If you’re about to join a tech start-up, you might be bewildered by the alphabet soup of stock-based (or stock-linked) compensation terms that typically makes up part of your salary package. They can certainly be confusing — think ESOP, RSU, DSPP, and phantom shares. 

Still, that’s all the more reason to understand them if you’ve been issued equity as part of your compensation. It’s important to understand because stock-based compensation can be a big portion of your total compensation. 

In some cases, the stock-based compensation can actually carry a higher value than your cash compensation — especially if the company uses the more liberal “options pricing” approach (more details in the “cautionary tale” below).

To understand the value of your stock-based compensation, you’d need to correctly value your equity — that is, to figure out how much the shares you hold in the company is worth — so you understand your total compensation, and how that value might change over time, and when you can monetise your shares.

Only then can you figure out if you are comfortable with the trade-offs between cash salary and stock-based compensation, and whether you should negotiate on your total compensation. 

You’d also want to know what you may be giving up if you decide to hand in your resignation letter as normally these stock-based compensation have vesting schedules.

With this in mind, this article will first explain the difference between various stock-based compensation — ESOP, RSU, phantom shares and other quasi-equity instruments — from the perspective of an employee who must also wear a second hat as an investor. 

We will then explain some common features of stock-based compensation, such as vesting,  strike price, exercising your options, and tax considerations, which can make a world of difference in what you ultimately take home to add to your wealth. 

One major underlying principle to remember is that you only want to take any stock-based compensation if you believe in the mission, vision, team and therefore the growth in the value of the company you work for.

Taking more stock-based compensation rather than cash compensation is intimately tied to your conviction about the business, and your financial priorities and life goals at that point in time.

Basics of stock-linked compensation

To start, there are different forms of equity compensation, which are usually granted when an employee has hit certain performance benchmarks or stayed long enough with the company.

Here are the most common examples —

Employee Stock Options Plan (ESOP): ESOP offers employees the opportunity to receive an agreed number of shares from the company’s ESOP pool. Vesting is often tied to duration of service or other conditions (e.g. performance criteria). For Singapore-based companies, it typically allows employees to buy stock at a discount. In some cases, these shares are offered at no cost (also known as zero strike).

Direct Stock Purchase Plan (DSPP): DSPP allows employees to purchase shares of their respective companies directly, without going through a broker at a pre-agreed price. In some cases, DSPP allows employees to purchase company shares at a discount.

Restricted Stock Unit (RSU): RSU gives employees the right to receive shares, often tied to duration of service or upon meeting certain performance criteria. In some cases, RSU will come with vesting periods.

Phantom Stock: Phantom stocks are cash bonuses used to incentivise employee performance. The value of the award is tied to a certain number of shares, but note that this is paid out in cash and not in stock. Phantom stock is used when company founders do not want dilution. Note that there is no actual stock ownership and hence no further upside after the payout.

This article will focus on ESOP, which is likely the most common but also often the most complex of the lot with different permutations, from the perspective of a Singapore-headquartered private company issuing ESOP to its Singapore-based employees. However, although the specifics may differ, many of the key considerations that we outline apply to all types of stock-linked compensation issued by private companies in various jurisdictions.

Key definitions behind stock-based compensation

To start, we first need to understand some key terminology —

• ‍Grant: Refers to the award of ESOP to an employee.
• ‍Vesting: Refers to the point when the employee “earns” the right to some or all of the ESOP granted, and can hence exercise and sell the ESOP if one chooses to do so. 
• ‍Cliff: A specific type of vesting where an employee first earns the rights to an accumulated amount of ESOP (often 12 months). An employee typically has no ESOP entitlement before the cliff. In some cases, cliff vesting refers to the date when employees receive 100% ownership of all shares.
• ‍Exercise: The process by which an investor puts into effect the process to buy the company shares specified in the ESOP plan, in exchange for the payment of the strike price. Note that this can only be done before expiration.
• ‍Strike price: What you have to pay to get the shares. It is a per share price. This is often set at a discount to the current share price, or can also be zero. 
• ‍Sale: The exchange of company shares at the estimated or pre-agreed share price.
• ‍Estimated share price: Self-explanatory, but we’ll lay out a few scenarios in the next section.
• ‍Expiration: The point at which the ESOP contract is no longer in effect and you no longer can exercise your options. 

How should I value a potential ESOP grant?

