So you’ve been at your startup for more than a year…
By: Natty, Jon Natkins
Tags: Options, Equity, Taxes, Compensation, Startups

Welcome back for some more equity and compensation fun! If you haven’t checked out the first part of this series of posts, that post covers the basics of incentive stock options. For the rest of this, we’ll spend some time discussing the questions around exercising options (Should I? When should I?) and what that might mean from a tax exposure perspective. As a reminder, I am not an accountant, I just play one on TV, so before you make decisions, get some advice from an actual tax professional.

Exercising Stock Options and Tax Implications

So your company is doing well, you’ve vested some options, and now you want to exercise them. Great! If they’ve gained a lot of value (which you can find out by asking your stock administrator what the current fair market value or FMV is; usually the VP Finance, CFO, or someone you can reach at stockadmin@company.com), you’ll want to make sure you’ve also planned for taxes that you might need to pay.

Even though you may not be able to sell your stock today, when you exercise options, you’re essentially making money on paper (specifically, Fair Market Value — Strike Price). If the FMV is $5 and your strike price is $1 per share, the IRS considers this roughly the same as you getting $4 in your bank account. Fortunately, the IRS doesn’t think of this as exactly money in your bank account, but it will affect how much AMT you owe, and AMT tax bills can get really steep (if you’re not familiar with the Alternative Minimum Tax, I’ll try to cover it briefly here, but it’s fairly complex, so be really careful taking my statements at face value, and do your own research, as well).

No one (I think) relishes paying taxes, so this might make you think that there’s no reason to exercise options until you can sell the shares or the options will expire. However, there are some very important reasons you might want to exercise options sooner rather than later: long-term capital gains and qualified small business stock (QSBS).

Gains on stock come in two primary forms: short-term and long-term. If you sell stock less than one year after you bought it, you pay taxes on short-term gains. If you hold it for any longer than one year, you get long-term capital gains tax treatment. The advantage is that short-term gains are taxed at your marginal income tax rate (probably somewhere in the neighborhood of 28–35% for your average startup employee) but long-term gains are typically at a rate of 15–20% (there’s an additional 3.8% tacked on for the ACA, depending on your income level). The net is that you can cut your tax burden roughly in half (at least on the federal tax side of the house) by holding the stock for more than a year.

It’s important to realize, however, that selling is not always at your discretion. For example, if a company is acquired in an all-cash deal, you’re going to be forced to sell your stock no matter what, which means you could end up paying short-term gains even if you intended to hold the stock for over a year (this happened to me the first time a former employer got acquired, and was a bit of a rude awakening). I’ll save some acquisition scenarios for another post in the near future.

Qualified small business stock is a much different beast, and one that early employees may benefit from, but typically will not be available to employees joining after Series C funding (not a hard and fast rule). It’s a huge tax windfall that allows startup employees to pay zero federal tax on the first $10,000,000 in gains (state taxes may still apply, though, and California is a great example of a state that does not recognize QSBS), provided they’ve held the stock for five years, and meet some other qualifications, and a subject for a different post another time. If you desperately need to know more about this right now, I recommend looking up §1202(c) in the IRS tax code.

As a side note, some companies allow for early exercising, which, if you have money available, and are confident in your company’s future success, may be a good option.

A Quick Thing about AMT

So the deal with AMT is that basically some time ago in the late 60s, lawmakers found out that a bunch of upper crusty folks were using various tax strategies and loopholes to avoid paying income tax, and they had this grand idea of fixing this by applying a flat rate tax to earners making over a certain amount. This is nice in theory, except they didn’t craft the law such that the income limit would rise with inflation, so over the years, more and more people (probably still mostly upper crusty if we’re being honest with ourselves, though sometimes living in the Bay Area, it doesn’t feel that way) get hit with AMT. Some of the AMT exemptions and phaseouts were changed by the Tax Cuts and Jobs Act, so many fewer people will be hitting AMT over the next several years. However, those cuts phase out later in on this decade, so it’s a good thing to be aware of for the future.

The annoying thing about AMT is you don’t really know if you’re going to end up paying AMT until tax time comes, because it’s a secondary tax system which you have to calculate alongside the traditional tax system, and essentially, you pay whichever amount is higher. The reason you need to care about this is that in that example at the beginning of the post (where you exercised for $1, and the FMV was $5), that exercise triggers a taxable event with a whole bunch of AMT exposure. The IRS won’t ask you to pay taxes on the $4 unless it would cause you to owe AMT, in which case you owe tax on $4 on every option you exercised (in real world scenarios this is often in the thousands or tens of thousands of dollars when it hits you hard). This is one reason it might make sense to talk to your friendly tax professional before an exercise to figure out how much you can exercise without triggering AMT.

To be clear, you’ll still the taxed on the difference between the strike price and the FMV at exercise, it just won’t happen until you actually sell your stock at some later date.

