How do incentive stock options work in your startup?
How do incentive stock options work in your startup?
Joining a startup in Silicon Valley often comes with a unique perk — stock options. On average, employees receive 12–14% of the value of their salary in the form of these startup stock options. For example, if your yearly pay is $150,000, you could be eligible for an extra $21,000 in stock options.
Most startups prefer offering Incentive Stock Options (ISOs). These options become valuable when the market value exceeds the strike price. However, it’s crucial to understand that exercising ISOs might trigger the Alternative Minimum Tax (AMT), potentially leading to higher taxes than regular income tax calculations.
In this article, we’ll look into the workings of Incentive Stock Options and understand how they operate in the startup culture.
How do Incentive Stock Options (ISOs) operate in a startup?
Incentive Stock Options serve as a form of equity compensation, allowing you to acquire company shares at a predetermined exercise price. Unlike tangible shares, ISOs require you to exercise or purchase them to become a shareholder.
ISOs stand out in taxation compared to non-qualified stock options (NSOs). Generally, you don’t face immediate taxes upon exercising ISOs, and under certain conditions, you may qualify for a lower tax rate.Startups and various U.S. companies often integrate ISOs into their overall compensation structure. These startup stock options incentivize employees to stay with the company until the options fully vest.
Once vested, you can purchase the ISOs at a predetermined strike price. The value of Incentive Stock Options is subject to change, influenced by the company’s performance. Successful outcomes can translate into financial gains based on the increased value of the options. Importantly, exercising ISOs is not mandatory, providing flexibility for individuals to decide when and if to proceed with the purchase.
What key terms are used for incentive stock options in your startup?
If you’ve got Incentive Stock Options (ISOs) from your startup, you might be wondering how to figure out when to exercise them, what your fair market value is, and what the tax implications might be. Well, it’s not a straightforward “one size fits all” situation, and there are some key terms you should know:
When’s the right time to turn those stock options into real shares?
It’s a crucial decision, considering it can get quite pricey. The specifics of your equity and your current financial status will determine your decision. To understand the process better, let’s look at some key scenarios and tax implications.
Scenario 1- Before the Company Goes Public or Has a Big Payout
- If you exercise startup stock options a year before selling and have held them for at least 2 years, you might catch a tax break. Instead of the usual high-income tax rate, you could pay the more favorable long-term capital gains tax rate.
- If your company’s shares have increased, one thing to keep in mind is the Alternative Minimum Tax (AMT). You might have to pay a bit extra when you exercise. The AMT rate is around 28%, calculated on the difference between the fair market value and your strike price.
Scenario 2- After the Company Goes Public or Has a Big Payout:
- Your strike price can vary depending on your startup’s growth stage. In a seed-stage startup, it might be as low as $0.05/share, making early exercising relatively affordable. It could be higher in a Series B stage, like $3.00/share, requiring more cash upfront.
- If you’re short on cash and your company is now public, you can opt for a “cashless exercise.” Your employer or a brokerage firm can give you a loan to exercise the startup stock options, then sell the stock immediately at the market price. It’s a practical way to handle it without needing a chunk of cash upfront.
Taxation on Incentive Stock Options (ISOs)
When it comes to the taxation of Incentive Stock Options, there are two main players: ordinary income tax and capital gains tax. Historically, capital gains tax rates have been more favorable than ordinary income tax rates.
Let’s break down the process and considerations with a handy flowchart:
Exercise ISOs: You can hold onto the resulting shares without selling them immediately.
Immediate Sale: If you decide to sell right away (maybe to cover exercise costs), these shares won’t qualify for the ISO tax advantage. The gap between your option’s strike price and its fair market value upon sale will be subject to ordinary income tax, as with Non-Qualified Stock Options (NSOs).
Hold for at Least One Year: Opting to keep your Incentive Stock Options for at least one year after exercising and two years after the grant date makes your stock eligible for the tax incentive when you eventually sell.
Sell After One Year: Holding your startup stock options for at least a year after purchase allows you to benefit from the lower capital gains tax rate on any increase in value. However, be aware of the potential alternative minimum tax (AMT) when you exercise — it’s more likely to affect higher-income individuals.
Immediate Sale Consequences: If you choose to sell your stock right away, you won’t experience any capital gain, and you’ll be subject to ordinary income tax rates on the portion you exercise and sell.
Mastering Startup Equity and ISOs
As the name implies, increasing the value of your startup stock options via your contributions to the company’s success is the goal of incentive stock options.
Understanding ISO timing, taxes, and use is crucial to maximize this employee advantage. Startup equity is a complex issue, and many parties are involved, including your company, outside investors, the Internal Revenue Service, and the board of directors.
To fully benefit from being a member of a thriving company, it is important to keep informed and make smart decisions to maximize the potential of your ISOs.
