Equity Guide for Employees at Fast-growing Companies
Conventional wisdom says that startup equity is worthless. While most startups fail, there’s a chance your equity will become a life-changing pot of money. This guide explains how to make the most of your equity.
Let’s start with an example.
Suppose you join a Series A startup as the fifteenth employee. A few months in, and you’re feeling incredibly optimistic. Customer demand is skyrocketing; you can’t seem to build quickly enough to meet their needs. The startup has added six new employees since you joined and is frantically recruiting more—you’re already a “senior employee!”
You’ve been offered the opportunity to “early exercise” all of the stock options you’ve been granted. This will cost you $40,000.
It sounds expensive (and it is!) but say that, two years from now, your company reaches a billion dollar valuation—it’ll then cost you upwards of $400,000 to exercise this same tranche of stock options and cover all of the tax obligations.
Silicon Valley is full of stories where startup employees miss out on material tax savings, on the order of hundreds of thousands, sometimes millions of dollars, because they ignored their equity compensation until it was too late. This guide helps you strategically maximize your upside as an early startup employee at a fast-growing company.
Employee Stock Options (ISOs and NSOs)
Your stock options represent the right to purchase shares of your company at a fixed price, known as the exercise price. You earn the right to exercise your options over time through a process called vesting, the timeframe of which is stipulated by a vesting schedule. There are two types—ISOs and NSOs—and early-stage companies will typically issue a mix of both to their employees.
For each tranche of options that you’ve been issued, be aware of three key numbers:
- Your strike price (aka exercise price): how much you pay to purchase each share.
- The 409A value (aka fair market value) of the shares, as of the time you exercise the options. For private companies, the 409A value is an independent appraisal of how much the private company’s stock is worth. After the IPO, this value becomes the company’s public stock price. Leading up to the IPO, the fair market value of your shares will likely rise greatly towards the company’s preferred price (or at least fluctuate). These fluctuations may greatly impact your tax calculations, and your company's finance team should keep you up-to-date on them.
- Your sale price: the price at which you later sell the shares.
On a high level, here is the difference between ISOs and NSOs:
- Pay ordinary income tax on (409A value - exercise price) when you exercise your options. So, if you pay $2 to purchase each share and the 409A value is $10, then you’re taxed on the $8 spread.
- Pay capital gains tax Depending whether you held the shares for over a year before selling them, you’ll either pay long-term capital gains or ordinary income tax on them. on (sale price - 409A at the time of exercise) when you sell the shares. So, if you exercise the shares when the 409A value is $10, then sell those shares for $50, then you’ll be taxed on the $40 capital gain.
- Pay no tax when you exercise—unless you trigger the AMT (details below)
- 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. Otherwise, (sale price - exercise price) will be taxed as short-term capital gains (roughly ordinary income).
Alternative Minimum Tax for ISOs
Upon exercising your ISOs, you will likely qualify for the Alternative Minimum Tax, or AMT. Back in 1969, 155 individuals with incomes over $200,000 managed to pay zero federal income taxes, triggering popular outrage. The AMT was introduced to prevent this from happening again.
The AMT is calculated based on the bargain element: the (409A value - exercise price). You owe AMT if:
- Your total bargain value ( [409A value - exercise price] * total ISOs exercised ) exceeds the AMT exemption amount. The AMT taxable income exemption amount for 2022 is $75,900 for single taxpayers and $118,100 for married couples filing jointly..
- The tax you owe under the AMT calculation We won’t discuss how to calculate your exact AMT burden in this article, but it will come out to 26-28% of your total bargain value. exceeds the tax you owe under regular tax calculations.
You will have to pay AMT when you file your tax return for the year that you exercise your ISOs (it is not withheld at the time you exercise), so make sure to plan accordingly.
Upon exercising your ISOs, you pay AMT. Then, when you sell those shares, you’re taxed again on your capital gains. To lessen the blow of thus being taxed twice on ISOs, Congress introduced AMT credits.
Suppose you paid $5000 in AMT in 2019. In any subsequent year where you don't owe AMT (say, 2020), you might be able to get back some or all of that $5000. There are a few conditions for getting this tax credit:
- You can't owe AMT in 2020.
- The maximum amount of AMT credit you can claim for 2020 is [regular tax bill for 2020 - AMT amount for 2020]. After you claim your credits for 2020, any of the original $5000 that's left over can be used toward a subsequent year's tax deduction.
There are many other caveats that may warrant speaking with a financial advisor. But the bottom line is: you may want to try to strategically maximize the amount of AMT credit that you can claim later. Or, you can limit the number of ISOs that you exercise and stay below the AMT exemption amount (thus avoiding the AMT altogether).
Restricted Stock Units (RSUs)
RSUs turn into shares of your company’s stock when they vest. They’re typically issued by companies valued at over $1 billion.
RSUs are subject to either single- or double-trigger vesting. Single-trigger RSUs can vest before IPO. This means you’ll owe taxes on them as they vest (because you’re coming into ownership of new shares of stock). However, if the company is still private, you won’t be able to sell those shares to make money to pay the taxes you owe on them.
