Stock option in a private company

Factual Questions
1

I hold some stock option in the company I work for. It is a very small private company. From my very general understanding, I think the basic idea of stock option is such that you can buy shares at the price specified in the option, and then sell them at their normal value (which hopefully will be worth much more than what you paid for). This all makes sense to me for a publicly traded company, where the value of each share can be easily determined, but how does it work for a private company? Also, do people usually just immediately sell the shares that they buy with the option, thus pocketing the difference? Are there any penalties for doing that (in terms of tax or anything else)? Or do people usually hang on to the shares for a little longer?

In addition, there’s also a chance that the company may be bought out by another private company in the near future. How is this going to change things? I have a feeling that it might be a good idea to exercise the option so that I hold shares of the company when it is being bought. Is that correct? What are the risks? What is going to happen if the deal doesn’t pan out?

What other questions should I ask? Any help would be appreciated.

2

I did PR work for a private company that offered stock as part of their retirement program. Since it was a private company and the shares weren’t traded on any exchange there wasn’t a way to really arrive at a daily share price (unless you added up the bricks & morter, furniture,etc. and divided by the shares, I guess).

Then one day a bigger company came along and bought the private company out.
Now we have a concrete number of the company worth.
One manager who had been participating in the program for 20 years got a check for almost half a million dollars.
A new hire who had been with the company for 14 months (and half heartedly participated) got a check for a few hundred dollars.

3

A private company I was with offered stock, but it was offered as a carrot dangling at the end of the “when we sell the company” stick. As a private company, it was worthless.

Most companies that offer options as a hiring or employment incentive, won’t let you flip stocks on the option. You have to wait until you’re vested for a few months. Some may even offer a staggered sell plan, where you can sell 20% at 6 months, 50% at 12 months, etc.

4

Not quite true. It’s worth whatever someone is prepared to pay for it.

For many years I worked for a private company and we frequently had share sales between employees (and some external parties). The sellers were happy to take a profit and run, while the buyers gambled on a higher payoff later. Eventually the gamblers were happy because we were bought out by a large company.

5

Owning a minority interest in a privately held corporation is, as a general rule, of limited value. The exception, as noted above, would be if the company was purchased.

6

Private companies which offer stock option plans will often also make arrangements to create some kind of market in the stock, precisely to make the stock more attractive, and increase the incentive-value of the stock option plan.

If they don’t do that, you are taking a punt in buying the stock. You don;t know when you will be able to sell it, and you don’t know that you will ever be able to sell it for as much, or more, than you paid for it. In theory a sale to an arm’s-length purchaser at any time is possible (subject to approval by the company); in practice there are not many arm’s-length purchasers willing to buy small amounts of private company stock.

7

*This all makes sense to me for a publicly traded company, where the value of each share can be easily determined, but how does it work for a private company? *

I used to work for a subsidiary of SAIC which at the time was a very large privately held, employee owned company. They periodically (quarterly or annually) valued the stock using some accounting black magic. Because the stock is not publicly traded, you couldn’t just go to your broker and sell it. But I never owned any so I don’t know the procedure for selling it.

Also, do people usually just immediately sell the shares that they buy with the option, thus pocketing the difference?

Depends on the person, and the option plan. Some companies require you to hold the stock for a minimum period before selling it, but I think it is more common to allow you to do whatever you want once your options vest (you didn’t ask about vesting, but there is usually a waiting period from the time the option is *granted *to you, which is when your option number of shares and price is set, until it is *vested *and you can actually exercise it). Many companies want employees to hold stock to give them a continued interest in seeing the company do well.

Are there any penalties for doing that (in terms of tax or anything else)? Or do people usually hang on to the shares for a little longer?

This depends on the type of option, whether it is an incentive option, or a non-qualified option (you need to ask which one it is). I am rusty on the difference. In some cases, exercising the option is a taxable event and you must declare as income the difference between the price you paid and the market value. In this situation many companies allow you to exercise a “sell to cover” (sometimes called a cashless exercise) where you exercise the options then sell enough stock to pay for the shares plus resulting taxes. In other cases you need not declare the income until you realize it by selling the stock.

In addition, there’s also a chance that the company may be bought out by another private company in the near future. How is this going to change things? I have a feeling that it might be a good idea to exercise the option so that I hold shares of the company when it is being bought. Is that correct? What are the risks? What is going to happen if the deal doesn’t pan out?

This is very dependent on the individual situation and nobody can give you generic advice on this. Generally acquisitions occur at somewhat above market value but it’s not always the case. Holding the stock carries the same risk as holding any other stock of any other company: It might go up, and it might go down.

8

[QUOTE=CookingWithGas;11250586Are there any penalties for doing that (in terms of tax or anything else)? Or do people usually hang on to the shares for a little longer?

