Navigating Stock Options for Startups

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Navigating Stock Options for Startups

Stock options represent a contract that allows individuals to buy specific amounts of stock at a fixed price. Stock options are not actual equity or shares - just the potential (option) to buy them later. There are four critical points in time important to stock options:

  • Grant Date: Time when the company grants the employee the stock option. This information is often provided in the offer letter based on the 409A valuation; the price predetermined at the grant date is called the strike price. For more on this, check out this article.
  • Exercise Date: When the employee actually becomes a stockholder or exercises their option to buy the stock they are granted. The employee exercises (buys) at the price given at the grant date (strike price).
  • Expiration: Date when the employee is no longer eligible to exercise their options. This is often also known as the end of the exercise window — more on this below.
  • Sale Date: Time when the employee decides to sell the shares they purchased at the exercise date. Many private companies have rules around how, when, and who exercised stock can be sold to.

How Stock Options Work

In theory, stock options allow employees to own a piece of the company at a lower cost. This is advantageous to both the employee and the company: employees have the potential to make money on the shares they have while also having greater buy-in when it comes to the company’s success. The value of stock options thus relies on the assumption that a company will become more valuable over time.

Take the following example scenario: two companies grant the same stock option - 100 shares vesting over 4 years with a 1 year cliff date. This means that you get nothing for the first 12 months, at the 12th month 25%, and 1/48th every month thereafter (4 years x 12 months = 48 months. The exercise price per share given on the grant date is $1 per share. The value of exercised stock options at any given point (note that before year 1, when no shares have vested, there is no value) is the difference between the solid and dashed line. As the graphs demonstrate, this difference varies rapidly over time, directly tied to the value of the stock. This is an important characteristic of stock options to keep in mind - that their potential value to an employee is highly dependent on the company’s success.

Exercising Stock Options:

Like many forms of equity compensation, stock options often follow a vesting schedule. Stock options can be exercised once they have vested (after the cliff date) during the exercise window. An individual can exercise stock options only for a specific amount of time before they expire.

Some companies offer early exercise, an employee-friendly policy that allows individuals to exercise before the options have vested. For example, if we go back to the scenario above (100 shares vesting over 4 years with a 1 year cliff date), an early exercisable stock option would allow the option holder to exercise all or a portion of the option immediately. Early exercise often requires approval from the board of directors and/or could be reflected in stock option paperwork.

Similarly, many companies offer opportunities for employees who have left their roles to continue to exercise their options. In the past, most companies opted for a 90 days after an employee was terminated (post-termination exercise period or PTE) for their window to remain open. This window was often considered too short.

In response, many companies have extended their exercise windows, for example:

  • Brex: 7 year exercise window after 2 years of employment
  • Coinbase: 7 year exercise window after 2 years of employment
  • Gusto: 10 year exercise window after 3 years of employment
  • Ladder: 7 year exercise window after 2 years of employment
  • Loom: 10 year exercise window after 2 years of employment
  • Notion: 10 year exercise
  • Pinterest: 7 year exercise window after 2 years of employment
  • Strava: 5 year exercise window after 2 years of employment

Some external events that can trigger vesting are called accelerated vesting. A merger, acquisition, or any other change of control is an example of single trigger acceleration. Single trigger acceleration generally ceases some or all of the vesting restriction. Double trigger acceleration requires two events to trigger acceleration (i.e., a company is sold and everyone at the company is involuntary terminated).

Common Times to Exercise: Generally, the best times to exercise stock is when your shares are more likely to be liquid and/or have the highest market value

  • Departure: If your company offers a limited post-termination exercise period, leaving a company is a good opportunity exercise. If you think the company is likely to increase in value, this is a chance to gain shares at a discount.
  • Before they vest (early exercising): Early exercise can often be beneficial for tax purposes. It limits the amount of taxes one may pay because less time elapses between the grant date and exercise date (assuming the value of the stock also hasn’t changed very much). We will go into tax implications more below.
  • After IPO: When a company goes public, there is often more certainty that the shares will be worth more than the strike price. Additionally, IPOs are times when the stock is more liquid.

