Now is the perfect time to build a plan for your stock options, so you can maximize their value and avoid paying unnecessary taxes in the future. For many people, building a stock options plan early can mean tens of thousands of dollars (and in some cases, hundreds of thousands of dollars) in future tax savings.
This guide is designed to help you understand your equity grant, and build a plan for when, how, (and even if) you’ll exercise your stock options.
Caveat: This guide covers the majority of common scenarios around employee equity in the United States, but doesn’t capture edge cases. After reading this guide, consider building a stock options plan with the help of a CPA or licensed financial professional.
How to understand your offer letter
Begin by taking a closer look at your offer letter, and look for the following information around your stock options grant:
- What type of stock options are you earning? ISOs, NSOs, or RSUs?
- What is your vesting schedule?
- What is the value of your stock options? For ISOs and NSOs, how many shares will you receive, and at what strike price?
This information comes in different formats, depending on the company. We’ve seen offer letters where the employee’s stock option grant is described in great detail, and others where it’s barely a sentence long.
Your offer letter might be missing necessary context
After reviewing your offer letter, you might find it’s missing crucial information around your stock options. For example, here’s common boilerplate language from a recent job offer that we reviewed (numbers and specific information have been changed to protect privacy)
“Stock Option. Subject to the approval of the Company’s Board of Directors, you will be granted an option to purchase 15,550 shares of the Company’s Common Stock (the “Option”). The exercise price per share of the Option will be determined by the Board of Directors when the Option is granted. The Option will be subject to the terms and conditions applicable to options granted under the Company’s Stock Plan (the “Plan”), as described in the Plan and the applicable Stock Option Agreement. Subject to the terms of the Plan and Stock Option Agreement, the Option will vest over 4 years; 25% of the total grant will vest after 12 months of continuous service, and the balance will vest in equal monthly installments over the next 36 months of continuous service.”
This offer letter failed to describe the type of stock options that the employee will earn, or their value.
Without more information, it’s impossible to know whether 15,500 shares is a little, or a lot. For example, if the strike price was 10 cents per share, this employee would be vesting the equivalent of $1,550 worth of equity over the next 4 years. If the strike price was $20 per share, the employee would be vesting $310,000 worth of equity.
At a minimum, your offer letter should tell you the type of stock options you’re earning, your vesting schedule and the value of the shares. If it doesn’t, reach out to your HR representative for more details.
What type of stock options are you earning?
In the U.S., there are three common types of employee stock options:
- Incentive stock options (ISOs): ISOs give you the ability to purchase company shares at a specific price. They enjoy tax advantages, and are taxed under the alternative minimum tax (AMT) system, rather than the income tax system.
- Non-qualified stock options (NSOs): NSOs give you the ability to purchase company shares at a specific price. They are taxed under the income tax system, and typically enjoy fewer tax advantages compared to ISOs.
- Restricted stock units (RSUs): RSUs are different from ISOs and NSOs in that you don’t purchase shares — you earn them outright, as long as you remain employed or reach specific performance targets. They’re taxed as ordinary income as they vest.
In general, ISOs and NSOs are common at earlier-stage startups, while RSUs are more popular at late-stage startups that are preparing for an exit, and at publicly traded companies.
What is your vesting schedule?
“Vesting” is a financial term that describes what you need to do to earn your stock options. This could be either staying in your job for a specific amount of time, or meeting specific performance targets.
For most employees, the industry standard remains a time-based stock grant — typically a 4-year vesting period, with a 1-year cliff.
That means you won’t earn any stock options until your first work anniversary, when you vest one-quarter of your total stock option grant at once — your 1-year cliff. From there, you’ll continue to vest stock options each month until you’ve reached 4 years of employment, when you complete vesting your initial stock grant.
Many companies offer their employees refresh grants — offering them new grants as bonuses or as part of promotions — to reward them, and also as a way to keep them engaged and motivated for more than 4 years. If you do get refresh grants, you can vest stock options from multiple grants simultaneously.
What is the value of your stock options?
The answer here will depend on the type of stock options you’re earning, and the specific language in your offer letter.
For ISOs and NSOs, the value of your stock options will likely be described in a set number of shares, at a specific strike price — a financial term that means how much each share will cost. The strike price is set when you’re initially granted your stock options, and does not change. If you’re offered refresh stock grants in the future, those stock options could have a different strike price.
