Stock Options 101
Startup options create an opportunity for immense wealth, but also create some tricky decisions to make. Learn to navigate ISOs, NSOs, 409As, cliffs, and more.
Equity (also known as “shares” or “stock”) is partial ownership in a company. Stock Options, in contrast, are the right - but not the obligation - to purchase equity in a company. It’s a formalized way of saying that you can buy the equity, but you don’t have to.
Intro to Options
Options are a contract between you and the company that gives you the right - but not the obligation - to purchase shares in the company. Here, we'll explore the most common terms.
There are two key structural elements to options:
- Strike Price (aka Exercise Price) - the price an employee pays to purchase their shares. This price is typically lower than the current market price per share. The act of purchasing your shares is known as “exercising” your options.
- Bargain Element - the difference between the Strike Price and the market price per share at the time of exercise. As a company grows and becomes more valuable, your bargain element grows as well.
Bargain Element
The price for the equity - and therefore the size of the bargain element - depends on the share class.
Most startups have common and preferred classes. There can be many classes of preferreds but there's typically only one class of common. Investors typically receive preferred shares that have additional rights. Common is almost always the share class with the least rights, it's what employees receive.
The price for preferred shares is typically determined when a company raises a round - it's whatever the investors were willing to pay. When you see an announcement for a funding round (e.g. Seed, Series A, Series B …), that's typically a sale of preferred shares.
The price for common equity is typically determined through a process called a 409A valuation, a value appraisal conducted by a third party that the IRS accepts as a "fair basis" for value. The price for common equity is almost always less than the preferred price because the common equity has fewer rights.
Your options will likely be for common equity, so your bargain element is the difference in price between the strike price in the options contract and the 409A determined price.
Vesting
Vesting means earning ownership rights. Reminder: with options, that means you’re taking ownership of the options, not the equity.
Vesting is most commonly time-based but can also be tied to performance or other metrics. A typical time-based structure is 4-years monthly vesting with a 1-year cliff. That means you take ownership of 25% of the award at the end of year 1, then take ownership of an additional 1/48th of the total award for the remaining three years.
Expiration & Exercise Windows
Most startup options expire. When they expire is mostly up to the company and will be detailed in the options agreement. After expiration, options are worthless - you forfeit the right to purchase equity.
If you leave the company, you'll often be forced to exercise the options or similarly forfeit them. The period when you can exercise is alternatively known as the exercise window or post-termination exercise period. The period is often limited to 90-days after you leave the company.
Owning Equity
To actually own equity, you must exercise the options. You do so by paying the strike price.
On paper, that can sound great - you pay a low strike price and immediately receive shares with a higher current 409A determined price. But the IRS isn't going to let you get away with that free money. How it gets taxed depends on whether those options are ISOs or NSOs.
Incentive Stock Options (ISOs) & Non-qualified Stock Options (NSOs)
Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs) are both options, but differ primarily in how they're taxed.
Exercising options triggers ordinary income taxes on the bargain element at the time when the option is exercised. As the company gets more valuable and that bargain element gets bigger, the taxes also get bigger. That means you ultimately owe more taxes immediately.
Imagine a scenario where you exercise all of your options at the end of year four versus at the end of year seven. If you exercise in year four, all of the price appreciation between years four and seven is tax-free until you eventually sell the shares. If you wait until year seven to exercise, that price appreciation is included in the bargain element, so you pay income taxes on it when you exercise
If your options are NSOs, you're stuck paying ordinary income tax on the full bargain element. If the options are ISOs, the IRS gives you a freebie - the first $100K of that bargain element is income tax-free every year. Once you cross that $100K threshold, any remaining options are automatically taxed as NSOs - you owe ordinary income tax on the bargain element.
Income taxes are one consideration. The alternative minimum tax and early exercise are also important. You can learn more about taxes here.
Early Exercise
Some companies will allow you to early exercise your options, meaning you can exercise them before they vest. It's a risk that can be very valuable if it pays off.
An early exercise keeps the bargain element small. As a result, you may owe less in taxes than you would have if you waited to exercise when the company became more valuable.
The tradeoff is that you may end up spending money and never get shares or those shares may turn out to be worthless. In the event you leave the company before the options vest, you will forfeit the shares you purchased even though you already exercised the options. If the company fails, you'll own the shares but they may be worthless.
It's a risk that you will need to evaluate for your own personal situation. There's no free lunch.
Additional ISO and NSO Differences
ISOs are only available to US-based employees.
If your company allows for a longer-than 90-day post-termination exercise period, any ISOs you hold will automatically convert to NSOs ninety-one days post employment.
Expiration dates are common but not required for NSOs. They’re mandatory for ISOs. All ISOs expire ten years from the grant date.
Additional Tax Considerations
You may owe additional state tax even on ISOs and you may be able to take action now to reduce your future taxes when you eventually sell your shares. It’s a big enough topic that we've put together a more in-depth guide here.
Even with careful planning, the cost of exercising options and the associated tax bill may be more than you can afford. It's a situation many startup employees find themselves in. Prism is here to help.
