If you’re working at a startup or new to the tech scene, you’ll want to familiarize yourself with equity compensation. It’s common and often expected for tech companies to include equity in the form of company stock as part of an employee’s compensation package. This is especially true for early-stage startups that often grant equity in the form of employee stock options. Stock options are not as straightforward as a paycheck, but they have the potential of a big payday. To understand how, let’s get into the basics.
What is a Stock Option?
An employee stock option is a contract that gives an employee the right to buy a specific number of shares in the company they work for at a fixed price. Mainly, stock options provide the potential to share in the growth of your company’s value. Some of the rules that regulate stock options are imposed by tax and securities laws. Still, many variables in the ways options operate are at the discretion of the company to provide in the grant agreement, which employees will need to formally accept.
To take full advantage of your stock option equity offering, you should familiarize yourself with your equity grant agreement before you make any decisions or take any action with your stock options. For starters, you’ll want to compare your grant agreement with any offer letters or employment agreements for inconsistencies or ambiguities.
Generally, your grant agreement will have:
- the grant date – the specific date the equity is granted to you.
- The number of options granted.
- the type of options granted – whether incentive stock options or non-qualified stock options.
- The exercise price – the price you will pay to buy the options, also known as the strike price.
- Vesting schedule – employees typically gain rights to their grant of equity incrementally over time.
- The exercise window – options are only exercisable for a fixed period of time, which is typically 10 years if still employed.
- The expiration date – the date an option expires and can no longer be exercised.
- The effect that termination of employment and a change in the control of the company have on vesting.
To put this all into perspective, imagine this: You are granted 2,000 stock options vesting over four years when the company’s share price is $10 per share. Your exercise price will be $10 per share. Under the vesting schedule, 25% of your options vests per year over the four years (500 options per year). If you stay employed with the company for all four years, all of the stock options become exercisable. Suppose the stock price has increased to $15 per share, the option contract gives you the right to buy the shares at the exercise price of $10. Note that options are only valuable if the price of the stock increases, creating a discount between the market price and your exercise price. If the stock price decreases, it’s best not to exercise them and let the options expire.
Subsequently, the potential for personal financial gain directly aligns with the company’s stock-price performance. The intention is to motivate employees to work hard to improve corporate value. In other words, as the company succeeds, the employees succeed.
Non-Qualified Stock Options
Companies can grant two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NQSOs) — NQSOs being the more common vehicle. The most significant difference between ISOs and NQSOs is in the tax treatment, hence the name non-qualified. For this reason, they can be granted to employees, contractors, and consultants.
Once you exercise the NQSO, you will trigger taxable income. The difference between the exercise price and the market price of the stock, known as the discount or bargain element, will be taxable as W-2 income for the year the options were exercised. If the exercise price at the grant date is lower than the fair market value of the stock, the difference is taxable as W-2 income at the grant.
Example: Your stock options have an exercise price of $8 per share when the fair market value is $8 per share. You exercise them when the price of your company stock is $15 per share. You have a $7 discount ($15 – $8) and thus $7 per share in ordinary income. If the fair market value of the shares were $10 at grant, you would have an additional $2 per share of ordinary income.
Generally, when you exercise NQSOs, your employer will withhold taxes — income tax, Social Security, and Medicare — resulting in employees receiving fewer shares in order to pay the taxes. When you sell the shares, whether immediately or after holding onto them, the proceeds will be taxed according to capital gains rules.
Incentive Stock Options
ISOs qualify for special tax treatment, which makes them favorable. However, they are bound by more rules, making them more complicated than NQSOs. For instance, they can only be granted to employees, and there is a limit of $100,000 on the grant value of ISOs in a given calendar year. If beyond the limit, the difference in value is treated as NQSOs.
At neither the grant date or the exercise date are ISOs taxable. In fact, if an employee were to hold the shares for two years from the date of grant and one year from the date of exercise, they will only incur the favorable long term capital gains rate on all gains over the exercise price when the shares are sold.
What’s so special about the long term capital gains rate, you ask? Rather than being taxed as ordinary income, which is your tax bracket for the current year, long term capital gains are taxed at a rate of 0%-20%. This favorable tax treatment presents a massive opportunity for tax savings.
The AMT Trap
Not so fast. Since when have you known Uncle Sam (no pun intended) to pass up some free lunch? Although the discount escaped taxation at exercise under regular taxes, they must be recognized under the Alternative Minimum Tax (AMT) rules. Without getting into the weeds of the AMT calculation, it’s important to note that AMT can present a tax planning issue if the AMT is applied to theoretical gains, but the company’s stock price then tanks, leaving you with a big tax bill on income that has evaporated.
Balancing all the issues involved in stock option taxation can be quite intricate. The first and most important step is to develop a financial plan that uses your stock options to advance your life goals. This prevents you from exercising too early and making hasty decisions based on your company’s stock price and short-term performance.