Disclaimer: I am not a lawyer nor an accountant. I don’t even play them on TV. What I have done is some research. I have also been at a couple of startups where I had to figure out the paperwork. It obvious, but please do consult a qualified financial or legal adviser before making any stock option related decisions. If any of you out there are professionals, feel free to drop me a line with any corrections.
Why Give Out Stock Options?
Because they are free. Well, not exactly free but close to it. Startups give out stock options to align their employees to the goals of the investors. Typically, a company will have a stock pool, after each round of funding, to give out to employees. This pool is roughly between 10-20% of the total shares outstanding and dolled out depending on service, rank and the whim of the board. So, stock options are a perk that tries to make employee a little more like owners.
Types of Stock
Before we dig into stock options, we should discuss the types of stock that a company can issue. It’s important to understand this because this will determine the fully diluted amount of stock outstanding, which affects your overall company ownership. The various types are:
Founders Stock: Is a special class of stock that is only issued once, upon founding of the company. You usually buy this type of stock since the price is low (on the order of cents) and there are tax advantages (long term capital gains) for buying and holding it.
Preferred Stock: As the name implies, preferred stock is special. It’s usually reserved solely for investors and has special perks. These perks include: being paid first, preferences before conversion to common (e.g. Multiples) and voting rights. The price and terms for preferred stock is set per round (e.g. A-round, B-round).
Common Stock: If it’s not preferred, then it’s common. Eventually, all stock may convert to common, depending on the preferences listed at each round. This is important to know since it sets the total shares issued as well as the amount of participation the common shareholders will have in a liquidity event (e.g. Being bought or going public). In some cases, the preferred will take all the money and leave the common stockholders with nothing. Common stock is what your options are for.
Types of Options
There are only two types of options that you will get at a startup — an Incentive Stock Options (ISO) or a Nonqualified Stock Options (NSO). In IRS speak, an ISO is called a Statutory option while an NSO is called a Nonstatutory option.
Incentive Stock Options
These type of options can only be issued to employees. They have certain tax advantages, the biggest being that ISOs are taxed on the sale of the stock not the exercise of the option. This means that you can exercise your options and not have to worry about taxes until you actually sell the stock. Well, not exactly. You do need to look into Alternative Minimum Tax (AMT) triggers since that plays by a different set of rules (see below). Some of the other rules that ISO’s follow are:
Must be granted at Fair Market Value (FMV)
Must be granted 10-years after board approval
Must be exercised 10-years after the grant date.
Nonqualified Stock Options
All other options, at a startup, are typically NSOs. There are something called warrant’s, but those are usually reserved for outside investors, so we won’t deal with that here. NSOs are more flexible than ISOs but they don’t have the same tax advantages. The main thing about NSOs is that they are taxed when you exercise the option. This means they are taxed at ordinary income tax levels and you don’t get the benefit of long term capital gains. NSOs have the flexibility in terms of:
Can be given to anyone
Can be priced at, above or below the current market price, so no issues with FMV
It is critical that you understand which type of options you have. The tax implications are real and severe if you do the wrong thing. It’s best to consult a professional tax advisor as to your best course of action.
ISO options are priced via a complicated process known in the trade as a 409A. We won’t get into the details since it’s complicated and for a startup, hard to calculate. The thing to keep in mind about option pricing is that it will be less than the present preferred round price. As the company gets closer to a liquidity event, the option price will converge to the round price. The rational for this is simple. Early in a startups life, the risks are high. The options can’t be exercised, so the value has to be based on a future value of a company that might not be around when the option can be exercised. All this means is that early options are worth less since they are more risky. As the probability of a liquidity event gets greater and greater, the options become less risky — thus worth more.
Stock options vest over time. Usually, options vest over a four year period with a one year cliff. The one year cliff means that you don’t get any of the vested options till a year after the grant date. At that point, you 25% of the options vest. After that, the vesting schedule is 1/48 per month for a four year vesting schedule.
There can be vesting triggers for certain events. These are all up to the company and board of directors. A typical vesting trigger might be a change of control or loss of title. In these cases, all of the options could vest right away. It really depends on the board. It is not unheard of to have fully vested options (i.e. 100% vested at the grant date) as a bonus.
IRS Section 83B
The IRS Section 83B is an election that allows employees to change how restricted stock options are taxed. Restricted stock usually comes in two categories:
Founders Stock: When a company is founded, the Fair Market Value (FMV) is really hard to determine and fairly low. The Founders stock is restricted and “granted” or given right away (e.g. No vesting schedule). This means without an 83B election, you would be paying AMT as the stock price appreciated at each round. So, all founders should buy their shares and file an 83B election. This ensures the most favorable tax treatment (since it starts the long term capital gains clock) and eliminates any AMT issues. The downside is that you can be out the cost of the stock (which is most likely low) if the company fails.
