Startup Employees, Before You Buy Your Options...
A few weeks ago, I wrote a post about a startup’s responsibility to explain equity to new employees. I wanted to go a little bit deeper on equity exercising and tax implications when leaving a startup.
If you’re leaving a startup after one year or more you likely have some percent of vested equity options available to purchase; the ownership you’ve earned in your time working there. When you were first hired and granted equity options, you probably got a nondescript envelope that looks like this:
Inside are the Notice of Stock Option Grant and a copy of the most recent Stock Option Plan that’s been approved by the board. There are two types of options offered to new employees, Incentive Stock Options (ISO) and Non-qualified Stock Options (NSO) here are simple definitions and tax implications for each, your envelope should tell you which type you have.
Incentive Stock Options: Often presented as ‘tax free on exercise’, ISOs are preferable to NSOs but not tax free. While you don’t have to pay an income tax when you purchase these shares, you do have to represent the difference between the strike price of the share at purchase (what you’re paying per share based on the share price when the options were granted to you) and the fair market value (FMV) of the share at purchase (what price the share is valued at today) as a ‘tax preference’ when filing Alternative Minimum Tax documents. The AMT is usually a 28% tax on the difference between the price you paid and the value of those shares today. Better then income tax, but still a large bill.
Example: Purchasing 25,000 ISOs with a $1 per share strike price when they were granted to you that have increased in valued to $10 dollars per share over the three years you’ve worked there would result in a $63,000 tax in addition to the $25,000 you paid to buy them in the first place.
Non-qualified Stock Options: NSOs are taxed with ordinary income tax rates when you decide to exercise them. So the delta from your strike price when options were granted and the current fair market value of the options is taxed roughly 33% when you file in April.
Example: Purchasing 25,000 NSOs with a $1 per share strike price and a present value of $10 dollars per share would result in a $74,250 tax in addition to the $25,000 you paid to buy them in the first place.
So, you’ll be out almost $100,000 within a year of leaving just to get and hold the ‘upside’ that you were supposedly a part of building. In theory, a long-term benefit comes after exercise tax when the company becomes liquid and massively more valuable and you sell your shares for a fortune, it is taxed as long-term capital gains, about 15%.
To Companies: There’s an immediate issue here that starts with new employee contracts. When you sign your options grant on your first day, you’re agreeing to decide whether or not you’re going to purchase your vested options when you leave within 90 days of your last day. This locks employees into a rushed decision. Those 90 days are rarely aligned with the company’s own growth and are not enough for an employee to assess if their ownership will pay off or not. In many cases, individuals can’t purchase even if they intend to. At a reduced startup salary and in consideration for living and familial expenses, many employees haven’t earned enough money from the company in order to buy their shares of the company. All employers know this very clearly, they can see your earnings and know what general costs of living are.
There’s a simple solution: throw out the 90 day standard and adopt a 5-7 year exercise window. Pinterest is leading the way today in adjusting for the sake of employees and everyone should follow suit. In seven years, most company outcomes will be much more clear and employees can make an informed decision about buying their options. They will also have had time to create a plan to be able to buy them without emptying their savings accounts. Employee options considered over the lifespan of a company as people come and go are never a large cap table burden. There’s no downside for the company or investors to extending the exercise window. Be good people!
To Employees: Ask for an extended options exercise window when you’re negotiating an offer with a new startup. Its not one of the major levers of immediate compensation but can save you so much when you’re at the other end of your time with a company. Its much harder to ask for an extension when you’re leaving then to have it locked in before you start.
And then, a word of warning on purchasing options at all. When you do it, you will pay a tax in the year that you exercise and it will be on the company’s paper valuation. Fair market value for private companies is basically made up and is likely to be more inflated then not. Just like any investment, you’re making a bet when you exercise. The advantage you have as a legacy employee is that you know what’s actually happening at the company. So break it down. Do you think the company will IPO? Will it have a huge acquisition? Is it all smoke and mirrors? Are they hemorrhaging talent or revenue or users? Is the leadership superlative or kind of meh? These answers can help you think of a rough percentage likelihood of you making bank on your options versus paying a huge tax on a paper valuation even if the company’s already gone under (yes you’d have to pay it regardless).
I hope this helps bring some clarity to the equity purchase decision. Its a big one for most people and should be considered thoughtfully. Thank you to Lee, Rob, Sam, and John for their thoughts and feedback on this post.