How to think about equity compensation when you work for a private company

Equity compensation can create a shared interest in a company’s overall success. If the company does well and the stock price appreciates, employees who hold stock options can potentially increase their own wealth by exercising and selling valuable stock.

But when you work for a private company, limitations on selling stock can complicate how its potential value fits into your financial plan. It can also affect exercising options, paying taxes, and how you manage the risk of owning something you might not be able to sell.

If you have shares of private company stock, there are a few things you should keep in mind:

1. Understand the basics of your award

First, review your equity compensation package to fully understand the details. Here are a few key points you’ll want to consider:

• The type of option granted: Do you have incentive stock options or non-qualified stock options?
• The exercise (strike) price: This is the price you pay to buy shares of stock if you exercise your options.
• The vesting schedule: This represents the time between when your award is granted and when you can take ownership of the shares.
• The expiration date: The last day that you can exercise your stock options.
• The current value (bargain element): The difference between your exercise price and the current stock price is the “bargain element per share.” This value helps determine how much the shares are potentially worth and what the tax implications of an exercise may be.

2. A low exercise price might mean a low cost to exercise, but that’s not the only thing to consider

Stock options at private companies are often issued with a low exercise price, which can allow you to buy shares for less cash. But you should also evaluate how much cash you may need to pay a potential tax liability if you exercise and hold your stock: Exercising stock options is a reportable, taxable event. 

Be sure to calculate how much cash you may need both to purchase shares and to cover any tax bill. Then you can better determine whether it’s a good idea to exercise.

3. You may be buying something you can’t sell right away

Before you exercise private company stock options, know whether or not you’ll be able to sell your shares.

Some private companies will allow you to sell shares in a secondary market, potentially giving you some ability to sell your stock. However, not all private companies will offer this choice. And even if your company allows you to sell your shares, they may have other restrictions in place.

If your company is private and has no secondary market where you can sell your shares, you should consider how this will affect your willingness to exercise your options.

4. Even with limited ability to sell your shares and a pending tax bill, exercising may still be a good idea

One potential advantage to exercising private stock options when you have the chance is that the alternative minimum tax (AMT) impact may rise in the future. A key factor in determining how much AMT you owe from exercising incentive stock options is the spread between the fair market value at exercise and the exercise price. 

If we assume that the spread between the two is smaller now than it will be later, the AMT you may need to pay will likely be smaller, too. This can mean that you can exercise your incentive stock options with a smaller tax impact than in the future. 

5. If the company goes public, you might need to wait even longer to sell

The process of going public takes private company stock and turns it into stock that listed on an exchange. A key benefit for stockholders in this situation is access to a publicly traded market where you may more easily sell your shares.

However, companies that go public often place restrictions on your ability to sell your shares. You may also be restricted by your status in the company, your ties to a 10b5-1 plan, or lock-up periods set by your company. While a private-to-public event might make your shares more liquid, your ability to sell may still be restricted to certain times and by certain rules. 

6. There might be other liquidity events

For private companies, “liquidity event” usually refers to an initial public offering (IPO), but it’s possible that your company may experience something very different. Your liquidity event might be via a private event, merger, acquisition, or takeover that could affect your stock compensation. Liquidity events might give you more choice about the route you take with the equity compensation you bring forward from your employer.

What to do next with your equity comp when you work at a private company

When you work for a private company, carefully consider all factors in deciding whether you should exercise your stock options. You’ll also want to consider how private stock fits into your big-picture financial plan.

Going through this process of evaluation and planning can help determine what your best course of action may be. It can also provide insight on how to plan for your private company stock moving forward.   

To learn more about Morgan Stanley at Work’s private equity solutions, visit Shareworks by Morgan Stanley.

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