Employee Stock Options: When to Exercise and the Tax Implications

Employee Stock options are a great way to incentivize employees and keep them in the company in exchange of a chance of owning a part of the company. We have heard stories of early employees of big tech companies making millions by selling the stocks of the company at a later stage. Sounds simple right? Join a promising startup which offers stock options and sell them at a later stage and make a ton of money.

But is it? Employee stock options are great but it might be somewhat complicated to understand for the employees joining a startup. Lets break it down in this article

What are Stock options?

Stocks options give employees the right, but not an obligation, to buy the stocks at a predetermined price (also known as strike price).

These options are used to incentivize the early employees. While they share similarities with call options, one key distinction is that stock options, unlike call options for publicly traded companies, cannot be traded on the open market.

The options are not granted all at once as it might lead to scenarios where an employee joins just before a liquidity event (such as an IPO, acquisition or merger) and choses to buy the stocks, sell and leave the company. This is not good for a startup as it becomes hard for startups to retain good employees.

Vesting Schedule

It is the schedule over which the employees are granted stock options

The stock options will not be granted to employees all at once but over time. In order to keep the employees vested in the company for longer duration, almost all companies follow vesting schedule.

The companies may follow different types of vesting such as time-based vesting or performance-based vesting. But most companies follow “4 year vesting schedule with one-year cliff”. One-year cliff implies that if the employees leaves the company within 12 months, he will not be entitled to any stock option. After a year, employee will vest 25% of the stock options entitled to him/her. And after that every month the employee will vest 1/48th of options until the end of the 4th year. Some companies may have quarterly or yearly vesting schedules, in which employees will vest 1/16th of their options quarterly or 25% of their options on a yearly basis. Upon completion of year 4, employee will have vested most of the shares.

Fair Market Value (FMV)

It refers to the estimated value of the share of the company if it were sold today in the current market.

Exercising the options

Exercising refers to buying the stocks of the company at the strike price.

Say you have vested 1000 stock options of a company at a strike price of $10 and the value of the shares of the company now is $50. It would make sense for you to exercise your options by paying $10,000 ($10 strike price per option * 1000 stock options) and getting 1000 stocks. If you decide to sell it at $50 per share, then you make $40,000 in profit.

Early exercising the options

Some companies allow their employees to early exercise their options before they vest in order to get tax benefit (they don’t have to pay or pay a lesser tax amount at the time of exercising). This might seem to be a better option as you will be able to buy the shares at a lower strike price and pay lesser tax at the time of exercising. But the earlier you exercise the more the risk of uncertainty regarding the company.

Note that not all companies allow early exercising.

Exercising stock options during liquidation events

a) Before IPO

If the company is planning for an IPO and you are bullish about the company, you can exercise your stock options earlier depending on the lock-up period. Usually when a company goes public, the employees are not allowed to sell their shares for a period of time, known as lock-up period (typically ranges from 3 months to a year post-IPO).

For example, if you are eligible for 1000 stock options and your company is planning for an IPO and the lock-up period is 6 months, then it is better to exercise the stock options at least 6 months before IPO. If you exercise 6 months before IPO and you decide to sell after lock-up period, you will be eligible for long term capital gains tax or else you will have to pay short term capital gains.

You can also maximize your gains by early exercising and you will have to pay lesser or no tax as the strike price will be more or less equal to fair market value.

b) After IPO

One benefit of exercising post IPO is you know what the stocks are worth. If the value of strike price is less than Fair market value, you can exercise and sell the stock to make a gain.

Also you will have more options to finance if the cost of exercising the options is high and you are not able/not willing to finance the purchase of stocks from your own pocket. These are the exercise and sell strategies:

• Exercise and hold: Exercise the options and hold it for a longer period if you are bullish about the company
• Exercise and sell to cover: Exercise your shares and sell enough shares at FMV to cover the costs.
• Cashless(Exercise and sell): You can exercise and sell the options in the same transaction. Hence you don’t need to pay for the cost of purchasing.

c) Acquisition

It is important to understand the liquidation preference before exercising.

