Damn!! Why Didn’t Someone Explain That to Me-- Managing Stock Option Grants at a Startup or Early-Stage Company

Stock option grants have become a very routine part of employee compensation packages at both public and private companies in the US.? While the rules are the same regardless of whether the company is publicly listed or not, there are a host of additional issues and complexities that confront employees working at early-stage or startup companies.? Unfortunately, it is rare that the rules are explained in a simple and practical manner at the outset, and this often leads to employees missing important opportunities and confronting difficult situations during their term of employment.

All the financial and legal issues surrounding employee stock options at early-stage companies must be considered against the background reality that the vast majority of startups fail and that their equity and options are ultimately worthless.? The percentage that fails is estimated to be 90+ percent.? Even if a company survives and remains in business, circumstances may not afford a holder of company stock options any ability to monetize and profit from them.? ?Employees choosing to work at these companies need to consider that when they think about the trade-offs between cash and equity compensation as well as when they contemplate exercising options and incurring the associated financial costs.

The purpose of this note is to provide some practical explanations to help employees make better informed decisions that will hopefully lead to more advantageous outcomes.? It is important to remember that situations vary from person to person depending upon individual financial circumstance as well as the details of employment including position and seniority.? Strategies appropriate for very early employees who join a company shortly after creation and initial funding may not apply to those who join a company after it has completed several rounds of financing.? When in doubt, ask someone who is knowledgeable and has your best interests at heart.

First Day on the Job

You’ve landed a wonderful job at an exciting and relatively new company.? As part of the onboarding process, you execute a standard employment agreement.? It sets forth your position, cash salary, your entitlement to participate in Company sponsored employee benefit programs including paid vacation and makes some reference to you signing a Proprietary Information and Inventions Agreement.? For present purposes, most important of all it contains the following paragraph:

“Subject to the approval of the Company's Board of Directors, you will be granted an option to purchase 50,000 shares of the Company's Series B Common Stock (the "Option"). The exercise price per share of the Option will be determined by the Board of Directors. …? You will vest in 25% of the Option shares after 12 months of continuous service, and the balance will vest in equal monthly installments over the next 36 months of continuous service.”?

You are happy with your position and salary and pleased, if somewhat uncertain, about the stock option grant.? What exactly does it mean?? What, if anything, do you need to know?

Employee Stock Options—The Very, Very Basics.

Essentially, the company is entering into an agreement with you giving you the right (but not the obligation) to purchase 50,000 shares (in our example) of common stock in the company subject to a vesting schedule.? Most importantly, though not specified in your employment letter, the option grant will state a fixed dollar purchase price.? Let’s assume that the purchase price is set at $2 per share.? This is what gives the option grant the potential of being very valuable to you.? Hopefully, over time as the company grows and becomes increasingly successful the value of its shares will appreciate (perhaps 2x, 5x, 10x, 100x or more) above the price at which you are entitled to buy them.? If the company goes public or is sold at some point in the future, you may be able to benefit from the fact that you were able to buy company stock at well below the then current market value.? Or so the story goes… ?

While the above is true, in fact things are a bit more complicated.? Let’s dig into that. ??Every stock option grant will have basic fixed terms:

1.??? The number of shares which may be purchased;

2.??? The purchase price for those shares (in option parlance the “strike price”)[1];

3.??? A vesting schedule (i.e., when you can exercise your options); and

4.??? A termination date (typically 8-10 years after grant) at which time the right to purchase shares ends.

In addition, depending upon company policy and the specific situation of the employee, the grant may also provide that under certain circumstances vesting may be accelerated.? On the other hand, it will also provide that even if rights have vested, if an employee leaves the company options must be exercised within 3 months or they will be forfeited.? I will have more to say on both points later.?

What Are My Options Worth?