For example, if you’re offered 40,000 ISOs at a $1 strike price, with a 4-year vesting period and a 1-year cliff:
- You’ll unlock the ability to purchase one-quarter of your stock grant on your 1-year work anniversary, spending $10,000 to do so (10,000 shares x $1 per share strike price)
- You’ll continue to vest ISOs from that stock grant over the next 3 years
- On your 4-year work anniversary, you will have completely vested your initial stock grant, unlocking the ability to purchase up to 40,000 shares at a strike price of $1 per share
RSUs are typically described in a total dollar amount, whose value is awarded based on the current value of the shares on the day they vest and are awarded to you.
For example, you might be offered $100,000 worth of RSUs, with a 4-year vesting period and a 1-year cliff:
- On your 1-year work anniversary, you’ll receive $25,000 worth of shares from the company. For example, if the company’s stock is trading at $10 per share on the day your RSUs vest, you’ll receive 2,500 shares
- You’ll continue to vest RSUs over the next 3 years
- On your 4-year work anniversary, you will have completely vested your initial stock grant
How to minimize taxes when exercising stock options
Now that you understand the components of your employee equity grant, you can begin to chart out when, how (and if) you’ll exercise your shares in the future.
Let’s take a closer look at how ISOs, NSOs, and RSUs are taxed.
How ISOs are taxed
ISOs enjoy preferential tax treatment under the alternative minimum tax (AMT) system, and there can be tax advantages to exercising your ISOs when they vest, rather than waiting for an exit.
To understand why, let’s talk a little bit about 409A valuations.
Every startup that issues stock needs to know how much each share is worth. Rather than calculating that value themselves, they hire third-party valuation companies that assign a dollar value to the startup’s stock, based on factors like new rounds of funding, revenue, and profitability.
When you join a company and are issued ISOs or NSOs, your shares will be assigned a strike price that is equivalent to (or higher than) the company’s 409A valuation (also known as fair market value) on that day. Your strike remains constant, while your company’s 409A valuation will change. If you work at a high-growth startup, the startup’s 409A valuation can rise sharply with new rounds of funding.
If you decide to purchase your ISOs, it will be your responsibility to tell the IRS how much you paid to exercise the shares, and how much those shares were worth on the day you exercised them, based on your startup’s 409A valuation (or public share price, if you’re working for a publicly traded company). Your employer typically doesn’t report this information to the IRS themselves.
If the assumed gain is large enough, you might trigger the AMT and will be required to file taxes under the AMT system that year, rather than the income tax system.
There can be tax benefits to exercising your ISOs as they vest, when the strike price is still relatively close to the company’s 409A valuation.
When you later decide to sell your shares, you’ll report any additional gain as either short-term capital gains (if the stock is held for less than 1 year) or long-term capital gains (if the stock is held for more than 1 year, and it has been 2 years since they were granted)
How NSOs are taxed
NSOs are taxed under the income tax system. If you decide to purchase your NSOs, you’ll tell the IRS how much you paid to exercise the shares, and how much those shares were worth on the day that you exercised them, based on your startup’s 409A valuation (or public share price, if you’re working for a publicly traded company).
You’ll report the difference between your strike price and 409A value as ordinary income — even if you decide to hold onto your shares and not sell them immediately. When you later decide to sell your shares, you’ll report any additional gain as either short-term capital gains (if the stock is held for less than 1 year) or long-term capital gains (if the stock is held for more than 1 year).
There can be tax benefits to exercising your NSOs as they vest, when the strike price is still relatively close to the company’s 409A valuation — minimizing your initial tax liability.
This is particularly true if you plan to hold onto your shares for more than 1 year, to take advantage of long-term capital gains when you ultimately decide to sell.
In practice, many people with both ISOs and NSOs perform a cashless transaction when exercising — buying their shares and immediately selling them, in what the IRS treats as a same-day transaction. While these transactions are easy, they are taxed as short-term capital gains, which can be as high as 37 percent, depending on your taxable income and filing status.
Cashless exercises also require a liquid market — i.e. a buyer who you can sell some or all of your shares to.
How RSUs are taxed
RSUs are taxed as ordinary income, and are treated like a cash bonus. Typically, when you vest RSUs, your employer will withhold a portion of the value of your RSUs, just like they would with a cash bonus.
Remember, you don’t have to purchase RSUs. They’re earned as soon as they vest, and you can turn around and sell them for cash as long as you’re not in a trading blackout period.
Just like any other stock, if you wait to sell your shares for at least 1 year after receiving them, you’ll be taxed at the long-term capital gains rate, rather than the short-term capital gains rate.
