Everything you need to know about startup stock options
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You may hear people compare the value of your startup equity to that of a lottery ticket. While it may be true that startup odds are ~generally~ low, this analogy is inaccurate and misleading.
Unlike lottery tickets, there are things (things that we will cover by the end of this essay!) that you can do to materially influence the financial outcome of your startup equity.
The first category of things—perhaps the most influential one—is that you get to pick where you invest your time. If you pick correctly, your startup equity could turn into a life-changing sum of money.
- Aside, you also get to define how you calculate your return on investment. In this essay, we focus primarily on the financial return on investment from working at a startup, but there are notable others such as learning, impact, fun, and prestige.
- We will emphasize that picking startups to join is a very challenging business to be in. It is such a difficult business that many venture funds—composed of supposedly professional startup investors—actually underperform the public equity markets. Even they (the venture capitalists) diversify their capital across many many investments within a fund (i.e. spread the risk out).
Picking is hard, but since you have to do it—we suggest you pick with rigor, because the delta between a good and great company is often material. (To fully grok how much picking matters, you should read about the impact of the power law). One alternative approach: rather than strictly underwriting businesses, consider underwriting people. It turns out that you have likely encountered many more people in your life than you have businesses, and thus may do a better job pattern matching successful people to help you find success.
The second variable is that once you join a startup, how you spend your time will actually influence the value of your equity. Joining a startup, pending the size and scale of it, is in many ways a bet on your own ability to create value (for your startup, your investors, and hopefully the world). The earlier stage the company and more senior the role, the more closely intertwined your work will be to your financial outcome. If you are confident in your own abilities to create value, well, then, this should be a more than fine bet to be making.
And the third category, the majority of the so-very-fun-contents of this essay, lies in how you go about managing your startup stock options. Management refers to the financial decisions you make with your stock options—the decisions of when to buy your options, when to sell your shares, and how you strategically manage all of the tax implications while not making finance your full time job.
Not understanding the implications of how you manage your equity will lead to unforced errors. Missteps can result in hundreds of thousands or even millions of dollars of missed savings or additional costs. You—the startup founder, employee, or investor—can avoid making mistakes and set yourself up for success (at least as best as possible) by reading the rest of this essay.
You will leave with an understanding of:
- How private company valuations work
- How stock options function
- How stock options are taxed
- How selling your equity impacts your finances
- And how terms such as QSBS, LTCG, AMT, and more make a difference towards your take-home income.
Disclaimer: The below is not financial or tax advice. Please speak with a professional. We may be able to help at Compound, where we provide everything you need to manage your finances (advice, tracking, investments, taxes, and more).
Startups do not have "public valuations." Instead, investors give them what's called a "preferred valuation.” This is the TechCrunch sticker number: "Company X has an $XXX million valuation." Your company receives a new preferred valuation every time it raises what’s called a “priced round.” A priced round is just a type of financing instrument (compare it to raising on a convertible note, for example).
There is a second influential valuation called the 409A valuation. This is the fair market value (“FMV”) of the common stock of a private company as valued by a third-party appraiser. Your company must conduct a 409A valuation at least annually or around every financing event.
Depending on the stage and size of your company, the 409A valuation/share is generally something like 20-30% of the preferred valuation/share. In a successful public listing, the 409A/share and preferred price/share converge.
As the company approaches the listing event, they begin conducting 409A valuations more often (sometimes on the order of once a week) to really line up the prices.
When you join a company, especially an early stage company, you may be issued stock options.
Stock options grant you the right to purchase shares (i.e. "exercise your options"). (Detail—stock options are not shares. To emphasize, they grant you the OPTION to purchase shares. This matters because it impacts some of the tax holding requirements involved in owning shares).
Your % ownership of the company is your number of shares (if you were to exercise your options) divided by the fully diluted shares outstanding (“FDSO”) count. The fully diluted shares outstanding count is the total number of options outstanding, plus the shares already owned by investors and founders (which could be zero). For a simple example, if you were to join a pre-seed stage startup with a total FDSO of 10 million shares, and you were granted stock options for 500,000 shares then you'd own 5% of the business.
As the company scales, your ownership will be diluted. Dilution is not always a bad thing. It occurs when the company is increasing the denominator of the ownership equation because they are increasing the number of new shares (by issuing new stock to investors who are purchasing more shares of the company). Dilution is not always bad because often companies issue new shares to investors (i.e. dilute you) in order to raise the overall valuation, which in turn increases the value of your ownership.
Your company may counterbalance this dilution by issuing what’s called a refresher grant. Refresher grants are new stock options that are issued to early employees in order to keep their ownership stake meaningful.
You unlock the right to purchase your stock options over time through a process known as "vesting.” A typical vesting schedule may be over “4 years with a 1 year cliff,” meaning after remaining at the company for at least 1 year, you unlock the right to begin exercising your stock options. If you were to leave your company (or be fired), your vesting would stop (and the remaining unvested options would be returned to the company). (Some companies offer a special clause called early exercising which we will cover down below)
The price you pay to exercise your options is known as the strike price. (This is sometimes also called the exercise price)
Your strike price is the company’s 409A valuation/share from the time you were granted the options.
The date you were granted the options is not equal to your start date. Generally, companies will issue equity roughly every quarter (around board meetings). They will typically backdate your vesting to be your start date but you should ensure that is accurate with them.
