This guide designed to provide you with valuable insights and strategies to maximize the potential of your equity compensation.
In the startup world, stock options play a vital role in your compensation package. To help you navigate the intricacies of stock options and make informed decisions, ESO Fund is pleased to offer you a comprehensive guide. This guide designed to provide you with valuable insights and strategies to maximize the potential of your stock options and unlock the full benefits of your equity compensation.
The below guide is a set of links to in-depth blog posts on different stock option related topics alongside quick simple explanations of every thing you need to know about your equity.
1. Understanding Stock Options: An Overview
Stock Options are the right to purchase shares of a company's stock. This act of purchasing shares is called exercising. At private companies, stock options are given to employees as incentive to stay and grow with the company.
Options come in two forms: ISOs & NSOs. The main difference between the two is taxation. ISOs are treated more favorably but expire 90 days after an employee leaves the company. NSOs can be extended up to 10 years and given to non-employees like contractors, but have more punitive taxation.
Many later stage companies use a different type of equity compensation called RSUs. Here is some more information on Stock Options vs RSUs.
Key terminology and concepts
- Strike Price: The cost to exercise (or purchase) one option, resulting in the ownership of one share of the company's stock.
- Fair Market Value: The current IRS recognized value of one share of the company's stock. This number is primarily used for taxes when exercising, and as the strike price for new option grants.
- Vesting: Typically you don't just get 100% of your options at once, you must earn them over time. This is called vesting. A standard option package will vest 25% of the options after 1 year and vest the remaining 75% monthly over the next 3 years. This incentivizes employees to stick around at a company.
- Expiration: All stock options (and RSUs) expire at most 10 years from their grant date. ISOs expire 90 days after termination from the company, and while NSOs can be extended beyond 90 days they typically follow a similar timeline. Expiration means the options are no longer available for exercise.
- Rule 701: Much like their public counterparts, large private companies are required to provide financial information to prospective stock holders. In private companies, this means employees with stock options. Only companies that meet certain requirements are required to provide Rule 701 Disclosures, but it is worth asking for if you are considering exercising.
2. Tax Implications of Stock Options: Navigating the Complexities
- When Granted: Stock options are not taxed when they are granted, neither are RSUs. If you are given shares by the company those are taxed as short term income based on the current FMV.
- When Exercised: Both ISOs and NSOs are taxed at exercise based on the difference between their strike price and the current FMV. ISOs are taxed via AMT (Alternative Minimum Tax) and NSOs are treated as income. Typically companies withhold NSO taxes at exercise, while ISO AMT is paid the following spring when taxes are due.
- When sold: All stock options are taxed when sold based on the difference between the eventual sale price and their cost basis. For ISOs, the cost basis is simply the original strike price. For NSOs, the cost basis is the FMV at the time of exercise. In both cases, tax rates are based on the holding period between exercise and sale, which determines whether the income is treated as long-term or short-term capital gains.
Check out ESO's AMT Calculator!
3. Exercising Stock Options: Strategies for Maximizing Value
- Expiration: When your options are set to expire soon, it definitely makes sense to consider exercising.
- Early Exercise: If your company allows it, it can often make sense to exercise early in order to take advantage of little or no tax implications.
- Reduce Taxes: Similar to early exercise, if you find yourself in an advantageous tax situation it can make sense to exercise. This could mean simply starting the clock on Long-Term Capital Gains or exercising ISOs when you don't owe AMT. Other examples of tax-based rationale for exercising include but are not limited to exercising before a suspected rise in FMV or exercising while your company is still eligible for QSBS.
Understanding liquidity events and exit strategies:
- IPO: Initial Public Offerings are the ultimate exit for any startup. Simply put, the company is "going public" meaning its shares will be traded on the public markets. For pre-IPO shareholders this means they can finally sell their stock for cash (after the 6 month lockup period). Similar routes to IPOs are Direct Listings and SPACs, at the end of the day all of these methods result in a publicly traded entity.
- M&A: Another way that a company can exit is by being acquired. In this case typically pre-acquisition shareholders will either be cashed out or given shares of the acquiring company's stock. Either way most of the time shareholders become liquid. Corner case: In March of 2019, Airbnb acquired HotelTonight while Airbnb was still a private company. HotelTonight shareholders received both cash and Airbnb stock. Luckily for them, Airbnb went public less than 2 years later.
- Secondary Sales: Traditionally private company shares have been considered illiquid, meaning they cannot be readily exchanged for cash. In today's world, there are many routes to selling your private stock, namely marketplaces such as Forge, Zanbato, and Hiive. Not every company allows their shares to change hands, so it is best to check with your stock administrator to see if private sales are permitted.
In conclusion, understanding and effectively utilizing stock options can be a game-changer for individuals navigating the world of investments and startups. This comprehensive stock option guide provides valuable insights and practical advice on topics such as exercising options, managing risks, and maximizing potential gains. Explore the linked blog posts to delve deeper into specific areas of interest, and empower yourself with the knowledge and strategies needed to make informed decisions and capitalize on the potential of stock options.
Feel free to reach out using the form below to discuss your options or for help exercising risk-free.