Not surprisingly, many employees wonder what their options are worth.? I have heard very smart professionals, well-versed in business and startups offer incredibly silly answers.? This probably reflects the fact that valuing options, even in a publicly traded company, is a complex calculation involving the current share price, the strike price, the term of the option, prevailing interest rates and most important of all, the volatility of the stock.? Applying all of that in the case of a private company is probably best left to academicians and theorists.?

One point that is worth making relates to the capitalization of your company, meaning the different classes of stock that have been issued.? Your options will entitle you to purchase a fixed number of “common shares” of the company.? Investors who have financed the business are almost certain to have received “preferred stock.”? Without getting into too much detail here (if you are interested take a basic corporate finance course) preferred shares are just that—they have a preference over common shares and are entitled to get paid out in full before common stockholders receive anything.? This, combined with the fact that the shares of the company have little, if any current liquidity (i.e. market for sale), means that the common stock will be valued at a discount to the preferred.? Using the pricing of the most recent fundraising round to try to value your options is fraught with difficulty, particularly in the early stages of a company.

My advice is not to spend a whole lot of time on the issue.? So many uncontrollable events need to occur between now and the time that you might be able to realize economic value from your options that you are better off thinking about how you can excel at your job, improve your marketable skills, or fulfill your dream to become a rock star or professional ball player.

Where Does the Complexity Come From?

Like so many things in life a great deal of the complexity surrounding employee stock options—though certainly not all—comes from the way in which these grants are taxed under the US Federal Income Tax Code (the “Code”).? Let’s take this step-by- step and try for some clarity surrounding these issues.

There are essentially two basic types of employee stock options.? They are referred to as Incentive Stock Options (“ISOs) and non-qualifying options (“NSOs”).? Of course, both ISOs and NSOs are used as part of “incentive” compensation plans, so the terminology is unfortunate from the outset.? You need to move beyond that, or you will have no chance of developing any understanding whatsoever.

The Treatment of ISOs.

From an employee’s perspective ISOs are clearly preferable.? Subject to an exception that I will discuss below, ISOs can be exercised without incurring any current tax liability.? If shares acquired through exercise of an ISO are held for at least one year from the time of exercise and for two years from the time of original grant, sale of the shares will qualify for long-term capital gains treatment.? This means the profit will be taxed at the lower 20% rate rather than potentially at the highest US Federal rate of 37%. [2]

So why don’t companies issue only ISOs to employees.? The reason is that the Code limits the number of ISOs that can be granted to an employee.? You will often hear people say that the grant of ISOs is limited to options worth $100,000 to any employee each year.? Thankfully, this is not actually the case, and no valuation of any option is required.? Rather, tax law limits the amount of ISOs granted to an employee in a single taxable (calendar) year based upon the value of the shares subject to the option.[3]? For purposes of computing the $100,000 limit shares are considered only as options vest.? For example, the 50,000 options you were granted are only treated as “granted” for this purpose as they vest over a four-year period.

One nuance to keep in mind is that a typical grant structure like the one described above with 25% of the grant vesting on the one-year anniversary (called the “one-year cliff”) can produce some unforeseen consequences.? Suppose you started your job on January 2, 2024.? You were granted 200,000 options rather than 50,000.? Nothing vests during 2024 but on January 2, 2025, 50,000 options vest.? Since the value of the shares (indicated by the strike price) subject to the options does not exceed $100,000 all the options will be treated as ISOs.? However, as additional options vest ratably each month over the balance of 2024, they will exceed the $100,000 limit and will not qualify.? They will be treated as NSOs.? Obviously, the factual circumstances giving rise to the problem are not limited to the facts as described.? A myriad of different combinations of dates and values can potentially create issues.? It is best to be aware of this ahead of time.[4] ??

Why NSOs are Less Desirable.

