Understanding Startup Stock Options
When you should exercise, how to get paid out, how much you’ll make, and how much you’ll get taxed
Disclaimer: This is not legal or tax advice. Consult your own professionals before making any decisions.
If you’ve recently received stock options at a startup, are thinking about joining a startup, or are currently negotiating an offer, you’ve come to the right place. Equity can be a huge incentive for joining a startup early, but knowing when to exercise your options, how to get paid out, how much you’ll make, and how much you’ll get taxed is not at all obvious. It’s important to have a solid understanding of how options work, because the way you use them can have huge financial consequences.
What is a Stock Option?
A stock option is a contract that gives you the right, but not obligation, to buy a stock at an agreed-upon price and date. The price at which you can purchase the stock is called the exercise price, or strike price. So if your employer grants you 100 options, you do not own 100 shares. Rather, you have the option to buy 100 shares at the aforementioned strike price. Doing so is called exercising your option.
Most startups give employees Incentive Stock Options (ISOs), though some use Non-qualified Stock Options (NSOs). For this post we’ll assume that we’re only dealing with ISOs, but you can read about the difference here.
Options become valuable when the market price is higher than the strike price. Here’s a simple example:
Alice’s employer grants her 10,000 ISOs with a strike price of $1 per share. 5 years later, the company has gone public and is now trading at $10 per share. If she had exercised all of her 10,000 options, she’d make a profit of $90,000 ($10 * 10,000 - $1 * 10,000).
Bob’s employer also grants him 10,000 ISOs with a strike price of $1 per share. 5 years later, the company has gone public, but is now trading at $0.50 per share. Because Bob’s strike price is higher than the market price, his options are worthless. If he had exercised his options, he would have lost $5,000.
Understanding the Equity Component of an Offer
There are a few key components to an equity offer that you should always look for.
Number of Options
The number of shares you have the right to purchase.
Your percentage ownership of the company’s total outstanding equity, assuming that you exercise all of your options. This is calculated as (number of options) / (total outstanding shares issued by the company).
The per-share price that you pay to exercise your options.
Typically your equity grant will be subject to vesting, which means that you don’t receive all your options right away, but that you’ll receive them over time. A typical vesting schedule is four years with a one-year cliff. This means that if you leave the company within your first year, you’ll walk away with nothing. If you stay, 1/4th of your shares will vest on your one-year anniversary, after which 1/48th of your shares will vest monthly.
There are plenty of other vesting schedules too. Some companies have a five-year vest with a six month cliff. At Amazon, 5% of your shares vest after year one, 15% after year two, then 40% after years three and four.
Post-Termination Exercise (PTE) Window
If you leave your job, you’ll often have just 90 days to decide if you want to exercise your options. Once those 90 days are up you forfeit all your options, causing many employees to find themselves in “golden handcuffs”. Luckily, some companies like Pinterest and Asana are starting to do 5, 7, or 10 year PTE windows. Be aware, though, that even if your PTE window is more than 90 days, your ISOs will convert into NSOs after 90 days.
When will I be able to convert my options into cash?
Options can be converted into cash when your company experiences a liquidity event.
The best-case scenario is usually an IPO. If your company goes public, you can exercise your options and sell the stock on the public market.
Another possibility is an acquisition. If your startup gets acquired your options may get converted into cash, they may get converted into options in the purchasing company, or they may become worthless. It all depends on the terms of the acquisition, which you can read more about here.
If your startup hasn’t yet reached a liquidity event you can also try to sell your shares in the secondary market on a platform like SharesPost.
Finally, some companies like Uber have occasionally offered to buy back employee stock as well. If none of these scenarios work out for you, your options are worthless.
So what is my equity really worth?
I once received a job offer that included 0.1% equity in a Series A company. When I negotiated for more equity, the recruiter pushed back and said “If the company is worth $1B one day, then your equity would be worth $1M”. This is incredibly misleading because it ignores dilution, which is the key to understanding why you can’t just multiply 0.1% by $1B and conclude that you’re going to make $1M.
