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Employee stock option grants are financial instruments that grant the recipient the right (though not the obligation) to purchase a predetermined amount of a company’s shares at a predetermined price, at a predetermined time. The shares allocated for these options come from the employee option pool.
In the startup world, employee stock options have become a standard part of compensation packages. Startups like offering stock options because they align employee incentives with those of the company, while reducing cash burn rate (as stock options often allow companies to offer a lower base compensation). Employees with stock options can share in the financial benefit if and when a startup has a liquidity event.
In this article, we’ll break down how employee stock options work, the different types of employee stock options, and their respective tax implications.
Suppose hypothetical employee Alex takes a job at Startup X. As part of his offer, Alex receives a grant for 5k stock options, each with an exercise price of $5/share. His stock options have a four-year vesting period (with a one-year cliff) and a 10-year exercise window from the grant date.
The exercise price—also called the strike price—is the price at which the option holder can purchase the underlying shares. In our case, Alex would be able to purchase 5k shares of Startup X at $5/share.
The exercise price is often determined by the most recent 409A valuation (if the company is private). Typically, the younger the company, the lower the strike price. Assuming the company is increasing in value during Alex’s employment, his strike price should represent a discount to the current fair market value of the shares (i.e., Alex can purchase his shares for $5 each, even though the latest 409A valuation says they’re worth $20 each).
Most companies don’t allow employees to purchase their stock options right away. Instead, employees must wait until their options have “vested”—which is determined by their vesting schedule and will be laid out in the grant documents.
A common vesting period for startups is four years with a one-year cliff. The one year cliff means that 25% of the options will vest at the first anniversary of the grant date. From there, the remaining 75% of the option grant will vest evenly over the remaining three years (typically, the options will vest in even, monthly installments after the cliff). If an employee leaves within the first year, no options will have vested and the entire grant will likely be forfeited.
For Alex, this means he won’t be able to exercise any of his options for the first year following the official date his options were granted (known as the grant date). 25% of his grant (1.25k options) will be available to purchase one year after the grant date, with the remainder of his grant (3.75k options) vesting equally over the remaining 36 months. Meaning from month 13 till month 48, about 104 options (3.75k/36) would vest each month.
The exercise window is the period during which the recipient can exercise their vested options. The exercise window usually changes depending on whether the recipient is currently employed by the company that granted them the options. Departing employees often see their exercise window reduced to 90 days, creating a scramble to exercise. Following the expiration of the exercise window, the employee will be unable to exercise the options.
In our case, Alex has a 10-year exercise window from the grant date to fully exercise all his vested options—after which they would expire. However, should he leave Startup X, he’s subject to a 90 day post-termination exercise window. This is how long he would have to exercise his vested options after he leaves the company.
There are two main types of employee stock options—incentive stock options (ISOs) and non-incentive stock options (NSOs). The main difference between the two is the tax treatment of these employee stock options.
ISOs—also called statutory stock options—can only be granted to employees of that company. Their key benefit is that when the recipient exercises their ISOs, it’s a non-taxable event. The only taxable event happens when the recipient sells the shares.
Let’s go back to Alex. Say all his options have vested, and Alex pays $25k to exercise all 5k options. Sometime later, Startup X goes public, and Alex decides to sell the 5k shares he received at the current market price of $20/share.
His total proceeds are $100k (5k x $20/share) with a total gain of $75k ($100k - $25k exercise cost). He would only be taxed on that gain of $75k—either at the higher ordinary income tax rate or the lower long-term capital gains tax rate. For Alex to qualify for the latter, he must meet the following holding period requirements:
Because ISOs can only be granted to company employees, if Alex leaves Startup X, his vested ISOs will generally expire within 90 days. The exception to this is if his company offers an extended exercise period. If so, his ISOs can be converted into NSOs after 90 days.
Further, because ISOs are tax advantaged, there’s a $100k per year limit on granting ISOs—with anything above that limit treated as NSOs.
The above tax explanation is rather simplified. While exercising ISOs is not a taxable event, there can be Alternative Minimum Tax (AMT) implications. Let’s say that when Alex exercised his options, the fair market value was $10/share—implying a $5/share gain upon exercise. While that gain is unrealized, it will still factor into his AMT calculations.
The mechanics of AMT tax and ISOs are complex. If you’re an employee with ISOs, it might be best to consult a qualified tax professional when you choose to exercise.
