Silicon Valley Self Regulation

SVSR Employee Essay

EMPLOYEES: WHAT YOU NEED TO KNOW 

“…but in this world nothing can be said to be certain, except death and taxes.”

- Benjamin Franklin (in a letter to Jean-Baptiste Leroy), 1789

Introduction

Equity comes with strings attached. Learn what your shares are really worth, when you can realize the value of your shares, and whether your company is giving you a fair deal. This essay will help you understand what an offer letter really means.

Forms of Equity Compensation

Stock Options

If you work in Silicon Valley, chances are high that you were granted stock options as part of your employment agreement. A stock option is an ownership stake in a company. A stock option gives you the ability to purchase shares in your company at a fixed price. Stock options bear fruit for an investor if a company grows and increases in value.

For instance, assume you were granted an option to purchase 100 shares of your company’s stock at $5 per share when you joined in 2010. Further suppose that your company grows rapidly, and by 2020 a share in you company is worth $60. Your stock option entitles you to purchase 100 shares of your company’s stock for $500 ($5 per share). You may then resell these 100 shares at their market value of $6,000 ($60 per share). The difference of $5,500 is your gross profit.

There are two kinds of stock options: Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). ISOs may only be granted to employees of a company, must be redeemed (or “exercised”) within a specific time frame, and will lose their special tax status if they are transferred to another person. NSOs aren’t subject to these restrictions, and may be granted to anybody

You will be taxed at different rates depending which kind of option you possess. If your stock option is an ISO, you will not have to pay income tax when you exercise it in the future. Instead, if you exercise your option within a year after it is granted to you or before your company IPOs, you will pay the Alternative Minimum Tax (AMT) on your gains. After a year has elapsed or your company has gone public, you will pay the Long-Term Capital Gains tax.   In general, the AMT will be calculated as roughly twenty-six percent of the cost whereas long-term capital gains runs up to twenty percent of the value at the time this article was written (these values refer to federal tax rates).

If your stock option is an NSO, you will have to pay income tax as well as capital gains tax on your profits. If you exercise the option within a year after it is granted to you, you will pay the Short-Term Capital Gains tax; if you exercise the option after a year has elapsed, you will pay the Long-Term Capital Gains tax. Unlike an ISO, an NSO may be granted at strike price lower than the market value of the stock at the time of issuance – but if it is, it will face more severe taxes as NSOs are taxed as ordinary income, which has higher rates than capital gains taxes.

Important note: stock options are the most common means of equity compensation for non-founders at startups. These options will eventually be able to be realized as common stock in the company, and the option is used to encourage employees who want to contribute to the company over time as opposed to a short duration of time at the company. 

Restricted Stock Units

Unlike stock options, which are rights to purchase shares at a given price, restricted stock units are common stock shares. RSUs “vest” over time, which means that you will receive your stock in installments over time as you hit vesting “milestones”, like a vesting cliff. When your stock has vested completely, you are entitled to 100% of your shares. An RSU is an entitlement to part of the value of your company in the case that your company goes bankrupt. Hopefully this doesn't happen! If your company remains healthy, you may sell your RSUs at a price determined by periodic “409a valuations” of how much your company would be worth if forced to liquidate all its assets (in bankruptcy). 

This graph represents a four year vesting schedule with a one year cliff.

Today, technology companies are staying private for longer periods of time and many companies have very high valuations that they simply won’t reach for a number of years. Your stock options only pay off once a company climbs beyond its current valuation, which means that stock options at a high-profile tech company are often worthless for multiple years. This was notoriously the case at Facebook in 2007, which was valued by investors at $4 billion, and would have had to grow by more than $1.3 billion before employees’ stock became valuable. Subsequently, companies began giving employees RSUs so that employees can share in the company’s success irrespective of whether it meets lofty financial targets.

Stock options aren’t taxed until you exercise them, which means that you have some control over how they will be taxed (AMT or long term capital gains).RSUs are far less “flexible” because your vesting schedule determines your future taxation rate. You are required to pay taxes on restricted stock units as soon as they vest and become liquid. This often leaves you with a difficult decision: pay your company cash to retain all your stock or let the company withhold some of your restricted stock units to cover your tax obligations. RSUs are also taxed at regular income tax rates, which means that you may be required to pay up to 52.9% of that value in federal and state income tax (depending on your home state and on the value of the RSUs).

To help you visualize the differences between ISOs, NSOs and RSUs, we have created a table listing their tax characteristics at the time they are granted, while they are vesting, the time the are exercised, and the time they are sold.

