There’s a lot of fear, uncertainty and doubt when it comes to stock options, and I’d like to try and clear some of that up today. As an engineer, you may be more interested in getting on with your job than compensation. However, if you’re working at a fast growing startup, with a little luck and the right planning you can walk away from a liquidity event with a significant amount of money.

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. Believe me, you’ll be kicking yourself if this happens to you, so why not arm yourself with some knowledge and make informed decisions.

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.

Shares 101

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.

Stock Options

When you join a company, you probably won’t receive any shares though, but rather the option to buy shares. This is a contract which states you have the ‘option’ to buy shares at a specific price.

You can think of a stock option as a Future. The company is basically saying: “Here’s our current valuation. We hope it’ll go up. In a year or so, once you’ve worked at the company for a while, we’ll give you the option to buy shares in the company at the price when you joined, even if our valuation has subsequently increased.”

Vesting schedules

Option agreements typically have a four-year vesting schedule, with a one year cliff. In plain English this means that you will receive all your stock options over a period of four years, but if you leave in less than a year (or are fired) then you won’t receive any options at all.

The ‘cliff’ is included to incentivize employees to stay at least a year, and to protect the company’s shareholders if the founders decide that you’re not a good fit.

Typically you see your shares broken up into 1/48ths. You get 12/48 at your 1 year mark, and each month after that you’ll vest another 1/48.

Exercising

Once you’ve cliffed, you have the right to buy shares in the company. There are few ways in which you can benefit from this right:

• Acquisition: 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.

• Secondary market: 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. 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.

• Cashless exercise: 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.

• Exercise before leaving: You can write your company a check and pay any taxes due — in return, you’ll get a stock certificate and become a shareholder in the company. You can carry on working at the company (and exercise more shares as they vest) or leave whenever you want.

• Exercise after leaving: 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. As a general rule, if the company you’re working for is growing like crazy (and you think it might go public someday) it makes a lot of sense to exercise your right to become a shareholder as soon as possible.

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. Furthermore you’ll probably only make money on the investment if there’s a liquidity event. This is why early employees at fast-growing startups essentially have a pair of golden handcuffs on and cannot leave — they’re paper millionaires but they’re not able to exercise their right to buy the shares and therefore have to stick around until the company is sold or goes public.

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. If you can’t afford to exercise, or decide not take the risk, then the option expires.

Questions you should ask going in

When you join a company, there are some important questions you should ask:

• How many shares will I have the option to exercise?
• How many shares are there in outstanding? (or what is the total number of shares?)
• What is the exercise price per share? (Or what price can I buy them for?)
• What is the preferred share price? (Or what have investors paid for their shares)?
• What does my vesting schedule look like?

These questions will let you figure what it would cost to buy the shares and the current valuation of the company. Crucially, you’ll be able to calculate the percentage of the company your shares would represent if they were all vested today. As a company grows and issues more shares this percentage will decrease as your shares are diluted. Nevertheless, it’s still good to have a rough idea of the percentage of the company you own when you start.

Don’t be deceived if you’re offered a large number of shares without any mention of the number of shares currently outstanding. Many companies are reluctant to share this kind of information and claim it’s confidential.

If the company seems reluctant to answer these questions, keep pressing and don’t take ‘no’ for an answer. If you’re going to factor in your options into any compensation considerations, you deserve to know what percentage of the company you’re getting, and its value.

I’d be wary of compromising on salary for shares, unless you’re one of the first few employees or founders. It’s often a red flag if the founders are willing to give up a large percentage of their company when they could otherwise afford to pay you. Sometimes you can negotiate a tiered offer, and decide what ratio of salary to equity is right for you.

Likewise, I’d take into consideration the likelihood of an IPO when estimating how valuable your options are. 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.

Other questions

There are some other questions you should ask, but may have a harder time getting a straight answer:

• How many shares is the company authorized to issue?
• Have any shares been issued with a liquidation preference greater than 1x?

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. Additionally, if some investors have a preferred liquidation preference, then they have the right to cash out first if there’s a liquidity event.

Example scenario #1

Let’s say the company gives you the option to buy 100,000 shares at an exercise price (or strike price) of $0.50 per share. If the company has 10,000,000 shares outstanding, then you have the option to buy 1% of the company when fully vested. It also means the current valuation of the company is five million dollars.

