“It was at that moment, staring at a bank account balance of zero, I was dead broke, but also a paper millionaire.”
-Rich / Poor Guy I once worked with
Welcome back to our month long series on employee equity:
Part 1: What’s a 409a Valuation (LAST WEEK)
Part 2: A Tech Worker's Guide to Exercising Equity & Optimizing Taxes (TODAY!)
Part 3: Getting RICH off Secondary Transactions (NEXT WEEK!)
Incentive stock options are a form of employee compensation. They can make tech workers fantastically wealthy if the company goes parabolic. However, they require employees to take a financial leap of faith, breaking out their checkbooks to both exercise their options and sometimes pay taxes on an asset which lacks a liquid market to “sell and cover” (a term we’ll cover below).
Here’s what we’ll get smarter on today for all of you folks out there who are compensated through equity in some form or another:
Tax Treatment for Different Forms of Equity
ISOs
What is Alternative Minimum tax?
Selling your ISOs
NSOs
RSUs
Early Exercise
Tax Treatment for Different Forms of Equity
1. Incentive Stock Options (ISOs)
ISOs are the most common form of equity for full-time employees working at earlier stage startups (I’m talking pre series D / sub $1 billion and valuation / fewer than 500 people).
NSOs are generally reserved for advisors and consultants, while RSUs typically come into play when the company’s size and valuation balloons.
ISOs are unique because they are just that - Options to buy a stake in a company. You get to purchase your shares (or exercise your option) at a predetermined price. And you can pick when you make that jump.
If you leave your company, and are past your 1 year cliff (which is typical for most equity grants), then you have up to 90 days post termination to exercise your options. If you need longer, you can ask your company to convert them to NSOs, but there’s no guarantee your company will play nice and help you out.
ISOs are also more favorable to NSOs because, up to a certain level, you are exempt from having to pay taxes at the time of exercise.
In addition, if you hold the shares for at least one year after the exercise date and two years after the grant date before selling, any profit is treated as long-term capital gains, which are taxed at a lower rate than ordinary income.
The fastest scenario (excluding any early exercise shenanigans) in which you qualify for long term capital gains would be if you work for one full year to hit your cliff, vesting 25%, and immediately exercise…
Then you sit on them for one more full year before selling.
So the clock ran for two years total.
However, past a certain point, you are subject to Alternatives Minimum Tax (AMT), which is the taxable difference between your strike price and the company’s latest 409a at time of exercise.
WTF is AMT? (and why am I broke?)
Quick tangent!
AMT is a separate calculation meant to ensure taxpayers with substantial deductions and exclusions pay at least a minimum amount of tax. And it’s possible for your ISOs to trigger too large of an exclusion.
And that’s the rub - while ISOs are awesome, after a certain point, employees can get hit with a hefty tax bill when they exercise if the value of the company has increased significantly since their start date (which you hope it would).
So a really good thing creates a really shitty tax thing, which you gotta come out of pocket for.
There are two alternative minimum tax rates, 26% and 28%. While this is lower than ordinary tax rates in some circumstances, there’s usually no liquid market to sell those shares and cover…
Explained in the words of someone who basically failed entry level tax accounting, it’s a law which treats the shares you exercise as adjusted gross income. This pushes up your tax bracket. It looks like you made more, even though you didn’t receive anything yet.
In my opinion, it’s a tax for rich people who might try to skirt paying their fair share by taking comp packages HEAVILY weighted towards equity. The only problem is, you aren’t a rich person…YET!
And herein lies the lesson. It can be expensive to get rich. So save up your post tax W2 money to not only the exercise, but to also pay more taxes on what you just exercised.
Selling your ISOs
OK, let’s talk about selling your ISOs.
Good news - your company was acquired / IPO’d / is offering the chance to sell shares in a secondary transaction (which we’ll cover what those are in detail next week).
If you held the shares for at least one year after the exercise date (which is when you probably paid AMT) and two years after the grant date before selling, any profit is treated as long-term capital gains, which are taxed at a lower rate than ordinary income.
What I’ve seen in many cases, especially involving secondaries which don’t always come around at predictable times, is the employee sells what they have before that two year shot clock is up. Sometimes they even do a cashless exercise, where they exercise and sell immediately, avoiding having to fork over any cash, and just netting the proceeds. Sexy stuff!
If that’s the case, and they take the money and run, it’s called a "disqualifying disposition," which is a fancy way of saying you pay taxes like it’s normal W2 income; you’re disqualified from getting more favorable tax treatment. Higher taxes suck, but at least you have cash to pay this (higher) tax bill.
2. Non-Qualified Stock Options (NSOs)
Non-qualified stock options (or NSOs) are a type of stock option that does not ‘qualify’ for the same favorable tax treatment that other types of stock options (specifically ISOs) do. Hence the “Non Qualified” thing.
“NSO are taxed on both exercise and sale. On exercise of the option, the ‘Spread’, being the difference between the FMV at the time of exercise and the strike price at the time of grant, are taxed as wages for employees or self-employment wages for non-employees.”
ISOs are more favorable than NSOs from a tax perspective because:
With ISOs, you can potentially qualify for long-term capital gains tax rates, which are lower than ordinary income tax rates.
They allow you to defer paying taxes on the difference between the exercise price and the fair market value of the shares until you sell them (up to a certain point before triggering AMT, of course). With NSOs you always have to pay taxes upon exercise.
And even if you have to pay AMT on your ISOs of ~28%, that’s probably lower than your ordinary income rate which (which is probably in the high 30%’s if you are triggering AMT). So that sucks a little bit less.