Early Option Exercise: Some option plans allow you to exercise your options before they vest. This type of exercise has to happen within 30 days. The tax advantage is that it starts the long term capital clock while the stock vests.
See, this is kinda tricky. You really do have to read that grant paperwork carefully to understand how taxes will be calculated. It is perfectly acceptable to ask your CFO to explain this to you or have them recommend a professional.
Taxes are complicated. To make it even more complicated, the IRS actually has two tax systems. Yup. Two different tax systems that have completely different rules. Exercising stock options will have tax implications for each system.
Standard Income Tax
Most people are used to this system because we all pay taxes. Options can be taxed two ways in this system: as short term capital gains (like ordinary income) or long term capital gains (at a reduced rate). These rates vary all the time, so it’s best to look up the long term capital gains rate and how it relates to options. As of this writing, the criteria for long term capital gains is 2 years from the grant date and one year after the exercise date. The long term capital gains rate is between 5% or 15%, depending on your tax bracket.
Alternative Minimum Tax (AMT)
AMT becomes a problem with ISO options because of the ability to hold without a taxable event. Remember, that an ISO is taxed when you sell the shares not when you exercise the options. NSO’s are taxed when you exercise the options, so they are taxed at your regular income tax rate. Keep in mind that if you exercise and sell an ISO in the same year, AMT is not an issue because it’s consider short term capital gains and taxed at your normal income tax rate.
ISO’s have a major disadvantage to the employee in that the spread between the purchase and grant price is subject to AMT. For taxable incomes up to $175,000 or less, the AMT rate is 26%. Above $175,000, it’s 28%. If the AMT rate is more than your normal tax rate, then you pay AMT and not the regular tax rate. There is also something called a Minimum Tax Credit (MTC), which is the difference between the AMT amount and your normal tax amount (if AMT is higher). This MTC can then be deduced in subsequent years.
I’m sure by now your brain hurts from all this. Mine too. The thing to take away from the whole AMT thing is to know that it exists and talk to your accountant.
Lets take a look at some examples to see how this stuff works.
Example 1: NSO Options
Jane received 5,000 NSO options at $1.00 from Wonderful Company. The vesting schedule is 4 years with a one year cliff. It’s been two years since the grant date and Jane now wants to exercise some options. The present stock price is $2.50. So, the math looks like this:
Total Options: 5,000
Option Price: $1.00
Options Value: $1,000 (at Grant)
Vested options after two years: 2,500 (24/48 or 1/2)
Vested option worth: 2,500 * 2.50 = $6,250
As soon as Jane exercises her NSO options, she will owe regular income taxes (short term capital gains) on the spread, which would be $2.50 – $1.00 = $1.50 per share or
$6,250 (Exercise Value) – $2,500 (Option Price) = $3,750 taxable income.
Now, if she held the stock, even for the long term capital gains timeframe, she would still owe taxes on the $3,750. So, it’s important to sell some options to cover the taxes that you owe even if you think the stock will go up later.
Example 2: ISO Options
Jim received 10,000 ISO options at $0.25 from Uber Cool Company. The vesting schedule is 4 years with a one year cliff. It’s been 1.5 years since the grant date and now Jim wants to exercise some options. The present stock price is $9.50. Jim’s math looks like this:
Total Options: 10,000
Option Price: $0.25
Options Value: $2,500 (at Grant)
Vested options after 1.5 years: 3,750 (18/48 or 3/8)
Vested option worth: $35,625
Jim exercises his vested ISO options. At that point, he owes no regular income taxes but the spread ($9.50 – $0.25 = $9.25 * 3,750 = $34,687.50) between the grant and exercise price is subject to AMT. So, Jim needs to talk to his accountant to see if he will trigger owing AMT. If Jim holds his stock for more than a year after he exercises it, then he will owe long term capital gains when he sells it.
The complexity of the tax system makes it challenging to understand what you might owe when exercises options. Couple that with the changing nature of our tax system and you can see why 1) I am not an accountant and 2) why they get paid so much. It’s always best to seek out professional help when trying to sort this out. What you should do is become familiar with the terms so you can ask the questions. Listed below is a summary of things you should be aware or:
Option type: ISO (Employees Only) or NSO (Everyone else)
ISOs are not taxed at exercise but at selling. It does have that nasty AMT trigger
NSOs are taxed at the time they are exercised.
Vesting schedules are typically 4 years with a 1 year cliff.
Your particular AMT triggers for ISOs (talk to an accountant)
Exercised option hold period
Does your options qualify for a IRS Section 83B election?