LoginAbout Compound

Stock Options 101

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.
  • Your sale price: the price at which you later sell the shares.

On a high level, here is the difference between ISOs and NSOs:

For 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 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. (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 rates on them.)
For ISOs
  • Pay no tax when you exercise—unless you trigger the alternative minimum tax (AMT) (explained 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.

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 (which was $72,900 for unmarried individuals and $113,400 for married couples filing jointly in 2020)
  • The tax you owe under the AMT calculation 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.

This material presented on Compound’s Manual is for informational purposes only and should not be construed as legal, tax, accounting or investment advice. Under no circumstances should any material on this Manual be used for or considered as an offer to sell or a solicitation of any offer to buy an interest in any securities or investment fund. The material on this website does not constitute, and may not be used in connection with, an offer or solicitation by anyone in any jurisdiction in which such offer or solicitation is not permitted by law or in which the person making such offer or solicitation is not qualified to do so or to any person to whom it is unlawful to make such offer or solicitation.Any analysis or discussion of financial planning matters, investments, sectors or the market generally are based on current information, including from public sources, that we consider reliable, but we do not represent that any research or the information provided is accurate or complete, and it should not be relied on as such. Our views and opinions expressed on this Manual or in any post content are current at the time of publication and are subject to change.