The important exception to this rule is NSOs. Non-qualified Stock Options are very similar to Incentive Stock Options, but with a key tax treatment difference. Where ISOs get this preferential tax treatment at exercise time, where you only pay taxes on the FMV/strike spread if you would hit AMT, the IRS does tax you on that spread for NSOs. Most people are unlikely to ever encounter NSOs, but the likeliest place where you would run into this is if you have an unusually long option expiry. As I alluded in the last post, there were a few years where it was in vogue to offer 5-, 7-, and 10-year option expiries as a benefit to employees. You’ll receive ISOs as an employee, but what happens is that after you leave the company, the company converts your ISOs to NSOs for the remainder of the option period. Those long expiries end up being a bit of a blessing and a curse.

And a Side Note about FMV

Since FMV plays an important part in understanding tax implications for an exercise, it’s also worth noting that there are situations where the company’s FMV may not exist. (…What?)

As a refresher, FMVs are set by 409A valuation processes, which are an independent appraisals done by external auditors of the company to determine what it’s worth. This process takes a little while, and has to be done any time there is a tangible valuation change for a company, which is almost always due to a round of financing. As soon as the company receives a term sheet from a prospective investor (even if it’s unsolicited), the current 409A valuation is invalidated, and there is no new 409A valuation until the process is completed again. This often results in a period of time where you can exercise your stock, but you won’t be able to know the FMV until after the 409A process completes, which means it’s impossible to estimate taxes at the time of exercise. Shucks.

On a totally unrelated note about 409A valuations and FMVs, there’s often confusion between FMV/409A prices and preferred stock prices, which are typically much higher than the 409A. Basically, when the company is raising money, they’re going and selling this preferred stock (which imparts some benefits that us common folk don’t get) to investors. And they’re off telling the investors how awesome the company is, and how they’re going to have so much FOMO if they don’t get in, but they have to pay this crazy exorbitant price for the stock. As soon as the round is closed, they turn around and go to the 409A auditors and say “Oh no, this startup is worthless, we’re so risky, and we’re basically about to go out of business tomorrow, so make sure our 409A is really low.” They do this because a low 409A benefits the employees, since it sets the strike price, and limits that AMT and tax exposure at exercise. I, personally, find this dichotomy very amusing.

Early Exercise and Restricted Stock

Some companies allow employees to early exercise stock, which means you exercise your stock option before it’s actually vested, which can get the long-term capital gains and QSBS timers going sooner — extremely beneficial if you think the company is going to do very well, or could be acquired in the next year or so.

Early exercising doesn’t mean you get your stock right away, though. Usually what happens is that the company will apply restrictions to the stock that you’re purchasing via the early exercise (called restricted stock), and creates sort of a reverse vesting schedule. Instead of you vesting the right to exercise your stock options over four years, the company will lose the right to repurchase the stock from you over the course of your vesting schedule. As an example, if you have 1000 stock options, and early exercise 750 of those options, but leave after two years, the company still has the right to repurchase 250 of your shares (since at the two year mark, you will have vested 500 shares). They’ll hand you a check on your last day for the price you paid for those shares, and you’ll walk away with 500 exercised shares. The remaining 250 options will be forfeited, since you haven’t stayed long enough to vest those options.

Very early employees (usually ones who join pre-Seed funding, or sometimes pre-Series A) will receive restricted stock grants out of the gate. This typically happens when the strike price is so low that employees can afford to purchase all of the shares up front. In those cases, there is a similar reverse vest.

DON’T FORGET TO MAKE AN 83(b) ELECTION!

The most important rule of early exercising (or buying restricted stock) is that you need to file a form with the IRS called an 83(b) election, which is a document that tells the IRS you paid for stock that hasn’t been vested yet, but are recognizing the tax gains now. There’s a large tax advantage to this: if you early exercise before the 409A valuation changes, the fair market value of the stock and the strike price are the same, which means there are no taxable gains (and no AMT exposure!). However, there are risks to this: if the stock loses value, you can’t claim a capital loss on options exercised or stock purchased with an 83(b) election. With careful understanding of the risks associated, early exercises can be a powerful financial mechanism for startup employees.

Should I exercise? When should I exercise?

The ultimate question of should I and when should I exercise is a tough one to answer definitively, because it’s very situational. Generally, if you feel strong conviction that your company is going to do well, exercising earlier is often better. If you’re not quite sure, it’s probably better to wait, but there are always exceptions. QSBS is one of those scenarios where the payoff for highly appreciated QSBS is so big that you might want to take a flyer on a stock that isn’t quite as clearly a winner, since you’ll save 20% on taxes. A lot of the answer depends on personal situations, how much you have available to invest, and how you choose to diversify your investment portfolio. Startups are highly risky investments, and the lottery tickets often end up being less of a Megaball and more of a $10 scratcher.

In an effort to provide some framework to think about this, I put together a flowchart of how I think through the logic of an exercise decision. This isn’t right for everybody, but it generally works for me:

Next time!

In the next post, I’ll cover some details about how to think about the future value of your stock, which will incorporate a bunch of important concepts around dilution and liquidation preferences. Understanding an offer, and your total compensation requires a holistic view, so we’ll try to take that angle to understand it a bit better. Also, if you’re waiting for it, I promise I’ll get around to a discussion of some of the more obscure aspects of stock compensation, like QSBS, which I’ve mentioned a handful of times (because I find it really exciting!), single/double trigger acceleration, and possibly also some details about the elusive secondary stock transaction, how it works, and how you do it. Stay tuned, and let me know what you want to read about in the comments!