Demystifying Private Investing: Publication #3: Employee Equity Terms

Demystifying Private Investing: Publication #3: Employee Equity Terms

By Linqto’s Alan Kerlidou & John Murray

The Linqto team is pleased to share the third edition of “Demystifying Private Investing”, a series of informational articles that will provide definitions and use-cases of the common terms employed in the field of private investing.

Vesting

When a company grants equity to an employee in the form of stocks or options, the person frequently receives ownership of the equity over a period of time. This process of a time-based equity compensation is called vesting, and is intended to incentivize employees to remain involved with the business. The usual market standard for vesting equity is 4 years. In this case, this means an employee will vest 25% of the total stocks grant agreed upon each year of employment.

For employee stock options (ESO), which are contracts that allow an employee the right to purchase a number of shares at a set price in the future, the employee receives the right (not an obligation) to vest a certain amount of shares within their ESO plan.

In the United States, the award of stocks or options as part of an employee’s compensation package can have significant tax implications, for both the company and the employee, if the process is not handled correctly.

Cliff

Employee vesting agreements often include what is called a cliff, which refers to the initial period during which no employee equity (stocks or options) are vested. Once the cliff period is over, the employee generally receives the initial equity allocation, and vests the balance of their equity compensation with monthly installments.

For example:Imagine that Declair Inc. hires Paul on January 29th, 2020. Paul’s compensation package grants him the option of purchasing 384 shares, priced at $1/share (the ‘strike’ price), which has a monthly vesting period of 4 years with a 1-year cliff.

On January 29th, 2021, Paul’s cliff period comes to an end. He has the right to exercise the option and acquire 86 shares for $86 on that date. (25% of the 384 shares). Paul will also start vesting options on 8 more shares every month at the same price ($1/share) for the remaining 3 years (298 shares equally vested on monthly installments of the remaining 36 months).

Incentive & Non-Qualified Stock Options

We covered the general topic of employee stock options in our previous publication. Yet, there are many different types of stock options available to employers, which define when and how the options contracts are to be exercised by employees, as well as their tax implications.

Incentive stock options (ISO) are often granted to employees as a way to help them benefit from the success of the company. ISOs fall under a special tax category that avoids the employee having to pay taxes when the option gets exercised. On the other hand,non-qualified (or non-statutory) stock options (NSO) can be granted to contractors, advisors, or other non-employees. However, NSOs transactions may involve taxation issues when the individual exercises options and sells their shares.

In the case of ISOs, the tax liability will be defined by the difference between the strike price and the value at exercise. The capital gained is then considered for determining the tax implications.

For example: Imagine that Paul vested his entire 384 shares and acquires them at $1 per share for a total price of $384. If the actual company share price has increased in value to $4 when Paul sells them, and he may be obligated to pay taxes on the capital gains realized of $2,304 or $3 per share.

Lock Up Period

A period of time that must elapse before an employee is allowed to sell his equity.For publicly traded companies, the lock up period applies upon completion of their initial public offering (IPO). Once the company listing is complete, insiders of the company will not be able to sell their shares for a period ranging from 90 to 180 days. In this situation, the Lock Up Period acts as a gate to prevent private investors from flooding the market with liquidity, which could imbalance the supply of shares available and plummet the stock price of a company.

Linqto’s platform is helping to democratize access to private markets. Linqto enables accredited investors to invest in pre-IPO unicorn companies in a matter of minutes using our App or web browser. We invite you to register on the Linqto website. You can also register on our free app on your Apple or Android device.

To learn more, download a complimentary copy of “The Intelligent Investor: Silicon Valley” eBook, featuring investing insights from over 50 experts, published by Fifth Era Media.