Unlike in the case of ISOs, an employee exercising a NSO will be subject to immediate Federal income tax on the difference between the option strike price and the market value of the shares subject to the option.? This is treated as compensation income.? Barring special circumstances, the market value of the shares will be determined based upon the company’s most recent Sec. 409a valuation, if the valuation has occurred within the previous twelve months.[5]? Whether taxation on this “phantom” gain is a significant problem depends, of course, on a myriad of factors including the amount of the gain, the financial circumstances of the employee and the likelihood that the shares will eventually be able to be sold at a profit.? If the shares purchased pursuant to exercise of the NSO are eventually sold, any additional gain will be further taxed.? If the shares have been held for 12 months from the date of exercise any additional gain will qualify for taxation at long term capital gains rates.

ISOs and the Alternative Minimum Tax

As I noted above, the exercise of an ISO will not trigger any current tax liability for the exercising employee—subject to one important exception.? That exception relates to a complexity of the Code referred to as the Alternative Minimum Tax (“AMT”).? Essentially, it provides among other things, that certain types of transactions that do not give rise to basic Federal income tax liability, will nevertheless create potential tax liability in certain circumstances.? One of those transactions includes the “gain” realized by an employee who exercises an ISO when the strike price is lower than the current market value of the underlying shares, effectively treating the ISO as if it were an NSO.? This is the case when the employee’s taxable income is above a certain dollar threshold.? For 2024, the threshold is $85,700 for individuals and $133,300 for couples filing jointly.? In that case the employee needs to compute his or her tax liability under standard rules and the rules applicable to the AMT and pay the higher amount.? This is something that requires the assistance of an accountant or tax lawyer, and you should seek out guidance before making any decision to exercise an ISO if there is any chance the AMT rules may apply.

Early Exercise of Options

One strategy that might be considered to help mitigate some potentially undesirable tax consequences is to exercise your options early if the applicable stock option plan permits you to do so.? If you are an extremely early employee at an early-stage company and your options have been granted with a de minimis strike price (perhaps just a few pennies), it might be worth exercising them as soon as possible to minimize any possible AMT costs that could occur if the options are exercised later when the underlying stock has appreciated in value.[6]? Many stock option plans permit an employee to exercise options prior to the time they vest, subject to the obligation to sell them back to the company at the exercise price if the employee leaves the company prior to the vesting date.

Clearly, exercising options early may require doing so before you have much, if any, visibility into the likely trajectory of the company and whether the stock will ever be of any value.? Moreover, any AMT tax paid is a sunk cost.? However, depending upon the amounts involved it may be a strategy worth considering.? One additional benefit of early exercise is that the holding period for capital gains tax treatment will start that much earlier.[7]

Other Matters—Triggers and Termination Clauses

Two other issues, both mentioned above, are worth some further brief elaboration.? The first relates to what is often referred to as “trigger events.”? Suppose you are a more senior employee joining a company.? You have given up an attractive position elsewhere and your stock option grant was an important factor in your decision to join the company.? You are concerned about what happens if the company is acquired before your options vest and even more focused on what happens if your executive position is made redundant as the result of an acquisition.? One way to address those concerns and to protect yourself to some extent is to negotiate for the acceleration of your options in the event of certain circumstances (hence “trigger events”).? There are basically two types of trigger clauses and your ability to get one of them written into your employment agreement will be a function of company policy and more importantly, your negotiating strength as you work out the terms of your employment.?

A “single trigger” clause provides that in the event the company is acquired all your options accelerate and become currently exercisable.? This will have the benefit of entitling you to get paid for your shares as part of the acquisition.? Given the potentially large payout and the “windfall” nature of the profit to the exercising employee, these types of clauses are extremely rare.? A more common form of trigger clause is called the “double trigger” and provides that your options will accelerate and vest immediately if there is an acquisition of the company and because of the transaction you are terminated or your position at the company is substantially diminished.? If you are in a situation where you believe that you may be able to negotiate a form of trigger, it probably makes sense to speak with an employment attorney who can guide you and make sure that the language contained in your employment letter is appropriate under the circumstances.? Absent any form of trigger clause, in the event of an acquisition your options will be treated in accordance with the terms of the acquisition agreement, which is likely to provide that they convert into options of the acquiring company based upon a defined formula.