Let’s use a simple example to provide a better illustration. A hypothetical employee named “Greg”, who is provided with an offer to join a promising young company (say a fast-growing wealthtech firm):

• Offered a grant of 1,000 ESOP by a prospective employer as part of his compensation. 
• Told the strike price is $80 per share and that the company is valued currently at an estimated $100 per share, with a lot of future upside.
• Told the ESOP will vest over 48 months (4 years), with 25% after the first 12 months (known as a cliff), and subsequent monthly vesting for the following 36 months.
• The right to buy these shares, or to exercise vested ESOP, expires after 10 years from grant.

How should Greg value this potential grant?

Let’s start with the simplest scenario. If there is no change in the company value over the next four years, what will this be worth?

If Greg crosses his first-year anniversary with the firm, he will be allowed to exercise his option to buy a quarter — that is, 250 — of his 1,000 ESOP shares at a discount to the current share price. Let’s say the share price remains unchanged at $100 at that time. Greg therefore uses $20,000 ($80 x 250 shares) to purchase these shares at the 1-year mark.

Theoretically, the shares are worth a total of $25,000 ($100 x 250 shares), making a total profit of $5,000 in the first year.

Now to compute his total compensation, Greg could conceivably attribute $5,000 a year to the total value of shares offered under the ESOP plan ($20,000 in total). 

It would also be fair for him to compute the value of his annual total compensation as the sum of his monthly salary, any expected bonuses or allowances, plus the annual ESOP value of $5,000 a year to arrive at the total compensation figure which he can then use to compare “like-for-like” against another offer.

This is sometimes referred to as the intrinsic value of an option.

We should value the ESOP at a higher price at a fast growing company, right?

Indeed, what may seem straightforward at first glance can actually be very complex. In the first example, we had assumed that the current — and also that the future — share price is $100. But in a non-publicly traded company, there isn’t really an objective “reference” for the current share price. 

Is $100 the price in the previous fundraising round, and if so, has the company become more or less valuable since then? And if so, by how much?

Or is $100 the price the dollar value that someone was willing to pay for the shares in a secondary transaction — and if so, how significant was the transaction relative to the overall equity pool, and was it an arms-length transaction that reflected the true value of the company?

Other employees — particularly founders — will often “sell the story” to guide current and prospective employees to look at the future price of the company. While this could be perfectly valid, employees run the risk of over-valuing the compensation package if they only look at the upside without considering downside scenarios.

So, to illustrate the possible range of outcomes, let’s construct a few additional scenarios for the company (total gains shown are over 4 years):

• What if the estimated price after four years goes up by 2x, because Greg believes the company will grow in value? 

1,000 ESOP *($200 wishful 2x share price - $80 strike price) = $120,000

• But, what if the estimated price after four years goes up by 5x, because this company is a rocket ship headed for the moon? 

1,000 ESOP *($500 rocket ship 5x share price - $80 strike price) = $420,000

• But, what if the estimated price after four years goes up by 10x, because this company is doing ludicrously well? 

1,000 ESOP *($1,000 ludicrous 10x share price - $80 strike price) = $920,000

• But, what if the company does not do so well, and halves in value over the next four years?

1,000 ESOP *($50 brutal share price - $80 strike price) = -$30,000

So, you can see that the value of the ESOP can be almost any figure at all. Also, in the case of a negative scenario, you would actually not exercise — after all, you wouldn’t pay $80 for something worth only $50. In fact, this is where the “option” comes into play — you have the option of waiting it out (before expiry), to see if the share price rises above the strike price, before deciding whether to exercise.

To summarise, figuring out which price to use to value your ESOP will therefore depend on which reference point you are most comfortable with as an individual. 

Whatever value you ascribe to the stock, give some thought to both the timeline and how you expect to monetise your stake in a private company — be it through a potential secondary sale to an investor, a stock buyback by the company in advance of a fund raise, or an eventual exit on the IPO market.

How does vesting work, and what happens if I resign?

Everything we’ve talked about so far assumes Greg sticks around for four years, or the duration of the plan.

How would the number of ESOP shares that vest be affected if Greg leaves after a shorter time frame? 

Often, an employee at a tech start-up firm will need to remain employed with the firm for at least one year before any of their ESOP vests and they are provided the option to exercise their stock options into company stock. This is known as a cliff vest, and forms one part of what is known as the vesting schedule. 

