Understanding Startup Stock Options
Benjamin Beltzer ?is Director of Engineering at?Berbix (S18) , a startup building identity verification and fraud deterrence as a service. He previously founded his own company, worked at both Apple and other startups, and joined Berbix as an early engineer.
Ben wrote a great resource on understanding and evaluating stock options. With his permission, we’ve shared an excerpt from his piece covering the basics. If you want to learn more about stock options — including valuing them, questions to ask your employer and more. Read the?full article on his Medium .
Find Ben on Twitter?@benbeltzer7 , and?work with him at Berbix .
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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 implications.
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.
Understanding the Equity Component of an Offer
There are a few key components to an equity offer that you should always look for.
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.
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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.
Early Exercising
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:
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.
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.
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.
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If you're interested in diving more deeply into startup equity, Y Combinator is hosting a live virtual event with Compound (S19) on Wednesday, July 13th. Register here: Startup Talk with Compound: Understanding Equity