Finally, I want to address the issue of employment termination and its impact on vested stock options.?? This is rarely talked about and almost never appreciated until a departing employee is faced with some very unattractive alternatives.? Stock option plans almost always provide that if an employee leaves the company any vested options must be exercised within a period of three months, or they will be forfeited.? This has certainly become a more glaring issue as companies have stayed private longer and consequently many more employees will leave a company before an initial public offering or other liquidity event.? For many employees the first time they hear about this requirement is when they execute their termination agreement.? Holy crap!? They don’t have the necessary funds to execute their options[8], or they are not sure if it is financially the smart thing to do.?

Many people who have some passing familiarity with this issue believe that the three-month rule is a requirement of the Code (in case you forgot, that means the Federal Income Tax Code).? The truth is there is no such requirement in the Code.? The Code does provide that to be treated as an ISO an option must be exercised within three months of an employee’s departure from the firm.[9]? However, and importantly, failure to do so only results in the option being treated as an NSO.? While this will trigger tax upon eventual exercise, at least in my opinion, this is preferable to being forced to exercise or forfeit your options.? If you have worked for years at a company, making a significant contribution to its growth in value, there is a strong argument to be made that you should be entitled to hold on to your options through their expiration date in the hope that you will be able to exercise them and get the financial reward that was a major factor in your years of dedicated service (and perhaps below market cash compensation).?

In Conclusion

Stock options can be an important part of an individual’s overall compensation package.? While the applicable rules are not exceedingly complex, they can be challenging for someone with no financial or legal background.? Companies should make sure that their employees understand how their stock options work and how they can take maximum advantage of the rules that do apply.? When in doubt talk to a qualified professional.? To state the obvious, nothing contained in this article should be viewed as legal or financial advice.

[1] To comply with the US Federal Income Tax Code the strike price must generally be set at the fair market value of the option shares at the time of grant.? 26 U.S Code sec. 422(b)(4).? This is determined by the company’s board of directors, usually in reliance on a valuation completed by an outside firm.? You may hear this referred to as a Sec. 409a valuation.? For reasons discussed under “What Are My Options Worth?”, this will not be the same as the value of the shares issued to outside investors.

[2] The provisions pertaining to qualifying ISOs are found in 26 U.S. Code sec. 422.

[3] Since options are granted with a strike price equal to the current value of the underlying shares, the strike price for the shares can be used for purposes of calculating the $100,000 limit.

[4] Another restriction on the grant of ISOs applies to employees who are deemed to own 10% or more of the stock of the issuing company.? To qualify as an ISO a stock option granted to such individual must have a strike price of at least 110% of the market value at the time of grant and a maturity of no more than five years.? 26 U.S. Code sec. 422(b)(6) and (c)(5).

[5] For this reason, most private companies with options outstanding will make sure that they always have a valid Sec. 409a valuation in place.

[6] Technically, if you exercise early the options will not qualify as ISOs.? 26 U.S. Code sec. 422(b)(6).? However, since you are exercising shortly after grant, there should be no taxable gain.

[7] If you choose to exercise options early, whether ISOs or NSOs, to benefit from reduced tax liability later, you should file a Sec. 83(b) election with the IRS informing them of your early exercise and decision to be taxed currently on any gain.? There is a very short window of only 30 days to file.? If you do not file in a timely manner, for tax purposes you will not get the benefit of the early exercise.? You should be able to get the necessary forms from your company’s HR personnel.

[8] There are firms whose business includes extending loans to employees to enable them to exercise stock options.? These loans are typically non-recourse, meaning that the lender will be looking exclusively to the stock underlying the option to get paid and the employee will not be personally on the hook.? While I have had only limited dealings with several of these firms, my strong impression is that given the non-recourse nature of the loans, they are exceedingly strict regarding the situations in which they are willing to get involved.? This should not surprise anyone.

[9] 26 U.S. Code sec. 422(a)(2).