NSOs are usually reserved for advisors and contractors (not W2 employees). All things equal, an employee would rather receive ISOs than NSOs. Offering ISOs is therefore looked at as “more employee friendly” than NSOs. But you take what you can get!
3. Restricted Stock Units (RSUs)
To speak in broad strokes here, RSUs are more common to issue to employees when a company gets large… like over $1B in valuation.
As we covered, ISOs offer tax benefits to employees, potentially qualifying for long-term capital gains treatment if certain conditions are met.
However, as the company grows and the value of its stock increases significantly, the alternative minimum tax (AMT) implications of ISOs can become burdensome for employees. RSUs, on the other hand, are taxed as ordinary income when they vest, which can be simpler and more predictable for employees to manage.
This is a key call out - you don’t have to exercise RSUs. They just vest on their own.
Now, here’s where RSU’s get a bit more complicated. There are two flavors:
Single Trigger RSUs: Based on service (or time).
Public companies, because they’re liquid, issue single trigger RSUs. Once the RSUs vest, the employee can keep, sell, or transfer the shares.
Taxation occurs immediately upon vesting. So the company can automatically sell off RSUs on your behalf for withholdings like payroll, social security, etc.
And you get taxed like income (like your W2 pay). So a high rate.
Double Trigger RSUs: Based on service (or time) PLUS a liquidity event (like an IPO).
Startups began hitting this moment where the options just got way too expensive at late stage. But the strike price would be egregious.
Plus, the tax burden would be way too high for employees to pay without liquidity.
As such, necessity is the mother of invention. Facebook was the first private company to give out double trigger RSUs.
They put a twist on the original version to keep their employees happy: They don’t vest until the shares become liquid.
And therefore, the tax doesn’t hit until they become liquid
Think of these as more akin to ISOs, without:
The cash needed to exercise
The decision as to when you should exercise
The AMT associated with exercise
Previously, workers at pre-IPO companies were not able to sell a portion of their double trigger RSUs to pay their income taxes…
To avoid this, Facebook put in a second vesting condition, also known as a “double trigger.” This second vesting condition would only be met once a liquidity event occurred such as the company getting acquired, an Initial Public Offering (IPO), or a direct listing. Therefore, the employees don't have to pay income tax and capital gains tax, among other concerns.
Including this additional trigger allows a company to keep a portion of the stock promised to a worker not technically vested. Once there is liquidity (cash) from the IPO, listing, or acquisition, then the final vesting trigger gets pulled and then the company does what’s called a “sell to cover.” All or a portion of the worker’s stock is sold to pay the ordinary income taxes on the stock the worker has received. This way workers can relax, knowing that they will probably not have to pay out of pocket for tax or legal guidance in order to receive and deal with stock options.
So Facebook, while they did steal your data, kinda-sorta revolutionized the way RSUs could be used to incentive employees.
However, some things that kinda suck about RSUs:
IPO = Big tax bill
You could be sitting on millions of dollars of shares… And then when you go public, it’s just like whammy: treated as income. So a massive tax event with tax treatment as ordinary income.
Double trigger RSUs are generally taxed as ordinary income (like your salary) at IPO. So while you don’t have to come out of pocket to exercise, like ISOs, you do miss out on the capital gains aspect (which ISOs may benefit from). That’s a high rate to pay on potentially large sums of money.
Plus, sometimes employees are surprised when their company sells off shares on their behalf to pay the tax bill.
RSUs typically have only a seven year window
So companies that stay private for wicked long, like Stripe (or Airbnb before them), run up against employees being at risk of expiration… like hundreds of millions of dollars that could potentially go away.
This forces them to run tenders to clear the decks.
Early Exercise
Early exercise is possible through something called an 83(b) Election. It allows employees to come out of pocket and exercise ISOs (and sometimes NSOs) before they vest. This can be beneficial because it means the strike price and the 409a price is the same. That eliminates the possibility of paying Alternative Minimum Tax on the spread between the two. However, you do have to pay ordinary income tax on whatever the strike is at.
How it works:
Timing: The 83(b) election must be filed with the IRS within 30 days of receiving the restricted stock (so within 30 days of receiving your ISO grant). The filing is irrevocable, and if the deadline is missed, the employee loses the opportunity for this election.
Tax Implications at Grant: If an 83(b) election is made, the employee pays ordinary income tax on the fair market value of the stock at the time of the grant (so your strike price). This amount is also subject to payroll taxes.
Tax Implications at Vesting and Sale:
At Vesting: If an 83(b) election is made, there are no additional taxes due at the time of vesting, as the taxes have already been paid at the time of the grant.
At Sale: When the stock is eventually sold, the increase in value from the time of the grant to the time of sale is taxed as capital gains, which typically has a lower tax rate than ordinary income. So you get into capital gains faster.
Risks
Upfront Tax Payment: The employee must pay taxes upfront on the stock’s value at grant, which is a risk if the shares are underwater (below the issue price). The taxes paid are not recoverable, even if the stock becomes worthless.
Liquidity Risk: Since the stock is restricted and cannot be sold immediately, paying taxes without immediate liquidity from the stock can be financially challenging. That’s why it’s usually well-off execs exercising early, since they probably have more financial freedom and have a few exits under their belts.
Failing to Vest: You may early exercise all four years of your options, but if you either quit or get fired before that timeframe, you’re in deep doo doo. If that’s the case, you hope the company buys the options back from you (it’s pretty much always guaranteed and required that they do). But still, you are making a bet not only on the company’s ability to appreciate, but also your ability to make it through four years, when your money could have been put to use somewhere else.
Stay tuned next week when we cover Secondary Transactions.
