Understanding Stock Options

Disclaimer: this post contains my current best understanding of topics at a level appropriate for myself. I make no guarantees on correctness

The Basics

A stock option gives the owner of the option the ability to purchase a given stock at a given purchase price. This process is known as “exercising” an option. Stock option grants are commonly given to startup employees, and contain 4 main pieces of information.

  1. How many options are being granted. E.g. a stock option grant of 10,000 options allows for the optional purchase of up to 10,000 shares.
  2. The strike price of the options. This is the price per share that the owner of the options must pay to purchase shares. This price stays fixed, even if the company’s valuation changes over time.
  3. Vesting schedule. Stock options cannot be exercised until they vest. (Except in the case of early exercise, more details later.)
  4. Option type - either incentive stock options (ISOs), or non-qualified stock options (NSOs). ISOs, when exercised and sold in a qualifying disposition, incur less tax than NSOs. A qualifying disposition is a stock sale that occurs at least 2 years after option grant, and at least 1 year after option exercise. An additional difference is that ISOs can only be owned by current employees - an employee leaving a company must exercise ISOs within 3 months or they are forfeited. Some companies will allow ISO to NSO conversion, which can allow departing employees to avoid the 3-month deadline (though grants usually still expire after 10 years).

Exercising Stock Options

Once an option is vested, it can be exercised by paying the strike price. At private companies, shares cannot be sold for cash, so exercising is making the bet that the upfront cost of exercise (plus associated tax costs) is worth the future value of the shares once they can be liquidated (as well as time and opportunity costs).

Early Exercise

Some companies allow for early exercise - this allows an option to be exercised before it has vested (which confers all the usual results of owning a share). The direct cost of exercising does not change, but exercising early usually means exercising when a company has a lower valuation, which can reduce or even eliminate the tax costs of exercising covered in the next section. To receive these tax benefits, an 83(b) form must be submitted within 30 days of the early exercise event. Exercising early also means shares can be held for longer, which can help reach the holding thresholds required for favorable tax treatments. If an employee leaves before their early-exercised options are vested, the company generally has the right to purchase the unvested shares back at the original strike price.

Tax Implications

Taxes are owed when an option is exercised, as well as when the resulting share is sold. The former can be quite surprising to startup employees, as upon exercising, they may owe a large tax bill, despite not being able to sell their shares to help pay that bill. 3 values are needed to compute taxes owed - the strike price, the fair market value (FMV) at exercise time, and the stock sale price.

Fair Market Value

Fair market value for a public company is simply its public stock price. For a private company, FMV is determined instead by its most recent 409A valuation, which usually occurs every 12 months, and also upon significant events such as fundraising. Note that FMV should not be confused with company valuations typically discussed (e.g. in the news) around VC fundraising. The price VCs pay for shares is generally much higher, as they are paying for preferred stock, which has a number of benefits, and also is not priced following the rules of the 409A process.

Taxes for NSOs

NSO taxes are simple. When an option is exercised, the difference between FMV and the strike price is taxed as ordinary income. Afterwards, stock sales are treated like any other stock sale, subject to either short-term or long-term capital gains, on the difference between the sale price and FMV at time of exercise.

While short-term capital gains are taxed similarly to ordinary income, long-term capital gains are taxed at a much lower rate. Thus, having FMV be close to the strike price relative to the sale price can have huge benefits in terms of reducing tax costs. This is where early exercise comes in - exercising immediately after a grant could result in 0 ordinary income, resulting in only captial gains taxes. And exercising earlier also means the clock starts moving earlier to reach the long-term capital gains holding period requirement. Having early exercise as an available option is extremely valuable with NSOs, and potentially puts them on par with ISOs.

Taxes for ISOs

The main benefit for ISOs is that exercising does not incur ordinary income tax (given a qualified disposition). However, alternative minimum tax (AMT) may apply, and different taxes may be owed and at different times, depending on when exercising and selling occurs. Here are the 3 possible scenarios.

Exercised and sold in same year (implies disqualifying) Exercised and sold in different years, qualifying Exercised and sold in different years, disqualifying
Taxes owed on exercise Ordinary income tax on eFMV - strike No ordinary income tax, but AMT on eFMV - strike No ordinary income tax, but AMT on eFMV - strike
Taxes owed on sale Short-term capital gains on sale - eFMV Long-term capital gains on sale - strike Short-term capital gains on sale - eFMV AND ordinary income tax on eFMV - strike

strike denotes the strike price.

eFMV is the FMV at the time of exercise

sale is the sale price

While avoiding the ordinary income tax with ISOs is great, AMT still counts eFMV - strike as income, and if that value is large, there can still be a sizable tax bill to pay.

AMT for ISOs

AMT, as the name implies, is an alternative way of calculating taxes, and if AMT is higher than regular tax calculations, AMT must be paid instead. To roughly estimate AMT, first add the difference between FMV and the strike price to all other income, then subtract the AMT exclusion amount, and then multiply the result by the AMT tax rate. If the result of this computation is higher than the amount of taxes normally paid, then this should be factored into the cost of exercising ISOs.

However, paying AMT due to ISO exercise also grants AMT credit. In future years, if the regular tax owed is greater than AMT, AMT credit can be used to reduce the regular tax bill until reaching the AMT as a lower limit. AMT credit does not expire, so for people who don’t normally pay AMT, tax costs for ISO exercising can be entirely recouped over time, though this may take many years.

Conclusion

I wrote this post to help me examine my own understanding of stock options, and to organize information in a way most useful for my own reference. Working for startups, stock options can be a significant chunk of compensation, and unlike most other forms of compensation, it really does pay off to have a good understanding of what choices are available, and to make a plan early.