Let’s say you leave the company after the first year, meaning you have only vested 25,000 shares (100,000 / 4), which will cost you $12,500 USD to purchase. This is a highly simplified example which doesn’t include any tax liabilities, but it gives you the general idea.

409A valuations & tax

A 409A valuation is a fair market valuation of a company as determined by an accountant and is reported to the IRS. This valuation is often lower than the valuation at the last investment round because investors are more optimistic about the company’s future, and are speculating on its potential. As a company approaches an IPO, the delta between these two valuations will shrink and eventually disappear.

By comparing the company’s 409A valuation when you were granted the options and the 409A valuation when you purchase the stock, you can get a good indication of your tax liabilities. If you’ve only been at the company for a year (or the company hasn’t grown materially) the 409A valuation may not have changed, and if you decide to buy shares you’ll have no tax liability.

However, if the difference is significant, the IRS will treat this gain as an “AMT preference”, and tax you on the spread. 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. What’s more, if the company fails then you don’t get the tax refunded – only credits towards your next tax return. This can substantially increase the risk on the investment.

The last thing worth mentioning here is that if you’re buying vested shares before you leave the company, than I strongly suggest you look into filing a “83(b) election”, which could significantly decrease the amount of tax you have to pay. 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 409A valuation (even if the valuation subsequently increases).

Things you should know going out

If you’re thinking about leaving and you haven’t bought any shares, you should decide whether or not you’d like to become a shareholder. If you think the company’s going to be wildly successful, then it might be worth the risk. Assuming you decide to go ahead and purchase the stock, you have three months to give the company a check.

Ideally, you should know the following:

• How many shares have been issued
• The current 409A valuation
• Preferred share price of the last round

It’s much easier to find out the answers to these questions when you’re still at the company, so I suggest you get this information before you leave if at all possible.

Example scenario #2

You’ve left the company after a year and decided that you want to become a shareholder. Your option to buy the shares will expire 90 days after you’ve stopped working at the company, so you have to get the money together and give the company a check before that date. You know that the 409A valuation has increased from $0.50 a share to $5. Since you have the option to buy 25,000 shares (you vested a quarter of your 100,000 shares), this is going to cost you $12,500 to purchase.

However, since the 409A valuation of the company has increased to $5, the IRS will see the current valuation of your stock as $125,000, and you’ll have to report a gain of $112,500 ($125,000 - $12,500). As income, this will be taxed at around 40% (~20% federal, ~20% state). Obviously this tax level will vary vastly between individuals, but let’s just take 40% for arguments sake.

So your total cost to exercise is $12,500 to the company, and $45,000 to the government for a total of 25,000 shares.

Financing options

If you can’t afford to exercise your right to buy your vested shares (or don’t want to take the risk) then there’s no need to despair – there are still alternatives. 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. You hold the shares in your name and if there’s a liquidity event you distribute a percentage of the profits to them. They’ll typically ask for somewhere between 20-50% of the upside depending on the company, the taxes, and the size of the investment. It’s an interest-free loan without a personal guarantee. If the company fails, you don’t owe anyone anything; if it succeeds, you’ll be rewarded for the value you created whilst working there.

If you’re interested in learning more about financing your stock options then send me an email and I’ll make some introductions. I’ve set up an informal mailing list, and have a group of angel investors subscribed who do these kinds of deals all the time.

Conclusion

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. It’s also why I’m excited about stock option financing, which serves to level the playing field a bit and make exercising affordable, whilst removing the risk for the engineer.

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.

The inaugural hackUMBC hackathon was a smashing success!

Held in the UMBC Skylight Room from 7:00pm Friday to 7:00pm Saturday this past weekend, UMBC’s first-ever hackathon was open to all UMBC students of any skill level, from innovators and explorers to designers and hardcore coders. Its purpose was to allow students to mingle and collaborate for 24 continuous hours of community exploration to grow technology projects from scratch while expanding their connections to other students, industry leaders, and faculty. Admission was free and attracted students from across the UMBC campus community, including CS, CE, EE, IS, Biology, Biotechnology, Math, Physics, and Media Studies.

The term ‘hackathon’ hearkens back to the original meaning of “hacker” and “hacking” in early Internet history — namely, to “hack together (create) something quickly” instead of their current interpretations typically referring to illegal cybersecurity activities.

