Assumed vs. Cashed-Out Equity: Understanding Your Equity Compensation Package

Equity compensation, like stock options, restricted stock units (RSUs), and employee stock purchase plans (ESPPs), can be a significant component of your overall compensation package, particularly at startups and high-growth companies. However, understanding how this equity actually translates into tangible value requires a careful examination of what happens during key events like mergers, acquisitions, or going public (IPO). Two crucial concepts in these scenarios are assumed equity and cashed-out equity. Grasping the difference between them is vital for making informed decisions about your financial future.

In essence:

• Assumed Equity: Your equity continues to exist after the event, albeit potentially under different terms or tied to a new company. Think of it as transferring your shares or options to a new owner.

• Cashed-Out Equity: Your equity is converted into cash as part of the event. You receive a cash payment in exchange for your shares or options.

Let's delve deeper into each scenario with examples:

1. Assumed Equity

When a company is acquired or merges with another, the acquiring or surviving company might choose to assume the outstanding equity awards of the acquired company. This means they essentially take over the existing equity plans. Your equity doesn't disappear; it's just transferred to a new parent company. Here's what you need to understand:

a) Stock Options:

• Scenario: You hold stock options to purchase 1,000 shares of Company A at an exercise price of $10 per share. Company B acquires Company A, and Company B assumes your stock options.

• What Happens: Your options are typically adjusted to reflect the acquisition. The adjustment usually maintains the economic value of your options. The adjustment can occur in several ways:

  • Ratio-Based Adjustment: If the acquisition ratio is 1 share of Company A for 0.5 shares of Company B, your 1,000 options might become options to purchase 500 shares of Company B. The exercise price would also be adjusted. If Company A's share price was $20 at acquisition and Company B's was $40, then the exercise price for the Company B options would be adjusted to maintain the $10 spread, leading to an exercise price of $20 ($40 - $20 = $20, and the previous spread was $20 - $10 = $10).
    

  • Price-Based Adjustment: The exercise price is simply adjusted by a certain factor.

• Considerations:

  • Vesting Schedule: Your original vesting schedule usually remains unchanged. You continue to vest based on your initial agreement.

  • New Company Performance: The value of your options now depends on the future performance of the acquiring company (Company B in our example). If Company B thrives, your options could become very valuable. Conversely, if Company B struggles, their value could diminish.

  • Complexity: Understanding the adjustment terms can be complex. Carefully review the acquisition agreement and consult with a financial advisor to ensure you understand the implications.

  • Tax Implications: Assuming your options typically doesn't trigger a taxable event at the time of the acquisition. Taxes are usually only due when you eventually exercise the options and sell the shares.

b) Restricted Stock Units (RSUs):

• Scenario: You have 500 unvested RSUs in Company A. Company C acquires Company A, and your RSUs are assumed by Company C.

• What Happens: Similar to options, your RSUs are adjusted based on the acquisition terms.

  • Share Conversion: If the acquisition involves a share conversion ratio (e.g., 1 share of Company A for 2 shares of Company C), your 500 RSUs might become 1,000 RSUs in Company C.

• Considerations:

  • Vesting Schedule: Your original vesting schedule generally stays the same.

  • New Company Performance: The value of your RSUs is now tied to Company C's stock price.

  • Tax Implications: When the RSUs vest, you'll be taxed on the fair market value of the Company C shares at the time of vesting, just as you would have been with Company A shares.

Example of Assumed Equity:

Imagine you work for a fictional software startup, "CodeCraft," and you have 2,000 stock options. CodeCraft is acquired by a larger company, "TechGiant." TechGiant decides to assume CodeCraft's equity plan. The acquisition terms state that each CodeCraft share will be exchanged for 0.75 shares of TechGiant. Your 2,000 CodeCraft options now become 1,500 TechGiant options (2,000 * 0.75 = 1,500). The exercise price is also adjusted to maintain the economic value of your options. You continue to vest according to your original schedule.

2. Cashed-Out Equity

In some acquisitions or IPOs, your equity may be cashed out. This means your equity awards are converted into cash at a predetermined price. This is a straightforward transaction, but it's essential to understand the valuation and tax implications.

a) Stock Options:

• Scenario: Company D acquires Company E. Company D decides to cash out all outstanding stock options of Company E.

• What Happens: Company D calculates the "in-the-money" value of your options (the difference between the acquisition price and your exercise price) and pays you that amount in cash. For example, if the acquisition price is $30 per share and your exercise price is $10 per share, the "in-the-money" value is $20 per share. For 1,000 options, you would receive $20,000 (1,000 * $20).

• Considerations:

  • Gain or Loss: You'll realize a taxable gain based on the difference between the cash you receive and your original cost basis (which is usually zero for stock options).

  • Tax Rate: The gain is typically taxed as ordinary income (not capital gains) because you never actually purchased the shares.

  • Lost Upside Potential: You lose the potential for future upside. If Company D's stock price skyrockets after the acquisition, you won't benefit from that increase.

b) Restricted Stock Units (RSUs):

• Scenario: Company F goes public (IPO). As part of the IPO process, all outstanding RSUs are cashed out.

• What Happens: Your RSUs vest immediately before the IPO, and you receive cash equal to the IPO price per share for each RSU. For example, if the IPO price is $25 per share and you have 200 RSUs, you'll receive $5,000 (200 * $25).

• Considerations:

  • Tax Implications: You'll be taxed on the cash you receive as ordinary income. This is the same tax treatment as if the RSUs had vested normally and you had immediately sold the shares.

  • Potential for Future Growth: Similar to stock options, you forego any potential future gains from holding the stock.

Example of Cashed-Out Equity:

Let's say you have 500 stock options in a company called "GameDev," with an exercise price of $5. A larger gaming company, "MegaGames," acquires GameDev for $20 per share. MegaGames decides to cash out all GameDev options. Your options are "in the money" by  $15 per share ( $20 - $5). You receive $7,500 in cash (500 * $15). This $7,500 is taxable as ordinary income.

Key Differences Summarized:

Making Informed Decisions:

Whether your equity is assumed or cashed out, understanding the terms and implications is crucial. Here are some steps you can take:

1. Read the Fine Print: Carefully review the acquisition agreement, merger agreement, or IPO documents. Pay close attention to the sections describing the treatment of equity.

2. Consult with a Financial Advisor: A financial advisor can help you understand the tax implications of your equity compensation and develop a strategy for managing your wealth. They can provide personalized advice based on your specific circumstances.

3. Consider Your Risk Tolerance: If your equity is assumed, think about your comfort level with the new company's risk profile. Do you believe in its long-term prospects? If not, you might want to consider selling shares after they vest (if possible).

4. Understand the Tax Implications: Work with a tax professional to understand how the assumption or cash-out will affect your tax liability.

5. Diversification: If you receive a significant cash payout, consider diversifying your investments to reduce risk. Don't put all your eggs in one basket.

Equity compensation can be a valuable asset, but it's essential to understand the nuances of assumed versus cashed-out equity. By carefully reviewing the terms of any transaction and seeking professional advice, you can make informed decisions that align with your financial goals. Remember, knowledge is power when it comes to managing your equity compensation.