This depends on the type of option, whether it is an incentive option, or a non-qualified option (you need to ask which one it is). I am rusty on the difference.[/QUOTE]
I looked it up. Incentive stock options do not create a taxable event on exercise; you determine the taxable income when you sell the stock.

Non-qualified options do create a taxable event when you exericse the option. Then when you sell the shares, the tax treatment is just as if you had bought them at market price on the date of exercise.

In either case, note that if you sell the shares immediately the gain will be taxed as a short-term gain, which will be at the same rate as ordinary income. If you hold them for more than a year then you will be taxed at the long-term capital gains rate, a more favorable rate.

9

Thanks for all the responses so far.

From a couple of the responses, it sounds like the ability to sell the stock could potentially be a problem. I’ll have to look into that.

Bear with me a little bit here, as I don’t know very much about these things: Let’s say company A buys out company B for $X. Does it simply mean that $X is divided by the total number of shares of company B and distributed to the shareholders? Or is it different for every acquisition? If not, then where does all the money go? How do the shareholders profit from the acquisition, assuming that the company was sold for a “good price”?

I apologize if the questions may seem a little elementary. I’m trying to get a better grasp of how things work. Thanks for the help.

10

Now, would such a purchase really need to take all outstanding stock, or would it be practically enough to purchase controlling, even majority interest, and leave some minor stockholders with what they had?

11

You have to give careful thought to creating your options plan. When people take their 83(b) election they want the valuation as low as possible but the IRS won’t accept $0 valuations because they’re obviously aware of that possibility of a future liquidity event. If they were actually worthless they wouldn’t be compensation.

12

I am not a Stockbroker (and I live in the UK).

My understanding is that Company A makes an offer at a set price (e.g. $12 per share) for all the shares in Company B. (They must buy shares if offered, but will be happy to get enough to take control.)
So any shareholder in Company B knows exactly what they will get.
The board of Company B will discuss the offer and may recommend it (or not).
The press news that ‘Company A is offering $12,000,000 for B’ simply means that the offer price has been multiplied by the number of shares in the company (here there are 1,000,000 shares.) So if Company A is only offered 600,000 shares, it gets control of B for $7,200,00.

The offer price for a profitable or useful company is invariably higher than the current trading price. E.g. if Company B’s shares were selling on the market for about $10, then a takeover bid would offer $12.

13

I know of two cases.

**1st case **was before the dot com crash. One of our tenants was a small private company. The employees were paid low wages plus stock. The company was bought out by a bigger company in a stock exchange deal. The receptionist stock was worth several million. The buy out allowed the employees to sell their 50% of their stock. Most did. New houses, new cars the works plus a raise in pay. The new company was bought out by a bigger company. The buy out was a pay the debt of the bought company’s, and the stock was declared worthless in the deal.

2nd case My son worked for a small private company and was given stock as part of his pay. With the buy out the new company assumed the debt of the small company and declared the stock wothless.

It is a gamble and can go either way. My son’s company was still in the develment stage so had little income but large debt. Basically the company if not bought out would have gone under. By taking up the debt of the small company they were able obtain the product that was being developed.

If your company is going to be bought up, look to see what it has to offer and what are its liabilities. Then make your descision on what to do.

14

I have with two companies that were bought out.

!st company went through a change and then a buy out 2 years later.
Company was in chapter 11. One man through his finical company bought up all the bad debt at 0.50 cents on the dollar. Then went to the board and offer them a deal. He would either go to the courts and force the company into chapter 13 or they could issue new stock. He was given a majority of the new stock and the stock holders were given one share of the new stock for every share of old stock.

When he took control of the company he put some one in charge who ran the company down in two years. Just before the company closed the doors company M comes along and made an offer. It was a stock exchange Ibelieve the rate was for every 25 shares in the existing company you recieved 1 share in company M, and the stock in the old company was declared useless.
The other case was the best case of timming I ever saw. the industry was office building propertys. The company I worked for was company S the buying company was company E.

The offer was a stock exchange offer. Based on the December stock exchange price of the two companies. Company E stock was given to company S stock holders based on the two prices. This left company E holding the stock in company S. The new holders of company E’s stock could at that time hold onto the stock or sell it back to company E for the exchange price.

The guy and his friends who started company S sold their stock for millions. Then timming part, in Janurary the next month wasw the dot com crash. In December our property managers rented out one office, a full floor, at $7.35 per sq foot as is. After the crash rents wer in the range of 1.85 per sq foot with a credit of from .50 to $0.90 per foot fot the TI.

Timming is everything.

15

Timing.

16

Thanks for all the follow ups. I think they’re helpful.