Incentive Stock Option Non-qualified Stock Option Stock Grant
Grant No tax consequence No tax consequence Stock grants are subject to taxes either due to 83(b) election or in the case of no vesting limitations.
Vesting No tax consequence No tax consequence Stock grants are subject to income and employment taxes if the grant isn’t taxed at the time of the grant.
Exercise ISOs are subject to the Alternative Minimum Tax (AMT) where applicable at the time of exercise, which can be extremely high relative to other taxes NSOs are subject to income tax at the time of exercise as well as income and employment taxes (where relevant). N/A
Sale ISOs are subject to either capital gains tax or ordinary income depending on circumstance. They will be treated as capital gains if the option adheres to specified holding periods, and they are treated as ordinary income in all other cases. NSOs are subject to capital gains tax at the time of sale. Stock grants are subject to capital gains tax at the time of sale of that stock grant.

ISO and NSO above should be considered as priced at fair market value at the time of the equity grant for these purposes.

To learn more about how companies determine the fair market value of stakes in their company, visit our encyclopedia entry for 409A valuation reports.

83(b) Election

An 83(b) election is a form that you submit to the Internal Revenue Service that states your desire to have your equity taxed on the date that the equity is granted to you rather than the date that the equity vests to you. You can do this if you receive vesting equity--fully vested stock is taxed at the time of grant. You must file your 83(b) election within 30 days of the stock grant to be eligible for the change in taxation.

Why would you care about when your equity is taxed? Put simply, it has the potential to save you lots of money when the tax man comes to your door. The highest ordinary income tax rate is roughly nineteen percent higher than the highest long-term capital gains tax rate, and the long-term capital gains tax rate is always lower than the ordinary income tax rate. If you file your 83(b) election and then sell your stock a year or more later, then your gain will be taxed as long-term capital gains tax instead of the ordinary income tax rate. This will save you money.

An 83(b) election provides you with two benefits based on these facts: the year period before long-term capital gains tax kicks in starts earlier (date of grant v. date of vesting), and you don't face a big tax bill at the time of vesting when you might not have the money to afford such a bill. Still, not everyone necessarily should file an 83(b) election. If you are granted a number of shares at a considerable value, then you could face thousands, if not more, dollars in taxes upon filing the paperwork. Further, if your company fails (especially before vesting), then you will most likely have paid more taxes than you would have if you had not filed the paperwork.

Please consult a financial advisor before making a decision related to your filing, as we are not financial advisors and don't have access to the necessary details that will determine if you ought to file paperwork. Regardless of your decision, remember that you must act quickly: your thirty days to file starts as soon as the board approves the stock grant, which might be before you receive the stock issuance paperwork. 

How Cap Tables Work

A capitalization table (cap table) is a record of the individuals and entities that have an ownership stake in your company.  

In order to calculate the value of your shares, you may have to consult your cap table. A cap table contains the following information:

  • Authorized shares: This is the number of stock shares that a company may issue in total. This figure can only be changed by a board vote to amend your company’s charter.
  • Outstanding shares: This refers to the set of shares that have been issued and are currently held by a given individual with an ownership stake in your company. 
  • Stock option plan shares: These shares, sometimes called “the options pool”, are the total amount of shares that are set aside to be issued to holders who exercise their options.
  • Remaining unissued shares: These stock shares are authorized but not held by any particular individual.
  • Fully diluted shares: This means the total number of outstanding stock shares if all available forms of ownership and equity are converted or exercised. For example, many companies offer ownership stakes in the form of stock options and convertible notes, which are factored into fully diluted shares measurements.
  • Date of stock issuance: A consistent historical record of when the company issued stock shares to any given owner.

You should be extra mindful of dilution, which is the reduction in ownership stakes of an individual after the company issues new shares of stock. This could potentially change how much equity you own and ultimately how much your share of the company is worth. You can explore how dilution can change ownership stakes by using this tool available online. It is common for companies to experience 100-400% dilution as they scale as management works to secure capital that can help the company grow. Dilution doesn't necessarily mean that the value of an employee's equity will decrease, so employees of a company should look to how their management addresses the trade-off between resource and ownership constraints.

You should also be aware of how many outstanding shares there are at your company so that you can surmise the ownership stake of your equity. As an employee, you have a right to know this information since you will effectively be a stockholder of that company. You can then compare that ownership stake to what is commonly offered by position in Silicon Valley. We have used AngelList's offer data to create a quick representation of commonly offered equity by position. You can see live data and sort based on position or other locations by using the tool hosted on their site here.