Types of Stock Options

There are two types of employee stock options, Incentive Stock Options, and Non-Qualified Stock Options. The stock options differ most widely in who they can be awarded to and how they are taxed.

Incentive Stock Options (ISOs):

Incentive Stock Options are options that can only be granted to employees. They almost always expire 10 years after they are issued or 90 days after an employee is terminated - there are exceptions to this timeline that we’ll cover later. Incentive Stock Options get their name from their initial purpose - incentivizing employees to remain at the company and increase its value. ISOs are often seen as better to employees due to their favorable tax treatment.

Non-Qualified Stock Options (NSOs or NQSOs):

Non-Qualified Stock Options can be granted more widely - to consultants, advisors, directors, or employees.  Employers can claim a tax deduction for NQSOs.

Tax Considerations

There are three types of taxes most relevant to stock options:

  • Ordinary Income Tax: Tax owed on any income earned by an individual. As of the 2021 tax year, there were seven brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%, depending on your taxable income and filing status (single, married, etc.)
  • Capital Gains Tax: Tax that is owed on the profits from the sale of most investments (stocks, collectibles, investment real estate) if held for at least one year. The capital gains tax rate is 0%, 15%, or 20%, depending on your taxable income for the year
  • Alternative Minimum Tax (AMT): A tax system that expands the amount of income that is taxed by adding items that are usually tax-free and disallowing many deductions under the regular tax system. The AMT does not apply to everyone, but does often affect holders of ISOs. To find out if it pertains to you, consult a tax expert.
Taxes for ISOs

At Exercise: No tax liabilities are owed for holders of ISOs at the time of exercise.

  • Potentially owe AMT that tax year on the amount the Fair Market Value exceeds the exercise value at the time of the grant. This situation is highly unlikely (recall that the strike price is usually equivalent to the fair market value) but could happen if another 409A valuation is completed within a short period.

At Sale: AMT adjustment may be required depending on when purchase and sale is completed

  • Held for less than 1 year: Stock is taxable at the long-term capital gains rate and option grant date is less than two years before the sale
  • Held for more than 1 year and comes from options granted at least two years prior to the sale: Long-term capital gains tax

Holders of ISOs should be aware of the 83(b) election, an IRS provision that allows those with stock options to pay taxes on the total fair market value when it is granted. For more on this, check out Complete’s article on taxation.

Taxes for NSOs

At Exercise: Taxed as regular income, not eligible for the 83(b) election. Taxes are based on the spread between the stock's Fair Market Value when it is purchased (market rate) and the exercise price (or strike price).

At Sale:

  • Held for less than 1 year: Stock is taxable at the long-term capital gains rate and option grant date is less than two years before the sale
  • Held for more than 1 year and comes from options granted at least two years before the sale: Long-term capital gains tax

Selling Private Stock

As we’ve discussed, private companies often have restrictions on selling stock. Liquidating shares in a private company can be a complicated process. There are however, some choices that employees can pursue when it comes to selling their exercised stock.

Bi-Lateral Secondary Transaction: A handful of companies (Forge, Equityzen) serve as online marketplaces for trading pre-IPO/private employee shares from private companies. These marketplaces help connect private stockholders with individuals seeking to purchase private stock.

Tender Offer (Buyback): A transaction where owners of the private stock sell it back to the company or outside investors. The seller (the employee with the original stock options) has the opportunity to earn money off their equity faster, rather than waiting for it to IPO. Buybacks usually occur between one (or a combination) of two buyers: the company the shares are in (a corporate repurchase) or a third-party (and investor or other company).

Both tender offers and bi-lateral secondary transactions must be approved by the company before they are finalized. Consult with your HR individual to see if this is an opportunity for you.

Together opportunities like these offer employees more autonomy in their equity-related financial decisions. Instead of being at the mercy of executive decisions (like acquisition, merges, and IPO), employees can have greater flexibility in their compensation.

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