A four-year vesting schedule with a one-year cliff means an employee can exercise a significant portion (say 25%) of shares offered under an ESOP plan after one year, and have all shares fully vested and exercise-able after four years. Hence, using the same numbers as before:

• Greg sticks around for 4 years: 100% of the plan vests, or 1,000 ESOP
• Greg leaves after 28 months: 28/48 of the plan vests (58.33%), or 583 ESOP
• Greg leaves after 12 months: 12/48 on the plan vests (25%), or 250 ESOP
• Greg leaves after 11 months: Nothing vests because the cliff was not reached

As we learned from the section above, how you value this number of shares that has vested depends on how you look at the firm’s prospects when you start your new job, and how you believe the share price of the company will therefore increase or decrease (in cases where you think the firm is currently overvalued) by the time your ESOP vests. 

This example illustrates that ESOP typically vests over a few years, and it may not be of equal amounts in a year. So if you are planning to leave, you should factor any lost ESOP into your negotiations with the new firm. In fact, if you leave before a vesting cliff, you actually leave with zero vested ESOP at all.

After vesting, you then want to keep an eye on when your options expire. This is often 10 years from the grant date (note: not to be confused with the vesting schedule). Remember, you can only exercise after vesting but before expiry.

If you resign, the original expiry schedule no longer applies, and vested options can expire as soon as 30-180 days after you leave employment — so if it makes economic sense (more on that in the next section), remember to exercise as soon as possible once you’ve tendered your resignation. Much like airline or credit card points, once expired, they’re usually impossible to claim back.

Should I exercise my ESOP, and how about taxes?

It’s now time to bring in the tax issue. Spoiler alert: don’t rush out to buy that Ferrari or GCB just yet.

We should first caveat that we’re not tax advisors, that it is difficult to generalise as individual situations will differ (the specifics of your ESOP plan, your tax residency, etc), and so you should not interpret what follows as tax advice. Please speak to the tax authorities directly or to a qualified tax advisor if you require detailed advice on your specific circumstances.

Please note that many start-ups also impose contractual restrictions such as lock-ups until an exit event (e.g. IPO), and these clauses will have an impact on taxes. However, for the purposes of this primer, we’re just going to explore the straightforward case where there are no legal restrictions on the sale of the shares after exercise.

Now that we have gotten that out of the way, let’s highlight a few factors that you may choose to consider when it comes to exercising your ESOP.

First, how the accountants value the share price is important here because your tax bill is directly related to the profit (i.e. “accounting” share price minus strike price) when you exercise your rights under the ESOP. In Singapore, your employer will typically file these gains directly to IRAS in the IR8A, alongside your regular income and bonus — so there’s no scope for you to insert your (presumably lower) value of the shares!

Accountants typically reference the share price from the last fundraising round, as long as that round was not too long ago (typically 12 months). In fact, this explains why companies will often give employees a chance to exercise your ESOP rights before announcing a fresh fundraising round — as your tax bill will be calculated on the basis of the price of the previous round if done before fundraising is finalised.  

Note that this share price can be very different from the current, wishful, rocket ship or ludicrous valuations that you may have ascribed to the shares.

Your tax liability is then assessed on the basis of your theoretical gains — i.e. the premium of the share price over the strike price, multiplied by the number of options you have exercised, with the share price being what the accountants say it is. This is generally how it will be calculated:

At the point of exercise, the 5 price scenarios outlined earlier could translate to the following tax liability for Greg, with the number in bold reflecting Greg's net profit after tax:

So, it is generally preferable to exercise before the share price goes up, not after. Assuming an up round, it is also good practice for companies to open an exercise window before a fund raise in order to minimise the employees’ tax bill and at no extra cost to the company.

Clearly, there are downsides to exercising your ESOP. You first have to cough up the strike price — often no small change, unless you are holding zero strike options. Even if you are holding zero strike options, you will still become liable for taxes on the theoretical gains, even if you eventually sell the shares at less than what you had paid for them (i.e. the exercise price). The current market environment is a stark reminder that what goes up can also come down.

In short, you have to evaluate whether you can get more for the stock than what you’ve paid for it, plus what you owe IRAS in taxes, when you sell it in the future. In our earlier example with Greg, his ESOP came with a strike price of $80 for shares valued at $100. Even if Greg could exercise at that point, he would have to decide if the shares will remain above or go under $80. And Greg is liable for taxes on the $20 theoretical gain even if he eventually sells it for less than $80.

So, you will have to carefully assess the life stage of the company to come to a better decision on whether to exercise your ESOP, while factoring in the tax implications from vesting. 

The good news? In Singapore, the capital gains that you make after exercising is usually not taxed by the local tax authorities (but again, you may have other liabilities depending on your personal circumstances). More helpful information on local taxes can be found on the IRAS website.

