Stock Options in Privately Held Companies

Stock Options in Privately Held Companies
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If you work for a privately held company and are offered stock options as part of your compensation package, it can be easy to overlook the potential upside that these investment vehicles may offer. However, just because your company does not trade on a major stock exchange does not mean you should scoff at the opportunity to acquire shares in the business.

Ownership Benefits

Many people underestimate the benefit of being an owner in a business. As an actual shareholder, you have a vote in critical company matters, such as the election of directors, compensation of executives and acceptance of a buyout offer. If the company is profitable and periodically distributes earnings to shareholders, you will be entitled to your respective share of those distributions. In private companies, stock options may be your only way to acquire actual shares in the business, as it is usually not easy to buy shares from another investor or not possible to buy on the open market.

Valuation & Awarding

If you are seeking to obtain additional stock options in the company you work for, you may have a better chance of doing so with a private company versus a public company, provided the business you work for has a stock option program. Stock options have an exercise or "strike price," which is the price you must pay to actually become an owner of the underlying share of stock. In private companies, valuations are often far more subjective and lack the higher valuation or premium associated with public companies. As a result, you may have more success negotiating a larger option award by deferring salary or by citing the weaker valuation due to being a private company. Conversely, public companies often have more stringent rules that must be followed when doling out stock options.

Cashing Out

When you receive your stock option award, you may immediately think about the riches you will reap when you cash out. In a private company, this is often difficult to do, as there is no active marketplace for your shares like there would be if you worked for a publicly traded company. While it may be possible to sell your stock to a private investor, it is far more likely that you will be able to cash out if your company goes public or gets bought out by another company. Once the acquisition is agreed upon, there may be a limited time frame you in which you can exercise your stock options.

Tax Implications

All stock options have income tax implications. The tax liabilities can be particularly harsh if you hold stock options in a private company. When you receive stock, whether it be through a grant or stock option award, the IRS considers that income and taxes are due. In a public company this is less intimidating, as you can sell some of your shares right away to pay the tax bill. However, in a private company where there is no active market for your stock, you will have to pay the income tax liability out of your own pocket. A big issue arises when you wish to leave a private company and you are faced with the decision of exercising your options or forfeiting them. In addition to being out the cash for exercising the stock options, you can also expect to pay taxes on the difference between what you paid for the option and the valuation of the company. The latter is often subjective and is determined by a business valuation, as there is no public marketplace. In the event you exercise your options, pay your taxes and the stock becomes subsequently worthless, you can really feel the cash flow pain.