<.024% .025-.09% .1-.24% .25-.4% .5-.9% 1-2.4% 2.5-4.9% 5-9% >=10%
Developer 11.80% 16.68% 19.00% 12.20% 22.08% 12.20% 3.78% 1.63% 0.64%
Sales 21.92% 19.09% 20.50% 9.78% 16.72% 8.04% 2.21% 1.26% 0.47%
Full Stack Developer 8.18% 12.93% 14.51% 13.98% 24.01% 16.36% 6.60% 2.64% 0.79%
Marketing 16.03% 23.48% 23.93% 9.71% 13.09% 10.61% 2.26% 0.90% 0.00%
Backend Developer 9.24% 15.84% 19.80% 14.19% 22.44% 12.54% 4.95% 0.66% 0.33%
Frontend Developer 14.00% 20.40% 17.60% 13.20% 20.00% 9.60% 2.80% 2.00% 0.40%
Business Development 16.35% 18.75% 19.23% 12.98% 15.38% 10.58% 3.85% 1.44% 1.44%
Designer 19.53% 17.58% 18.75% 10.16% 19.53% 12.11% 1.95% 0.39% 0.00%
Mobile Developer 14.01% 20.38% 15.29% 12.10% 18.47% 14.01% 3.18% 1.27% 1.27%
UI/UX Designer 12.12% 14.39% 25.76% 13.64% 19.70% 12.88% 1.52% 0.00% 0.00%
Marketing Manager 11.18% 21.18% 25.88% 11.18% 16.47% 8.82% 4.12% 1.18% 0.00%
Product Manager 14.44% 23.89% 15.56% 12.78% 17.78% 10.56% 2.22% 2.22% 0.56%
Account Manager 20.13% 21.38% 19.50% 10.06% 20.13% 5.66% 2.52% 0.63% 0.00%
Data Scientist 16.43% 15.71% 24.29% 14.29% 15.71% 10.71% 1.43% 0.71% 0.71%
Growth Hacking 4.85% 22.33% 22.33% 13.59% 16.50% 14.56% 4.85% 0.97% 0.00%
Sales Manager 16.30% 10.87% 17.39% 7.61% 23.91% 17.39% 2.17% 3.26% 1.09%
DevOps 15.69% 23.53% 25.49% 13.73% 14.71% 3.92% 1.96% 0.00% 0.98%
Software Architect 14.94% 14.94% 18.39% 11.49% 12.64% 19.54% 5.75% 0.00% 2.30%
Content Creator 12.79% 18.60% 25.58% 9.30% 15.12% 12.79% 3.49% 2.33% 0.00%
Engineering Manager 7.69% 17.95% 19.23% 6.41% 15.38% 23.08% 6.41% 2.56% 1.28%
QA Engineer 20.63% 33.33% 19.05% 9.52% 11.11% 3.17% 1.59% 1.59% 0.00%
Manager Business Development 12.24% 10.20% 24.49% 14.29% 20.41% 12.24% 4.08% 2.04% 0.00%
Visual Designer 23.40% 19.15% 21.28% 4.26% 21.28% 8.51% 0.00% 2.13% 0.00%
Creative Director 7.14% 14.29% 25.00% 10.71% 21.43% 17.86% 0.00% 3.57% 0.00%
User Researcher 17.86% 21.43% 28.57% 10.71% 17.86% 0.00% 3.57% 0.00% 0.00%

Note that the number of each role varies, which could result in skewed data if the data set is significantly smaller than other roles. Your amount of equity will depend on the stage of your company and your seniority: you should expect to see higher values at earlier stage companies and lower values at later stage companies.

One helpful way to consider the offer that you receive is to frame it in terms of "dollars at work". For example, if you are being granted 0.5% of a company that just raised $10 million at $40 million post, you are getting $100,000 at work. This means that you are getting $25,000 worth of equity per year if your equity vests over four years. If your company were to jump in value by a factor of ten, then your equity will be worth $250,000 per year. This concept helps in discerning exactly what you can earn given the potential of your company.

Conclusion

Our mission at SVSR is to make complicated issues of equity and taxation more accessible, in order to promote fairness and transparency. We have also created an encyclopedia to explain common terms that you need to understand your compensation package. Please let us know if you have feedback on our site or our mission!