What is a cliff in stock options

As an engineer, you may be more interested in getting on with your job than compensation.

How Startups Should Deal With Cliff Vesting For Employees - Business Insider

On the other hand I have friends who have literally lost out on millions of dollars because the process of exercising stock options was so complicated, opaque and expensive.

This guide is an attempt to correct some of the imbalance in information between companies and employees, and explain in plain English the whole stock option process. I like thinking about shares as a virtual currency. Shareholders are speculating on that currency, and the company is trying to increase its value. Companies can inflate or deflate this currency depending on their performance, perceived potential or by issuing new shares.

When companies are formed, they typically issue around 10 million shares. These are split between members of the founding team and are diluted in subsequent investment rounds.

A portion of these shares are put aside into an option pool, a group of shares dedicated for employees. Any shares you receive will probably come out of this pool.

You can think of a stock option as a Future. The company is basically saying: Option agreements typically have a four-year vesting schedule, with a one year cliff. There are few ways in which you can benefit from this right:.

An Engineer’s guide to Stock Options

Hope that the company is acquired and the shares are sold at a large multiple of the exercise price in your option agreement. Investors pay a premium and their shares are preferred for a reason — if the company is sold for less than the value placed on it at the last round of investment, your shares will probably be worth next to nothing.

Stock option agreements usually give the company a right of first refusal. This means that you cannot sell the shares to a third party without giving the company the opportunity to buy them first.

Equity basics: vesting, cliffs, acceleration, and exits | by @robfitz | Figuring out early stage startups

However, once a company reaches a certain stage, the board may allow you to sell your shares through an exchange like Second Market or some other mechanism.

At this stage you can cash-out by selling your vested shares to outside investors. In the event of an IPO, you can work with a broker to exercise all of your vested options and immediately selling a portion of them into the public market. This means you can afford both the shares, and the tax without having to invest money yourself. You can carry on working at the company and exercise more shares as they vest or leave whenever you want.

You leave the company, and send a check for all your vested shares before 90 days is up. This, combined with a cashless exercise, are probably the two most common scenarios.

Each route has different tax implications that can depend on the timing of the sale and the amounts involved. Depending on your personal financial situation, the number of options granted to you, their exercise price, and their change in value, exercising the right to buy all of your vested shares may be prohibitively expensive. Even if you have the cash, you may not want to spend your life savings on a stock certificate and a tax bill. The earlier you joined the company, the cheaper these shares will have been.

If the value of those shares have increased considerably there will be signifiant tax liabilities. If you decide that you want to leave and you think the company has a great future ahead you typically have about 90 days to decide whether you want to exercise your vested shares and come up with the cash to buy the shares and the associated taxes.

What’s a typical vesting schedule for employee stock options? | FS Incubators Accelerators San Francisco Silicon Valley Bay Area China

These questions will let you figure what it would cost to buy the shares and the current valuation of the company. As a company grows and issues more shares this percentage will decrease as your shares are diluted. Sometimes you can negotiate a tiered offer, and decide what ratio of salary to equity is right for you. Companies such as small consultancies or lifestyle businesses may offer you shares, but a return is unlikely. Having a small slice of ownership may feel good, but may ultimately be worthless.

If the company has been around for a few years without a clear upward trajectory, an IPO is probably unlikely. There are some other questions you should ask, but may have a harder time getting a straight answer:.

The answers to these questions could affect any returns. For example, if the company dilutes the stock pool, then the value of your shares will decrease. It also means the current valuation of the company is five million dollars.

A A valuation is a fair market valuation of a company as determined by an accountant and is reported to the IRS. As a company approaches an IPO, the delta between these two valuations will shrink and eventually disappear.

The tax bill can often be greater than the check you have to write to your company. You have to pay real money for gains that only exist on paper. This can substantially increase the risk on the investment. A full explanation of 83 b elections is a guide in itself, but essentially they let you pay all your tax liabilities for both vested and un-vested stock early, at the current A valuation even if the valuation subsequently increases. Assuming you decide to go ahead and purchase the stock, you have three months to give the company a check.

There are a few funds and a number of angel investors who will front you all the cash to purchase the shares and cover all of your tax liabilities. The reason why I wrote this guide is that engineers are often the unsung heroes at startups, and they too deserve to benefit from the upside in any value they create.

Thanks to Richard Burton , Colin Regan , Adam Fraser , Josh Buckley , Kip Kaehler , Tim O'Shea , and Andrew McCalister for helping with drafts of this article. If you have questions or feedback, then feel free to email me.

As with all information on the internet, take this with a pinch of salt and get advice from a professional CPA before making any decisions. None of this article is to be construed as legal or financial advice. Juggernaut was one of the first solutions to pushing data in realtime to clients; at first