Liquidation preference determines who get paid first and how much they get paid in an event of liquidity.

In any event of liquidity, the order of payment is as follows:

1. Unpaid debt
2. Liquidation preferences
3. Participation along with common shareholders up to cap

After the debt is paid, the preferred shareholders are paid based on either seniority or all are paid at the same time.

Lets say a company has raised a total of $2 million from Series A investors at $10 million post-money valuation and an option pool has been created on post-money basis. Lets assume that the option strike price is $1 per share. (assuming that there is no outstanding debt)

• In this case Series A investors own 20%.
• In general, you would expect that in case of an acquisition offer 20% of the proceeds would be distributed to Series A and rest would be distributed among common shareholders.
• If the acquisition offer is for $2 million or less, the common shareholders don’t get paid as the preferred shareholders(Series A) will be paid first up to $2 million and if the acquisition offer is greater than $2 million the rest of the proceeds are distributed among the shareholders depending on the liquidation preference multiple and whether the investor has participating or non-participating liquidation preference.
• If investor has agreed on 2x non-participating liquidation preference, the investor will be paid out $4 million or 20% of the acquisition amount, whichever is the maximum. Here even if the acquisition price is $12 million, which might sound interesting, there is no point in exercising the options ($4 million will be paid to investor and the remaining $8 million will be distributed to the common shareholders. Assuming the options exercised, option price = $8 million/8 million shares = $1). In this case if the acquisition price is greater than $12 million it makes sense to exercise the options.
• In case of 1x participating liquidation preference, the investor will be paid out $2 million first and 20% of the remaining amount. Here even if the acquisition price is $12 million, which might sound interesting, there is no point in exercising the options ($2 million will be paid to investor and the remaining $10 million will be distributed to the common shareholders. Assuming the options exercised, option price = $10 million/10 million shares including the investor shares = $1). Again in this case if the acquisition price is greater than $12 million, employees can exercise options and benefit from it or else there is no point in exercising the options.
• In some cases, as we saw above, the acquisition price may sound attractive but post paying the liquidation preferences the value of a share may be below $1 per share. If you exercise your options, you end up losing money.

Hence, the type of liquidation preference(participating or non-participating), liquidation multiple and acquisition amount need to be taken into account before deciding on exercising the options.

Tax implications

Employee stock options are taxed at 2 instances:

• At the time of exercise
• At the time of selling

The tax at the time of exercising is taxed as income based on the tax slab rate. As we can see from example above if the Fair Market Value (FMV) at purchase is $3 and the exercise price is $1. Even if you do not sell the shares you need to pay tax on the $2(FMV at purchase — Exercise Price).

Note:

• There are 2 types of Stock options: Incentivized Stock Options (ISOs) and Non-Qualified Stock options. ISOs and NSOs mainly vary with respect to how and when they are taxed
• In case of NSOs, the above shown taxation method is used.
• In case of ISOs, you may need to pay Alternate Minimum Tax(AMT). And at the time of selling you pay for capital gains tax (short-term or long-term) on the $4 (Sale price — Exercise price), considering the example above, if eligible for tax benefits. Check out this post for more details.

In some cases ISOs may be eligible for deferred tax payments (or payment of tax at a later date) but incase of NSOs the tax needs to be paid at the time of exercising.

Conclusion

Employee stock options are an amazing and powerful financial instruments for startups to attract high quality talent. They offer employees the opportunity to share in the success of the companies they work for and align their interests with the organization’s growth.

However, employee stock options are also complex, and a lot of stock options go unexercised due to incomplete understanding of how these stock options work. It is important to understand type of liquidation preference, the liquidation multiple, acquisition amount in case of M&As and how it affects the price of shares and also taxation structure to benefit from the stock options.