How to decide when to exercise ISOs and NSOs
This is the big question that every startup employee faces — is it worth the risk to exercise my stock options? Here are a few helpful questions to think about and explore with your CPA or licensed financial professional:
How confident are you in the startup’s ability to successfully exit?
As a new employee, you took your first gamble by joining this company, rather than taking a competing offer at other companies. Deciding to exercise your stock options involves a second gamble: Do I feel comfortable investing in this company?
Statistically, most startups fail. However, failure is not distributed evenly and failure doesn’t happen randomly. Ask yourself:
- Do you have confidence in your company’s leadership team? Have they successfully built and sold startups in the past?
- Is your company offering a uniquely valuable product or service with a large addressable market? How sharp is the pain point that your startup is solving?
- How strong are your company’s investors? Have similar or competing companies been acquired recently?
You should approach the decision about whether to exercise your stock options (and how much to invest) based on your confidence in your company’s prospects and your personal risk tolerance.
How much will it cost to exercise your stock options?
If you’re joining a startup relatively early, the cost to exercise your stock options could be relatively minimal, tipping the risk-reward equation in your favor.
For example, early Google employees were offered stock options at around 30 cents per share. Exercising 10,000 shares in a promising startup for 30 cents per share will cost you $3,000 (before taxes), so the risk-reward equation might make sense for you.
The risk-reward equation might be different if you’re exercising 10,000 shares in a struggling, midsize startup at $8 per share: Investing $80,000 to buy shares in a company that you’re not confident will successfully exit could be considerably more difficult.
Remember to calculate your tax liability, to get a fuller picture of the total costs to exercise your stock options. Check out Secfi’s Stock Option Tax Calculator.
Are there tax benefits to exercising now, rather than later?
You might find that there are tax benefits to exercising sooner, rather than later.
For people joining very early-stage startups (typically defined as those that have raised less than $50 million in venture capital), exercising stock options while the company is still small might qualify you for the QSBS tax incentive. If you qualify, you might be able to avoid capital gains taxes on a large portion of your shares when it’s time to eventually sell.
For most people, exercising stock options early starts the clock on long-term capital gains, which can end up saving you tens of thousands (or even hundreds of thousands) of dollars in taxes when it’s time to sell.
Exercising stock options as they vest — when the stock’s strike price and 409A valuation are still relatively close — can help you minimize upfront tax costs. Some startups give employees the option to exercise their shares before the shares have vested, in a transaction known as an early exercise.
How do I afford the cost to exercise my ISOs or NSOs?
Although you’ve just started your new job, and very likely haven’t vested any stock yet, it’s important to chart out when, how, and if you’ll eventually exercise your stock options.
Let’s focus here on the question of “how.”
Here are the four most common ways people pay the costs and taxes associated with exercising employee stock options, and some potential associated risks:
Cash on hand: The simplest way to exercise stock options is with cash on hand. Risk: If the company fails, you could lose your entire investment. You risk tying up too much money in a single investment, and losing out on potential upside from a more balanced portfolio of investments.
Traditional loans: With loans, you won’t have to risk your own money to exercise your stock options. Depending on who you loan money from, you may need to immediately begin paying interest on the loan. Risk: If the company fails, gets acquired at a deep discount, or experiences a disappointing IPO, you will still need to repay the loan — on top of the interest.
Secondary markets: Some people use secondary markets to sell a portion of their stock options to raise enough money to exercise their remaining stock options and related taxes. Risk: It could take a long time to find a buyer on a secondary market, and buyers may drive a hard bargain, forcing you to give up more equity than you’re comfortable with. You may end up losing a significant amount of stock options, sacrificing potential future upside.
Non-recourse financing: There are two major benefits to non-recourse financing — like a traditional loan, the financing company gives you the money necessary to exercise your stock options and pay your related taxes. However, unlike a traditional loan, the financing company assumes all the downside risk in the transaction — if the startup in question fails and their stock options are deemed worthless, the employee doesn’t owe the non-recourse financing company anything. Risk: You’ll pay fees to the non-recourse financing company, and will lose some of your potential upside upon exit.
In this guide, you’ve learned about the different types of stock options, how they work and how they’re taxed, and given thought to when, how, and if you’ll eventually exercise your stock options.
If you still have questions about your stock options, reach out to your HR representative. If you want to build a plan for your stock options, consider reaching out to a CPA or licensed financial professional, or use our Stock Option Tax Calculator.