That’s why many companies instead offer double-trigger RSUs, which only vest after the IPO. That way, you’ll only owe taxes once the company is public and you can actually sell those shares. So, for the year that your company IPOs, be prepared to pay taxes on any double-trigger RSUs that you vest. Your RSUs may vest either on IPO day or after the lockup period, depending on the company.
When your RSUs vest (whether before or after IPO), you’ll owe ordinary income tax on the 409A value of your newly issued shares as of that day. As a reminder, the 409A value after IPO is equivalent to the company’s public stock price. Then, when you sell those shares, your profit (i.e. [sale price - 409A value as of the day the shares vested]) will be taxed as capital gains. Again, these qualify for long-term capital gains tax treatment if you hold onto the shares for over a year.
Qualified small business stock (QSBS)
You can actually exempt your stock from all the federal taxes we’ve discussed above, if it counts as qualified small business stock (QSBS). Your stock might qualify as QSBS if:
- At the time that your stock was issued (i.e. when you exercised your options), your company’s gross assets did not exceed $50 million.
- You’ve held the stock for at least five years before selling it.
Deciding to exercise
Exercising your stock options represents a high-risk, potentially high-reward investment in your company. At a high level, here are the pros and cons of making such an investment:
With the 409A rising, you’re incentivized to exercise sooner rather than later. Furthermore, your options do expire eventually, so you can’t put off exercising them indefinitely. This will kickstart the long-term capital gains clock and break your golden handcuffs. The term golden handcuffs refers to compensation incentives that discourage you from leaving your company. While your equity may pose a large reward, if you cannot afford to exercise it, you’re monetarily encouraged to stay at your company until at least the IPO.
Investing capital into stock directly tied to your single source of income greatly increases your overall concentration in a risky, illiquid asset.
To answer the question of whether or not you should exercise, consider the following:
1. Your liquidity constraints
Your liquidity constraints will limit the number of options that you are able to exercise. To determine these constraints, audit your personal finances. Consider metrics such as your current liquidity, movable assets, near-term liabilities, and financial goals.
Cash flow timing plays an important role, as startups often take 5-10 years to exit (if ever). Investing in your startup therefore comes with a significant opportunity cost: you could deploy this same capital into other opportunities (e.g., public stocks or real estate) that could generate steady, dependable returns over the course of those 5-10 years. You’re really looking to come up with a projected, probabilistic return on investment for exercising your stock options (and compare that to your broader financial picture).
2. Your view of the company
In deciding how much of stock to purchase, you are essentially quantifying your level of optimism in your company. While you’re unlikely to have access to every line-item on your company’s income statement, you do likely have access to key figures (e.g., revenue trends) to inform your analysis. In the end, you need to form your personal investment thesis—Why will your company win? What will prevent you from succeeding? What’s the best case scenario?
At the same time, keep in mind that even startups with the most seemingly promising trajectories can stumble. WeWork is an obvious example: in early 2019, it was valued at $47 billion and was filing for an IPO. By the end of the year, its valuation had dropped to $8 billion. Pebble went from a $740 million valuation in 2015 to $40 million by 2016. Juul went from $38 billion in 2018 to $12 billion in 2020. Employees who exercised their options at the higher valuations fell out of the money (and overpaid in taxes).
To quantify this decision, let’s explore another example.
- You have 100,000 options, with a strike price of $1
- The current 409A valuation is $1.20
- The 409A in 3 years will be $20
- In 5 years, your company will IPO, and each share will be worth $100
Here are the various strategies you can try:
- Early exercise everything now
- Exercise all options in 3 years
- Wait until the IPO to exercise
The table below estimates the hypothetical costs of exercising now, in 3 years, and in 5 years.
Importantly, these projections assume a successful outcome for your company and don’t account for relevant factors such as dilution, timing, and liquidation preferences. Early exercising performs worse than doing nothing in the event your startup fails. Exercising your stock options is making an investment in your company. You are betting on its future performance and if it fails, you will lose your principal investment. Consult your financial and tax advisers to make the right decision.
Deciding when to exercise is also a matter of timing. How soon do you need liquidity? It’s often possible to sell some of your equity before your company goes public (or gets acquired).
From time to time, your company may hold what’s called a tender offer. In a tender offer, some cohort of shareholders are given the opportunity to sell their shares for a set price per share. Most companies irregularly hold tender offers (once every couple of years), and generally restrict them to current employees who’ve reached some level of tenure. Deciding whether or not to opt-in the tender offer has trade-offs—every share you sell is potentially worth more (or less) in the future.
A number of secondary markets make it possible to sell shares to independent investors. There are also funds and brokerages designed to help you get financing to exercise your options. It’s not guaranteed that you’ll be able to participate in either of these vehicles; it depends on factors such as transfer restrictions, timing, and demand from investors.
No matter what, early-stage startups are inherently risky. You could end up with a life-changing pot of money in five years, or your equity could end up being worthless. Furthermore, along the way, funding rounds and 409A re-evaluations can occur and change your financial situation at any time without warning. In light of this risk and uncertainty, it’s crucial that you take an active role in managing your equity strategically from the start.