Most startups have to raise multiple rounds of funding before they reach a liquidity event. When a startup raises a funding round (i.e. seed, Series A, Series B, etc.) they cede a percentage of the company to new investors. Usually this will require issuing new shares, which results in dilution. Here’s an example:
Imagine you’re working at a seed-stage company currently valued at $4M. There are a total of one million outstanding shares. The company decides to raise a Series A, during which they sell 25% of their company to investors in exchange for $2.5M at a $10M pre-money valuation, or $12.5M post-money. So the investors want to buy 250,000 shares, but all of the existing shares are already owned by current employees or reserved for future employees. The company now has to create 250,000 new shares to sell to investors, bringing the total number of shares to 1,250,000.
Now suppose you own 1,000 shares. Before the Series A, you owned 0.1% of the company (1,000 / 1,000,000). After the Series A, however, you own only 0.08% of the company (1,000 / 1,250,000). Your ownership has therefore been diluted by 20%.
But wait, it’s not all bad! Your equity is actually worth 2.5X more than before! At the seed stage you owned 0.1% of a $4M company, valuing your equity at $4,000. After the Series A, you own 0.08% of a $12.5M company, valuing your equity at $10,000.
If you were to extrapolate your current level of ownership in the company out to a $1B valuation, you’ll find that your equity would now be worth $800k (0.08% of $1B), not $1M as the recruiter suggested.
Keep in mind, though, that most companies can’t go public off of a Series A alone and instead need to raise several rounds of funding to get to that level. According to Capshare, you should typically expect a company to take on 25% dilution during Series A, 24% at Series B, 13% at Series C, and 14% at Series D.
So if you join a Series A stage company and expect them to have to raise a D round before they’ll be able to go public, you should expect to see your original equity ownership diluted by about 43% (1 - 0.76 * 0.87 * 0.86).
When should I exercise my options?
Exercising your options can be expensive, so deciding when to exercise is going to depend on your personal financial situation. However, it’s important to understand all possibilities and the enormous tax implications that come with each one. After explaining each scenario, I’ll go through a set of examples.
Exercising one year before IPO
One of the best times to exercise your options is one year before the IPO, as described by Wealthfront here. If you exercise your options one year before selling and your grant date was at least two years prior to the date you sell, you’ll only have to pay long term capital gains tax on your profit, rather than the much higher typical income tax rate.
If the fair market value (determined by the most recent 409a valuation) of your company’s shares has risen above your strike price, you may also have to pay Alternative Minimum Tax (AMT) at the time you exercise your options. The federal AMT rate is 28% of the spread between the fair market value of your shares and the value of your shares at your strike price.
The problem preventing many people from using this approach is that it often requires fronting a significant amount of cash to exercise your options. If that’s the case, you can wait until after the IPO to exercise your options.
Exercising and Selling Post-IPO
If you can’t afford to exercise your stock options, but your company has already gone public, you can arrange a cashless exercise. In a cashless exercise, your employer or a brokerage firm will give you a loan to exercise the options, then sell the stock at market price immediately. You then use the proceeds from the sale to repay the loan. This is quite common at startups where employees can’t afford to exercise their options. Typically the mechanics of the process of receiving the loan, selling the stock, and repaying the loan is hidden from the employee, and he or she will simply receive the proceeds after the whole transaction is complete. The downside to this approach is that your gain from selling the stock will be taxed as ordinary income because you’ve held the stock for less than a year.
Many startups allow their employees to exercise their options before they’ve vested, which is referred to as early exercising. Early exercising is a good idea when you either have high confidence that the company will have a successful exit or the total cost to exercise is affordable. This approach has 2 major advantages:
- You’ll owe zero AMT at the time you exercise your options if your strike is equal to the company’s last 409a valuation.
- The 1-year countdown to qualify for long term capital gains tax starts ticking.
Keep in mind, though, that early exercising is risky. You should only early exercise if you are comfortable losing your entire investment.
The cost to early exercise varies drastically depending on the stage of the company. If you’re at a seed stage startup, your strike price could be $0.01. In this case, early exercising 50,000 options would cost you $500. At a Series A stage company, however, your strike price could be around $0.50. Early exercising 50,000 options at that price would cost you $25,000.
Pro-tip: If you’re negotiating a job offer at a startup that allows you to early exercise, try asking them to throw in a signing bonus for the amount it would cost you to exercise all your options. They write you a check, then you write them back a check to exercise your options a few days later! Of course, you should be aware that signing bonuses are taxed highly. Employers tend to be more open to this than a normal signing bonus because they’re getting all or most of their cash back quickly and it shows that you’re seriously invested in the company.
