Stock Options' Private Parts
June 13, 2010 10:08 AM   Subscribe

How can a private company offer stock options?

My employer just sent me an offer and contract for incentive stock options. This is great and makes me feel like I'm part of something big. Trouble is, it shakes everything I thought I knew about economics. My company is privately held and under 100 employees. I figure that buying shares would make me amongst the private owners. If there's no heavy buying or selling going on from the public arena, how can the price (roughly $2.50, according to the contract) possibly change significantly enough to generate financial gain/loss?
posted by spamguy to Work & Money (8 answers total) 3 users marked this as a favorite
 
Best answer: This is a pretty complicated question, especially for Ask Metafilter, but there are a couple of things going on here.

(1) Private companies issue options to their employees all the time.

(2) These options are not the same type of option that you may have heard about which are traded through the Chicago Board Options Exchange. Private companies issue privately negotiated options to their employees or major investors as a method of raising capital through means other than the public markets.

(3) Most private companies which issue options privately have an exit strategy, which is either to get acquired by another company or to go public. In either case, your options almost certainly will be worth more post-acquisition or IPO than they are currently, however there is no guarantee that they will stay more valuable during the lockup period during which you can't liquidate your holdings.

In short, these are illiquid securities with a lot of upside potential and a downside potential bounded by zero (options and stock can't be priced less than $0).


Finally, note that the tax consequences of exercising options is very complex; you need to retain the services of a qualified CPA to understand the liabilities to which you expose yourself by exercising these options.
posted by dfriedman at 10:15 AM on June 13, 2010


dfriedman has it. I have had several sets of options ("sloptions") from startup companies.

My understanding is that, if the company never makes it to an IPO or gets acquired, the options will never have any value. The valuation and "shares" that exist now are something that is made up by the company itself, and doesn't have a lot of meaning to the outside world. I guess MAYBE it is theoretically possible to sell them privately, I don't know, but basically there is no one to sell them to until:

a) The company becomes publicly traded or
b) Your company says "We've reached an agreement to sell our company to Megacorp X for $5 a share." At that point you can execute your options and sell to Megacorp for that price, just as you sell options of a public company on the open market.

Note that, for tech companies at least, option B is the only realistic scenario these days. There are no more dot com IPOs. I haven't heard of anyone even attempting it in years.

Note I am not a financial expert; this is just my experience and what I've been told from living through this scenario multiple times.
posted by drjimmy11 at 10:24 AM on June 13, 2010


Trouble is, it shakes everything I thought I knew about economics.
Really?
I figure that buying shares would make me amongst the private owners.
Right.

Stock options are a contract that lets you buy shares at a certain price, once they vest. The shares work just like shares on the stock market, except you can't really sell them the way you normally would. If the company is sold then you'll get paid for the shares you own. If the company goes public, then you can sell shares on the market.

But you usually don't need to exercise the options and buy the shares yourself. So if the company gets sold for $5/share, and you have these $2.50 options, then you should get $2.50/option. On the other hand if it's sold for $2.60, you get just 10¢/option. And if it gets sold for less then $2.50, you get nothing (but lose nothing if you don't exercise them)

Anyway, I wouldn't worry about it. Usually they give out these options and if the company is never sold, or never goes public they never become worth anything. Also, if the company takes on new investors, that devalues the shares that people already have.

OTOH options at companies like google, microsoft, yahoo have made people rich.
posted by delmoi at 10:24 AM on June 13, 2010


I guess MAYBE it is theoretically possible to sell them privately, I don't know, but basically there is no one to sell them to until

There are mechanisms to sell private equity amongst various parties. Its illiquid nature, though, means bid-ask spreads are larger than in the public markets and that transaction costs are higher. This is so far out of the scope of Ask Metafilter, though, that I would caution anyone reading this to understand that the private nature of these types of securities means that there is no standard here, and that each transaction is unique and negotiated on its own terms.
posted by dfriedman at 10:27 AM on June 13, 2010


I want to reiterate what dfriedman says; options have complex tax implications. Merely receiving the options is pretty simple (in the common case). But depending on your current situation and the expected future value of the stock you may want to exercise those options early, or as they vest, several years in the future, or never at all. This is a good time to talk to your accountant.

Also since you're considering an offer.. Many tech companies allow new hires to negotiate option vs. salary. You may be in a position to take less cash and more stock, or more cash and less stock. There's no easy way to know which is better; it depends on your appetite for risk.
posted by Nelson at 10:29 AM on June 13, 2010


In private tech companies, the value of the company is often set based on the most recent investment (financing event). So, let's say that there are 1M shares in a company and you are offered options at $2.50 each. Typically, that means that in the previous round of investment, the buyers (investors) and sellers (company) mutually agreed that the company is worth $2.50 @ 1M = $2.5M, setting your options at $2.50.

How can the price go up? The next round of investors, who may be willing to value the company at say $7.5M (the company has hit its numbers, the userbase is growing, or the market seems to have an even greater demand now for what the company is making). This means that the paper value of your options has gone up by $5 per share ($7.5M = $7.50 * 1M*).

Typically, though, none of this matters to you in terms of having more cash in your bank account. You can in theory sell your shares before the company goes public or is acquired, but unless you are connected and your company is hot, or you have a co-worker who wants to buy more shares, you are unlikely to find a buyer.

* - in a financing event, the number of shares usually increases, meaning the value of each existing share is decreased correspondingly. So the math I'm showing is for a simplified case where the number of shares stays constant.
posted by zippy at 1:33 PM on June 13, 2010


I want to reiterate what dfriedman says; options have complex tax implications.

spamguy, I recommend that you read about 83(b) elections. These allow you to minimize the tax consequences should the value of the company go up. If your options total to a small amount (say, under $1000) and you think your company has a chance of being worth something, than an 83(b) election is often a good idea.

There is at least one scenario where you can be left with sizable taxes and insufficient assets to pay them a few years down the road if you do not do this.

Rule of thumb: if the price of an 83(b) election is pocket change for you, you think the company has a chance of success, and your stock option value has not yet increased, do the election.
posted by zippy at 1:41 PM on June 13, 2010


note that the tax consequences of exercising options is very complex;

Get thee to an accountant. Maybe the rules have changed, but after the doc com bust there were some real horror stories involving stock options and failed companies.
posted by IndigoJones at 5:20 PM on June 13, 2010


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