Understanding Startup Stock Options

Goal: Understand the basics of startup stock options, including the key terminology, the tax implications of exercising options, and the benefits and risks of early exercise.

Stock options are often a large component of an employee's compensation at most startups. While the ultimate value of those options is impossible to predict, it's important for anyone who is granted options to understand the basics of how they work and their tax consequences. This article is an attempt to explain those basics and point out tax issues to explore further depending on your individual financial situation.

So first a disclaimer. I am an engineer, not a financial professional or lawyer. I hope this article will help prepare you for a conversation with a professional but it should not be used in place of one.

Terminology

Here are the key terms used when discussing options that you should know:

Option: A stock option is the right to purchase an asset (in this case a share of stock) at a specified price on a future date.

Strike Price: Also known as the exercise price, the strike price is the price at which you can purchase the share of stock referenced in the option.

Fair Market Value: The current value of the share of stock. The fair market value will change over time depending on the success or failure of the company.

Bargain Element: Also known as the spread or compensation element, the bargain element is the difference between the fair market value and the strike price.

Vesting: The period over which you earn your stock options. Most commonly, startups will follow a four-year vesting schedule with a one-year "cliff". Under this schedule, you earn 25% of your options on the one-year anniversary of your start date and 1/36 of the remaining options each month over the following three years.

Vesting Start Date: This is the date on which the vesting schedule defined in the option grant begins. It is almost always your start date with the company.

Option Grant Date: This is the date on which you are granted your option(s). Option grants are subject to board approval, so this date is often not the same as your vesting start date. The grant date has tax implications for Incentive Stock Options (ISOs), described below.

Exercise Date: This is the date on which you purchased your option(s).

409a Valuation: An IRS-mandated valuation that is used to determine the strike price of employee stock options. In 2005, the IRS added rules governing "deferred compensation", which apply to stock options. Startups must determine a valuation based on these rules in order to set the strike price of new options grants, and the valuation must be updated at least once a year.

Tax Rates

Understanding employee stock options is all about understanding their tax consequences, so before we continue it's important to talk about tax rates. The key distinction relating to gains from the sale of stock is whether they are taxed as ordinary income or capital gains. As of 2016, ordinary income tax rates range from 10-39.6% while capital gains tax rates range from 0-20%. For any given annual income level, it is preferable to have gains taxed as capital gains instead of ordinary income.

The Internal Revenue Code makes this distinction primarily to encourage saving and investment. There is a lively debate over the taxation of capital gains, with some arguing they should not be taxed at all and others arguing they should be taxed at the same rate as ordinary income. That debate is outside the scope of this article, but the distinction between capital gains and ordinary income taxation is essential to understanding the optimal strategy for exercising stock options.

ISO vs. NSO

The two main types of employee stock options are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).

ISOs are a special type of option that can be granted only to full-time U.S. employees. Gains from the sale of ISOs are taxed as capital gains if they are held for one year after the Exercise Date and two years after the Grant Date, and the bargain element does not need to be reported as income under the regular income tax in the year in which the options are exercised. If the company is successful, this can mean enormous tax savings for the employee. However, there is a catch. While the gains don't need to be reported under the regular income tax, they do need to be reported under an alternative system called the Alternative Minimum Tax (AMT). More on the AMT below.

NSOs can be granted to anyone associated with the company, including full-time U.S. employees, international employees, contractors, and advisors. When NSOs are exercised, the bargain element must be reported as ordinary income under the regular income tax. This income is also subject to tax withholding by the company in the same way an employee's regular wages are. Gains from the sale of NSOs are taxed as capital gains if they are held for one year after the Exercise Date.

When exercising NSOs, it is very important to check if taxes on the bargain element were withheld. If they were not or the withholding amount was lower than what you owe, you will have to pay the difference.

Alertnative Minimum Tax (AMT)

The AMT is an alternative method for calculating income taxes. As the name implies, it was enacted by Congress to ensure that all taxpayers over a certain income threshold pay a minimum amount in tax. Without the AMT, tax deductions could be used to eliminate tax liabilities for individuals and families who based on their income would otherwise be expected to pay taxes.

Each taxpayer must pay the higher of their tax liability under the regular income tax and the AMT. As mentioned earlier, the bargain element for ISOs is not taxable under the regular income tax when the options are exercised, but it is under the AMT. ISOs are a common reason why taxpayers end up on the AMT, so it's very important to calculate your AMT liability in years in which you exercise ISOs. The larger the bargain element, the higher the chance you will need to pay AMT.

If your options have a large bargain element, you can split the exercise of your options into multiple tax years. For example, if you were granted 20,000 shares in ISOs, exercising all 20,000 may put you on the AMT in a given tax year. If you can avoid the AMT by exercising 10,000 in one year and another 10,000 in the next, you should. There is a risk, however. The Fair Market Value of stock options will change along with the valuation of the company, so if the valuation changes before you exercise the rest of your options, the bargain element will be larger and the AMT calculation will be different.

Early Exercise

Early exercise is the ability to exercise your options before they vest. Many startups allow employees to do this, but why would you? There are two main reasons early exercise can be beneficial. One is that it starts the exercise period used to determine whether gains are taxed as ordinary income or capital gains. Since it's always preferable (other things equal) to have gains taxed as capital gains, starting the exercise period early will allow you to sell earlier and still realize the capital gains tax savings. The other is that assuming the valuation of your company rises, the bargain element will be smallest the earlier you exercise your options. As we've seen above, a smaller bargain element can help you avoid AMT for ISOs and minimize ordinary income taxes for NSOs.

There are a couple of assumptions I just made above. First is that early exercise will allow you to sell earlier, which of course assumes that your shares can actually be sold! If your company is private and there is no liquidity event (e.g. an IPO, buyout, or merger), you won't be able to sell the shares anyway, so having satisfied the holding period for capital gains tax treatment earlier won't matter.

The current trend is that companies are staying private longer. This means that it's taking longer (on average) for shares of startups to become liquid (can be sold). You should certainly factor this trend in when deciding whether to early exercise. Even if your company does incredibly well and the valuation rises considerably, you have to be willing to part with your initial investment for a long time.

The second and more obvious assumption is that the valuation of your company will rise. It may not! Most startups fail, and many of those that ultimately fail are successful for a time. If you exercise your options when the company is successful and it later drops in value or fails entirely, the bargain element could be much smaller than at the time of exercise (often negative).

So should you early exercise? It's a personal decision that depends on many factors, but there are three general guidelines. First, the initial investment required to purchase your options must be an amount that will not affect your finances for the foreseeable future. As mentioned above, the trend towards later liquidity events means you may not have an opportunity to sell for a long time after exercising.

Second, the startup may fail and you could lose your entire investment. Know your startup's current numbers before you decide whether to early exercise. You wouldn't invest in a publicly traded company without knowing its financials would you?

If your company refuses to give you the financial information needed to make an informed decision, that is a very bad sign. As an employee they see as important enough to grant equity in the company, you should be trusted enough for them to provide you with this essential information. Better yet, they should give you access to these metrics so you can more effectively help improve them!

Lastly, consider the bargain element. If your startup is very young, the bargain element could be very small or even 0. If you've considered the first two guidelines and want to early exercise, doing so when the bargain element is smallest will help you minimize your tax liabilities.

If you decide to early exercise, it is imperative that you file an 83b election with the IRS within 30 days of exercise. Send this return receipt so you know they received it.

Hopefully, this article has helped clarify some of the issues you should consider when making decisions about your stock options. Remember that this is a starting point, and you should do your own research and consult your own advisors about your personal financial situation. Thanks for reading!