If you choose to early exercise it is absolutely crucial that you file an 83(b) election within 30 days to inform the IRS of your decision. If you don’t file an 83(b) election form, you’ll be hit with additional taxes when your options vest.
🚨 Bonus: Pay Zero Tax If Your Company Qualifies for QSBS 🚨
Companies may qualify for QSBS (Qualified Small Business Stock) if they are a US-based C-corp with less than $50M in assets. If your employer qualifies for QSBS at the time you exercise your options and you hold them for at least 5 years before selling, you will pay $0 in tax when you sell your shares. I know this sounds hard to believe, but it’s true.
To drive the point home, imagine your startup becomes wildly successful and you make a profit of $2M when you sell your shares post-IPO. Normally you’d owe $467,000 in long-term capital gains tax when you sell your shares. If your company qualified for QSBS when you exercised your options and you held the shares for 5 years before selling, you’d owe $0 in tax.
What happens if you leave before your options have vested?
If you early exercise your options and leave before they’ve all vested, the company typically has 90 days to repurchase any of your unvested shares at the same price you paid. If they fail to do so after 90 days, all the unvested shares are yours. This can vary across companies though, so you should check your option grant letter or ask your employer.
The year is 2012 and you’ve just joined a seed-stage startup. You’ve received a grant for 100,000 ISOs with a strike price of $0.01. The options vest over four years and the company currently qualifies for QSBS. The company goes public in 2020 at $10 per share. Here are a few different ways this can play out:
Scenario 1: Early Exercise
Immediately after receiving the option grant, you early exercise all 100,000 ISOs for a total cost of $1,000. You owe $0 in AMT at this time, because there is no difference between the market price and your strike price. By 2016, all of your options have vested. After the 2020 IPO, you sell all 100,000 shares on the public market at $10 per share and $1,000,000 is deposited into your account. Because the company qualified for QSBS when you exercised your options back in 2012, you owe $0 in tax. It’s all yours. Congratulations on your $999,000 profit!
Scenario 2: Exercise Options 1 Year Before IPO
In 2019, your company files an S-1. You exercise all your options, costing you $1,000. The company’s most recent 409a valuation put the share price at $1, which means the spread when you exercise is $99,000 ($1 * 100,000 - $0.01 * 100,000). You now owe $27,720 (28% * $99,000) in AMT.
A year later, you sell 100,000 shares on the public market at $10 per share and $1,000,000 is deposited into your account. The long-term capital gains tax on this amount would normally be $200,000 (20% * $1,000,000), but you get to deduct the $27,720 in AMT that you’ve already paid, so you now owe a total of $172,280 in tax. This puts your net profit at $799,000 ($1,000,000 - $172,280 - $27,720 - $1,000). Not too shabby, but still $200,000 less than the version of yourself in Scenario 1.
Scenario 3: Exercise and Sell Options Post-IPO
After the 2020 IPO, you exercise your options and sell them on the same day. Again, exercising the options costs you $1,000, then you sell all your shares and $1,000,000 is deposited into your account. Because you’ve sold your shares within one year of exercising the options, the $1,000,000 is taxed as regular income at a rate of 37%. You owe $370,000 in tax, putting your net profit at $629,000. You also may owe state income tax on top of that. In California for example, you’d owe an additional $107,205 in state income tax, putting your net profit at $521,795.
Scenario 1: $999,000 profit
Scenario 2: $799,000 profit
Scenario 3: at most $629,000 profit
10 Questions to Ask Your Employer When Receiving Stock Options
Finally, here’s a checklist to go through with your employer anytime you receive an option grant.
- What is the total number of outstanding shares?
- What is the total number of shares in my grant?
- What is my equity percentage in the company?
- What is the strike price on my options?
- What was the last 409a valuation?
- What was the company’s valuation in the last round of funding?
- What is the vesting schedule for my options?
- How long do I have to exercise the options if I leave the company?
- Do I have the option to early exercise?
- Does the company qualify for QSBS?
Options can be quite a confusing topic and unfortunately, many employers don’t do a great job of explaining them. I hope you found this helpful. If you have any further questions, feel free to DM me on twitter @BenBeltzer7!