Most people consider stock options as golden tickets in tech startups since they offer a promise of life-changing payouts if the company succeeds. However, there are some hidden risks that many employees overlook under all of this appeal.
For instance, stock options often face unpredictable valuations, also coming with complex tax implications. All in all, they do not guarantee wealth, so you must understand these potential risks before signing up. Read on to discover these hidden pitfalls.
What Are Startup Stock Options?
Startup stock options are simply contracts that give employees the right to purchase company shares at a set price after a specified period. Startups often use these options to attract and motivate talent without paying high upfront salaries.
If a company grows and its valuation increases, employees can buy shares at the initial price, called the strike price. They can make profits by selling them at market value. You must understand the types of stock options and how they differ when dealing with them.
While stock options can be financially rewarding, their value depends entirely on the company’s growth and success. They also come with strict restrictions, rules, and tax implications that also determine how much profit someone can make.
Common Risks Associated with Stock Options at Tech Startups
Like any investment, stock options typically come with several risks. Before you make any decision, it is important to understand and consider them. Here are five of the most common possible pitfalls:
Abandoned Stock Options
Employees might leave a startup before their stock options fully vest or before exercising them. These unexercised options expire; this means that the employee loses the potential profits. This risk is common, especially in volatile startups where job changes and layoffs occur frequently.
Restrictive Vesting Schedules
Restrictive vesting schedules tie stock option ownership to lengthy employment. Most require four years before any shares vest. If employees leave early, they forfeit their unvested options. This significantly limits flexibility, especially in unstable startups where long-term commitment is unlikely.
Complex Tax Implications
Stock options can trigger unexpected tax bills. Employees may owe huge amounts in taxes when they exercise options, even if they haven’t sold the shares or realized cash gains. The type of option affects tax treatment, making it easier to overlook liabilities that reduce potential profits.
Waiting Too Long to Exercise
Delaying exercise of stock options can backfire. As a startup’s valuation increases, it affects the strike price tax impact, potentially leading to higher tax bills. Waiting too long can also increase the risks of losing options if employment ends unexpectedly. If the startup company succeeds, waiting might be worth it.
Unpredictable Valuations
Startup valuations can swing wildly as a result of market shifts, investor sentiment, and company performance. High valuations may appear promising at first, but might drop eventually, making your options worthless. This unpredictability means that employees risk counting on gains that may never come, despite years of commitment.
Endnote
Although stock options offer a solid opportunity for startup employees to build wealth, there are several associated risks. Besides employees often abandoning them, there are usually restrictive vesting schedules and unpredictable valuations, and the tax implications can be complex. Waiting too long can also increase the risks of losing your options.