The theme for hackUMBC 2013 was “Hacking to Improve Campus Life” with the goal of ‘hacking together’ any sort of hardware or software project that helps students, teachers, or schools. Accordingly, projects developed during the event included a textbook resale service, realtime intelligent parking space sensors, Peoplesoft interface refinements, and mobile apps to help UMBC students network, socialize, and monitor class schedules, among many others.

Throughout the event, volunteer mentors from UMBC and local industry circulated amongst the teams to offer advice and guidance on their efforts, including how to successfully ‘pitch’ their products to the judges.

UMBC President Freeman Hrabowski joined the festivities early Friday evening to offer words of encouragement and motivation for the nearly 100 UMBC students competing in this innovative and highly charged event.

hackUMBC was conceived by CSEE students Perry Ogwuche and Randi Williams following their summer experience as fellows at CODE2040. Assisting in the effort was Prajit Kumar Das, CS PhD student and president of UMBC’s ACM chapter, and Alexander Morrow, a senior CS student and president of UMBC’s Cryptocurrency Club. CSEE’s Dr. Rick Forno served as faculty advisor to the event.

Projects were evaluated by several faculty and staff judges based on creativity, technical difficulty, polish, relevance, and usefulness. More than $2500 in prizes were awarded!

Second Place: Erill Labs (Robert Forder, Talmo Pereira, Patrick O’Neill, Sefa Kilic)

Third Place: Clever Source Solutions (Edward Mukasey, Ian Shefferman, Chinonso Ugwu)

hackUMBC Judges: Tim Oates, Rick Forno, Wesley Griffin, Dan Hood, Shawn Lupoli, Valerie Thomas, Geoffrey Weiss, and Ashwinkumar Ganesan.

hackUMBC was sponsored by Northrop Grumman, the UMBC Department of Computer Science and Electrical Engineering, ClearEdge IT Solutions, Independent Security Evaluators, Next Century Corporation, TriTech Systems, Github, CODE2040, the UMBC BWTech Cync Program, and the UMBC Alex Brown Center.

More information can be found at the hackUMBC page.

An industry hopes to make Web-connected gadgets from different makers work well together.

Before you know it, you may be able to connect your “smart” coffeemaker to your “smart” toaster to ensure a properly timed java and bagel.

Extreme Reality announced its partnership with AngelHack for the  Barcelona and Silicon Valley AngelHack Hackthons coming this week.

Name:  Yohka Tanaka

Internship, Co-op or Research Site: Japan International Food for the Hungry

Major(s)/Minor(s): Interdisciplinary Studies

Expected Graduation Year: 2014

Briefly describe your internship, co-op, research, or service- learning opportunity, including your day-to-day tasks, responsibilities, and assignments.

I got my intern site, Japan International Food for the Hungry (JIFH), by typing "npo kiga (meaning "hunger" in Japanese)" in a search box, getting the site's website, and contacting them if they provide an internship opportunity, even though I found on their website saying: "At this time, there are no volunteer opportunities available." I just ignored it and asked them if there are internship opportunities available. The result is: I got an internship opportunity. 

What I'm doing is:
1) Learn about JIFH (what it does, how it works, etc)
2) Inform myself about what has happened in areas where JIFH have supported (9 countries in Africa, 7 countries in Asia, and 1 country in South America).
3) Office work (Word, Excel, PowerPoint, sorting documents), including translation between English and Japanese.
4) Event planning, preparing, and facilitating
5) Summarize information to make a report, which will be read by other NPOs, FAO Japan office, and the Ministry of Foreign Affair (Japan).
At the very beginning, I spent most of my time for learning, and then I've moved on to the next step: JIFH will ask me to write a report, plan/ prepare/ facilitate events, or join meetings for the World Food Day.

What have you enjoyed the most about your position or organization/company?

Specifically, I was so excited at the meeting for the World Food Day. People from FAO Japan, the Ministry of Foreign Affair, Table For Two, Second Harvest Japan, and six other NPOs working on food-related issues came by and talked about what we can do in Japan to support World Food Day. I was just listening to what they said, but it was pleasure to be there and to get their business card.

What have you gained from your experience that you could not have gained from another opportunity?

Face-to-face talk with people whose work is my dream job.

What advice would you give to another student who is seeking an internship or similar experience?

Don't give up. Actively seek an opportunity.