Sometimes also known as Non-Qualified Stock Options, NSOs are stock options that do not have the tax advantages of ISOs. Recipients may be contract employees, advisors, freelancers, or former employees whose ISOs have converted into NSOs.
NSOs involve two taxable events—one upon exercise and another upon sale of the received shares. If Alex had NSOs and exercised his options when the fair market value was $10/share, he would have an unrealized gain of $25k ($5/share gain x 5k options). This $25k would be taxed at the ordinary income rates and Alex would incur said tax liability immediately upon exercising.
Then, when he later sells those shares on the public market at $20/share, he would have another gain of $50k, being the $100k sale proceeds minus $50k—which is the fair market value when he exercised ($10/share x 5k options). If he meets the same holding period requirement mentioned in the previous section, this $50k gain would be taxed at the long-term capital gains rate.
Not all equity compensation offered by companies to employees is in the form of employee stock options. There are four other common types that we will briefly discuss here—Restricted Stock Units (RSUs), Restricted Stock Awards (RSAs), Stock Appreciation Rights (SARs), and Employee Stock Purchase Plans (ESPPs).
RSUs are essentially a version of stock options that do not need to be exercised. Like stock options, RSUs have a vesting schedule, but when RSUs vest, the recipient owns the shares outright. There is no need to exercise RSUs (and hence no need to bear any exercise cost).
As the recipient’s RSUs vest, their fair market value is taxed as ordinary income. If the recipient subsequently sells their shares, any gain will also be taxed at either ordinary income or short/long-term capital gains rates.
RSAs give the recipient the right to buy a certain amount of the company’s shares at the grant date. The purchase price can be set at the current fair market value, at a discount to fair market value, or even at zero. RSAs are typically only granted to the first few employees of a startup, likely before it has undergone its first financing round. Taxes are assessed as the RSAs vest, although the recipient can choose to pay their taxes upfront under an 83(b) election made within 30 days of the grant.
SARs allow the recipient to obtain the potential upside (the appreciation) of a stock option—but without needing to pay the exercise cost. In essence, the recipient will simply receive the difference between the SARs’ grant price and the current fair market value of the stock at the point the recipient chooses to exercise their SARs. This can be paid in cash, shares, or a combination of both. Exercising SARs creates a taxable event.
ESPPs are company-sponsored plans that allow employees to purchase company shares at a discount to the fair market value (maximum discount of 15%). Employees are often given the option of deferring their wages—up to the IRS’ contribution limit of $25k a year—and then using that to purchase the discounted shares. Unlike RSUs, however, taxes are only due when the recipient sells the shares. ESPPs are typically used by publicly traded companies.
The company issuing the stock options should provide the recipient with the details they need to exercise their options.
Under Generally Accepted Accounting Principles (GAAP), stock options are to be recorded as an expense at their fair market value. The expense should be listed in the books at grant date, although it should be recognized over time according to the vesting schedule. Option pricing models like the Black-Scholes Model can be used to measure this fair value.
It often depends on a variety of factors, including exercise window, fair market value, exercise price, tax implications, company prospects, personal finances, and broader market conditions. An early employee at a successful startup will be inclined to exercise their stock options because their strike price is at a significant discount to the current fair market value and the company’s prospects are bright. On the other hand, an employee at a failing startup will be less inclined to exercise their options because it’s unlikely the shares will ever be worth anything and the current value of the shares may be less than their strike price (meaning the options are “under water” or “out of the money”).
There are a few possible outcomes. The acquiring company may choose to “cash out” the options, in which case the recipients would take the cash and pay any taxes on the gains. The acquiring company could also give the recipients its own shares in exchange. What the recipient would be able to do with those shares would depend on whether the acquiring company is public or private.
This is a complex topic that also depends on the specific terms listed in the Change of Control clauses in the stock option plan. As a best practice, employees should carefully review their stock option plan with their employer before signing.
AngelList offers founders comprehensive equity management tools. Founders can issue employee equity grants and model the impact of stock issuances. Employees also get access to a dedicated dashboard where they can view the value of their options, vesting schedule, and exercise window. To learn more about AngelList for Startups, visit our website.
Not all startups succeed. As a result, working for (or investing in) a startup can be riskier compared to working for a more established company. Employee stock options compensate startup employees for the added risk by giving them a way to share in the success they helped create.
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