A cautionary note on alternative valuation approaches

The above discussion uses a common-sensical approach to valuing ESOP, based on future scenario analysis while factoring in vesting schedules and taxes. However, accounting rules dictate that companies apply an options pricing model to value the contract behind an ESOP, and carry that expense on the books and records. The most commonly used options pricing model is called the Black-Scholes Model, a widely-used mathematical method to calculate the theoretical value of an option contract.

So, why does what the accountants do matter to me? After all, to be conservative, I’m going to use the “simple” scenario (or implicit value), and that’s that, right?

Well, I have encountered examples of firms using the options pricing model to justify the price of each ESOP — in fact, at one of my previous firms, my annual compensation letter prominently displayed the value of ESOP (calculated using an options pricing model) alongside my annual salary and bonus, which were then summed up and displayed as my annual compensation package. Obviously, this resulted in a higher annual compensation package (which was clearly the intention).

How so? Using real numbers, and going back to the simple scenario, Greg’s options are possibly worth $68 per option, or $68,000 in total, versus just $20,000 in intrinsic value — this is a difference of more than 3 times.

The point to remember is that the two sets of numbers — while wildly different — are not wrong, but start-up employees must understand why the two approaches yield significantly different numbers, what the translation between the two approaches is, and then negotiate accordingly. This can make the difference between choosing Company X instead of  Company Y in the example below:

For those that need to be more fluent in how to compute numbers based on the Black-Scholes Model, please refer to the “geek note” at the end of this document.

Finally, how does ESOP fit into one’s asset allocation?

No matter how you choose to value your ESOP shares — and factor taxes in the process of doing so — there is a bigger picture to note. 

If much of your income comes from your salary and your hopes of a big payday from your ESOP shares, such a scenario also reflects significant concentration risk. Nine out of 10 startups fail — these are sobering odds to take into account. As the saying goes, don’t put all your eggs in one basket, no matter how much conviction you have in the business.

Many of us know folks at Lehman who lost both their jobs and their retirement pot in one stroke, and the financial impact of such a scenario can be devastating.

To sleep better at night, tech start-up employees should look at setting aside a portion of their monthly salaries and windfall gains from ESOP to invest in globally diversified and low-cost investments.

With digital wealth platform Endowus, you can plan and manage your money — whether held in cash, CPF, or SRS — by investing in globally diversified, intelligent, low-cost portfolios seamlessly. To get started, click here.

Appendix: geek note

For those who enjoy maths, here's the Black-Scholes Model Formula:

You’ll note that the Black-Scholes model requires you to estimate six specific inputs: current share price, strike price, risk-free rate, dividend rate, time to expiry, and volatility: 

• We’ve already covered share price and strike price (sometimes called “exercise” price) above, which form the basis for computing intrinsic value
• Time to expiry is stated in the terms of your ESOP grant. Note that for accounting purposes, the actual input is closer to half of the total time to expiry... it's a long story
• Start-ups typically don’t pay out dividends, while the risk-free rate can be found off Bloomberg as long as one is careful to identify the correct time period to use.
• But how about Volatility? And how does Black-Scholes shift the equation on valuation of ESOP?
  

The problem is that the option value is usually higher than the intrinsic value, and your company may actually be quoting you this option value when quoting the value of the options that you are being offered. There’s nothing wrong with this — the accountants will do the same, after all — but you are at a negotiating disadvantage if you don’t do the sums right. 

To do this, one needs to understand volatility.

Volatility is a measure of the day-to-day fluctuations in the share price of the company, as proxied by the company’s listed peer group (We know technically this calculation is historical volatility and not implied volatility, but the accountants don’t seem to make the distinction and so we won’t do that here, either). The general idea here is to come up with a mathematical representation of what the future share price might become, based on projected fluctuations in price. Most of us won’t be able to figure this out on our own, and in my experience, even founders don’t know what the appropriate level of volatility to apply is.

So let’s fall back on a rule of thumb, which is that most high-growth companies use an implied volatility of 40-50%. Now you have all the inputs you need to plug into an options calculator, and my personal favourite can be found here. Enjoy!

The author is the Chief Financial Officer and Head of Strategic Partnerships at Endowus, a leading independent digital wealth platform in Asia and the only digital wealth advisory for both private wealth and public pension. Endowus solves the problems of misalignment and literacy in wealth and investing, and takes on the challenge of meeting the needs of client's long term financial goals such as retirement adequacy. It is proud to be the first digital advisor for CPF investing in Singapore.

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