As I described how I got my internship opportunity...
(copied and pasted from the question #1)
I got my intern site, Japan International Food for the Hungry (JIFH), by typing "npo kiga (meaning "hunger" in Japanese)" in a search box, getting the site's website, and contacting them if they provide an internship opportunity, even though I found on their website saying: "At this time, there are no volunteer opportunities available." I just ignored it and asked them if there are internship opportunities available. The result is: I got an internship opportunity. 

How do you see your experience as meaningful? This might involve skills you’ve gained, information you’ve learned, mentors you’ve connected with, or projects you’ve completed.

I want to eradicate hunger. On UMBC campus, I established Table For Two UMBC (Table For Two is a Japanese NPO simultaneously addressing under-nutrition and over-nutrition). My experience as an intern at Japan International Food for the Hungry will directly contribute to my future, which is to establish a NPO to eradicate hunger. I'm feeling how my intern site is operated and connecting with people working at NPOs and the government that are interested in World Food Day. I feel that everything is meaningful.

Please provide a short quote about what you liked most about your position / earning internship credit / the internship placement process / the Shriver Center:

Networking: I could meet people and get their contact information, which will be surely used once I could establish my own non-profit organization.

Name:  Yohka Tanaka

Internship, Co-op or Research Site: Japan International Food for the Hungry

Major(s)/Minor(s): Interdisciplinary Studies

Expected Graduation Year: 2014

Briefly describe your internship, co-op, research, or service- learning opportunity, including your day-to-day tasks, responsibilities, and assignments.

I got my intern site, Japan International Food for the Hungry (JIFH), by typing "npo kiga (meaning "hunger" in Japanese)" in a search box, getting the site's website, and contacting them if they provide an internship opportunity, even though I found on their website saying: "At this time, there are no volunteer opportunities available." I just ignored it and asked them if there are internship opportunities available. The result is: I got an internship opportunity. 

What I'm doing is:
1) Learn about JIFH (what it does, how it works, etc)
2) Inform myself about what has happened in areas where JIFH have supported (9 countries in Africa, 7 countries in Asia, and 1 country in South America).
3) Office work (Word, Excel, PowerPoint, sorting documents), including translation between English and Japanese.
4) Event planning, preparing, and facilitating
5) Summarize information to make a report, which will be read by other NPOs, FAO Japan office, and the Ministry of Foreign Affair (Japan).
At the very beginning, I spent most of my time for learning, and then I've moved on to the next step: JIFH will ask me to write a report, plan/ prepare/ facilitate events, or join meetings for the World Food Day.

What have you enjoyed the most about your position or organization/company?

Specifically, I was so excited at the meeting for the World Food Day. People from FAO Japan, the Ministry of Foreign Affair, Table For Two, Second Harvest Japan, and six other NPOs working on food-related issues came by and talked about what we can do in Japan to support World Food Day. I was just listening to what they said, but it was pleasure to be there and to get their business card.

What have you gained from your experience that you could not have gained from another opportunity?

Face-to-face talk with people whose work is my dream job.

What advice would you give to another student who is seeking an internship or similar experience?

Don't give up. Actively seek an opportunity.

As I described how I got my internship opportunity...
(copied and pasted from the question #1)
I got my intern site, Japan International Food for the Hungry (JIFH), by typing "npo kiga (meaning "hunger" in Japanese)" in a search box, getting the site's website, and contacting them if they provide an internship opportunity, even though I found on their website saying: "At this time, there are no volunteer opportunities available." I just ignored it and asked them if there are internship opportunities available. The result is: I got an internship opportunity. 

How do you see your experience as meaningful? This might involve skills you’ve gained, information you’ve learned, mentors you’ve connected with, or projects you’ve completed.

I want to eradicate hunger. On UMBC campus, I established Table For Two UMBC (Table For Two is a Japanese NPO simultaneously addressing under-nutrition and over-nutrition). My experience as an intern at Japan International Food for the Hungry will directly contribute to my future, which is to establish a NPO to eradicate hunger. I'm feeling how my intern site is operated and connecting with people working at NPOs and the government that are interested in World Food Day. I feel that everything is meaningful.

Please provide a short quote about what you liked most about your position / earning internship credit / the internship placement process / the Shriver Center:

Networking: I could meet people and get their contact information, which will be surely used once I could establish my own non-profit organization.