How does raising a new round of funding affect employee stock options?

Your startup is raising a new round of funding, and you’re curious about what that means for the employee stock options you’re earning.

Good news: Your company is getting a fresh infusion of money that will help it grow. Bad news: It will likely be more expensive to exercise your stock options.

When a startup raises a new round of funding, it finds a group of investors who are willing to purchase shares in the company at a specific, negotiated price. If the startup is gaining value over time, investors will pay increasingly higher prices to purchase shares in the company.

Historically, it’s a good sign when startups raise a new round of funding — it means professional investors are optimistic about the company’s trajectory, and are willing to put money into seeing it grow.

For employees, raising a new round of funding can mean more money for hiring, more resources for existing projects, a strategic acquisition, or expanding into new markets.

The downside, at least for employees, is that new rounds of funding typically mean that it’s now more expensive to exercise their stock options. Let’s explore why.

When an employee joins a company and is granted stock options, they’re given what’s known as a strike price — how much it will cost to purchase a single share of the company’s stock. That strike price is set when you get your stock grant, and doesn’t change over time.

At least once a year, startups hire a third-party valuation company to estimate the startup’s current fair market value (FMV). Once they do, all employees who get hired afterward are granted stock options at a new (ideally, higher) strike price, which is informed by the startup’s current fair market value.

Raising a new round of funding affects the value of a startup, and triggers a fresh assessment of the startup’s fair market value.

When you decide to exercise your stock options, you’ll purchase shares at your strike price, and tell the IRS what your company’s fair market value was on the day you exercised.

Depending on the type of stock options you’re earning, and how many shares you exercise per year, you could end up owing taxes on the transaction. That’s because the IRS considers this difference, also known as a spread, as taxable income because the stock is now worth more than what you bought it for.

If you’ve been at your startup for some time and it’s raised a couple rounds of funding since you joined, you might be surprised to find that your stock options tax liability has grown considerably. Check out Secfi’s free Stock Option Tax Calculator to explore different exercise scenarios, and how much they’ll cost in taxes.