As the company grows, your hope is that the valuation will continue to go up and to the right. The difference between your strike price and the latest 409A is known as the Bargain Element.
A positive Bargain Element is a good thing. It means you could—at least in theory—buy low and sell high.
One problem—you cannot buy low and sell high as you wish because this is a private company with a private, paper valuation. Instead, you can buy low and wait. Or you can _not_ buy and wait.
There are tradeoffs to each approach.
Reasons to _not_ buy are pretty meaningful:
- This is a risky investment opportunity, closely tied to your single source of income (i.e. most startups fail, if yours fails you lose money AND you are out of a job)
- You may not have the money to afford exercise costs AND taxes
- Exercise costs == number of stock options TIMES your Strike Price (simple enough).
- Taxes depend upon the type of option you have, when you exercise, your overall income, and when you sell.
Here is a deeper dive on stock option taxes:
There are broadly two types of stock options: Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). (There are also restricted stock units (RSUs) but we will save that for another thread).
- When you exercise, you pay ordinary income tax on (409A value minus the strike price)
- When/if you sell, you pay capital gains tax on (sale price minus the 409A at the time of exercise)
- For ISOs:
- When you exercise, no ordinary income, but you may trigger something called the Alternative Minimum Tax (AMT). AMT is a rather complicated calculation that we do not go into detail here, but you can find elsewhere in the Manual. In shorthand, you will likely owe AMT if your total bargain element amount from the ISO exercise exceeds the AMT exemption amount.
- One nuance is that anything you pay towards AMT is a credit you may recoup in years where your AMT taxable amount is less than your ordinary taxable income. (Note: there is no guarantee you will have those years in the future)
- When/if you sell, pay long-term capital gains tax on (sale price - exercise price) when you sell—if the shares are sold at least one year after exercising, and at least two years after your options were granted.
- To summarize the above:
- If you exercise NSOs, you may owe ordinary income tax (due immediately).
- If you exercise ISOs, you may owe AMT (due at tax filing).
- If you sell NSOs or ISOs more than 1 year after exercising, you may get long term capital gains (LTCG)(and 2 years after grant date for ISOs).
There is also something to know about called the Qualified Small Business Stock Tax Exemption (QSBS). QSBS refers to the tax exemption (Section 1202) that enables taxpayers to receive tax-free gains from the sale of stock, up to the greater of (i) $10 million, or (ii) 10x their original investment. To qualify, you must acquire original shares, directly from a *qualified* C-corporation (not all categories qualify), and you must hold onto such shares for at least 5 years, The business must have no more than $50 million in aggregate gross assets at the time of issuance.
The benefits of exercising earlier (rather than later) include kickstarting the LTCG and QSBS clocks and locking in a lower bargain element at the time of exercise to reduce tax exposure As your equity scales in value, so do the raw tax benefits—can be worth millions in savings
Some companies allow you to do something called an *early exercise*. This allows you to purchase your options _before_ they vest, kickstarting the clocks even sooner and limiting tax exposure because the bargain element is lower.
- Make sure you file something called an "83(b) election” to lock in the tax benefit. This is basically a pledge to the IRS stating that you want to be taxed on the *current* valuation of your options, rather than the higher valuation at a later date. In order to avoid having to pay tax on the *bargain element*, you must send the 83(b) election postmarked no later than 30 days after the date of the stock purchase.
Many people decide against exercising their stock options due to the associated risks and costs. They rather wait for more information (and to see if there will be a liquidity event) before making a decision or investing more of their money. This is particularly true when the potential tax benefit (usually about 17% of the total) fails to outweigh the risk.
This strategy—the wait and hold—breaks though if you decide to leave your company because of something called the “post-termination exercise window.”
The post-termination exercise window is the amount of time you have between leaving your company (voluntarily or involuntarily) and purchasing your options before they expire. The typical window is 90 days. Some companies offer extended windows (to something like 10 years).
Even if you decide to stay at your company, most stock options (ISOs and NSOs) expire by default after 10 years. This means you have to purchase them otherwise they become worthless. This creates some rather tricky situations where you see long-term, early employees from a company having their stock options expire. Many employees cannot afford to exercise their options because covering both the exercise and tax costs while the company is still private (and you have not yet gotten liquidity) is expensive and risky.
You do not have to exercise (or even early exercise) all of your options at once. You may want to wait and collect more information before making any decisions or gradually dollar cost averaging into your company by purchasing a small portion of your options on a monthly or quarterly basis (as you would in and out of a public stock).
One way to actually get liquidity—before the company is public—to afford exercising is to get some form of loan or financing. There are different types of liquidity providers—ranging from true lenders, to non-recourse financing like forward contracts. Approach with caution as many of the terms are complicated, but there may be a solution as you navigate the sea of financiers.
Some companies provide structured liquidity events—called tender offers—that enable employees to get liquidity cleanly. Deciding to participate (or not) is a question of "what will you do with the money?" and what is your opportunity cost?
If your company ends up making it—and by making it we mean really making it to a big liquidity event—you will be faced with the fortunate (though still tricky) situation of deciding if and when to sell your equity and diversify your exposure. That topic is important, but also we will save it for a different essay as this essay tried to focus primarily on the ins and outs of startup stock options.
Understanding this whole thing—the ups and downs of equity—is hopefully an important reminder that startups can be a long, non-linear game. Money is one big reason to work hard, but we encourage you to think holistically about how you invest your time. We are hoping we can help you with your finances and taxes at Compound.