. If you get a grant of 1,000 options with a 4-year vesting period but only work 2 years at the company, 500 options would expire. Thus, the employee is incentivized to stay longer to vest their equity. Additionally, once an employee leaves their company, even their vested options will eventually expire. The standard expiration is 90 days from the employee’s final day at their company.

Basically, employees have 90 days following their last day of employment to exercise (or purchase) their options, regardless of how long they have worked at the company. Otherwise, they will expire and be worthless.

Why don’t employees exercise stock options?

There are two main reasons employees don’t exercise:

1) stock options are confusing, and

2) stock options are expensive.

Many employees simply don’t understand their stock options. Some think options are equivalent to owning stock in the company. Others lack knowledge surrounding taxes, and clarity as to what their equity is worth. So, while equity seems like an intriguing part of the benefits package, as the years go by, stock options often sit on the sidelines as employees reap the more tangible benefits of their job, rather than taking the time to self-educate on their equity packages.

When the time finally comes for them to move jobs, employees get an email from the company’s equity team about their stock options and often do nothing, as they likely are both preoccupied with the job move or feel uncomfortable moving forward with exercising their options due to a lack of understanding. Those that do have a basic understanding of their equity will look deeper into exercising their options and may find it to be expensive.

To put this in perspective, the average startup employee in San Francisco makes $150,000 per year. After taxes, this becomes just over $95,000. The average 2-bedroom apartment in San Francisco rents for just under $4,000 meaning each roommate pays on average $24,000 per year on rent. The average person spends $1,600 on living costs monthly, or $19,200 annually. This leaves only $51,800 of salary for discretionary spending including investments. Per LinkedIn, the average startup employee works at their company for 2 years meaning they earn just over $100,000 in cash after paying taxes, rent, and standard living expenses like food, utilities, and transportation.

After reviewing thousands of option grants at ESO Fund, we have found that the average cost to exercise is just below $150,000. This is how much it costs employees to exercise their options, not including the fact that most employees also must pay taxes on top of their exercise cost. The actual cash outlay is even higher. Due to the extremely high percentage of discretionary income required to exercise their options, individuals choose to spend this money on more immediate items like vacations or investments that do not have as much concentration risk.

Simply put, exercising is expensive, and for many employees, not economically feasible. Now remember these are all averages, but overall, up and down the food chain this problem exists. Entry level employees may only need $40,000 to exercise but only make $50,000 per year and the CFO might make $500,000 per year but their exercise costs $400,000. So on and so forth.

What can employees do to exercise their stock options?

While exercising can seem daunting, and is often expensive, there are several ways to reduce risk and maintain ownership of their hard-earned equity:

• Exercise a portion of the options

Stock options are not all or nothing. You may be granted 1,000 options and only vest 500, but that does not mean you need to exercise all 500 or let them expire. Even if you can only afford to exercise 1 option, it is still worth doing. Find an amount that you are comfortable with, and exercise those. Then, at least you retain some equity in the company going forward.

• Exercise along the way

One of the most powerful ways to invest is using time as your ally. Rather than saving the entire decision for when you leave, set aside a small portion of each pay check to purchase some options over time. This way you can spread out the cost to exercise over time, and by exercising some earlier, you may save some money on taxes.

• Finance your option exercise

If you find yourself with a large sum of options set to expire, all hope is not lost. Financing your stock options is a viable way to exercise before they expire. ESO Fund has helped employees at more than 700 companies exercise their stock options since 2012. ESO Fund pays for 100% of the exercise costs (including taxes) and takes 100% of the risk if the company fails. If there is a successful exit, ESO and you split the proceeds.

ESO makes sure the options don’t expire while allowing you to benefit from their upside, allowing you to have your cake and eat it too. Additionally, if you have already exercised, ESO provides opportunities for liquidity against your shares so you can free up income to spend on other investments or lifestyle choices.

Regardless of the method you choose, stock option packages are an important part of a compensation plan and should be treated as such. Through planning, education, and utilizing available resources, employees can better set themselves up to take full advantage of their hard-earned benefits.