I got 99 options and rich ain't one
May 5, 2021 3:00 PM   Subscribe

I've been granted stock options by my employer, a private tech company. I understand the basics, but not the details.

A private equity company known for grooming smaller tech firms for sale to larger ones has recently entered the picture, and they're pushing for massive growth over the next few years.

I have no idea how to evaluate the quality of the shares behind the (the agreement says each non incentive option can be converted to a single share of common stock). I also don't know whether it would make sense to exercise the options ASAP (for instance, for tax purposes, or in order to shield myself from losing the right to exercise them later if I were to be discharged for cause, which, based on the options agreement, seems it would be easy for the company to do if they wanted to get rid of me for any reason, whatsoever).

How can I better figure out whether these options are likely to be worth something in the future, and what I should do with them?

I don't foresee any issues with continued employment since they're trying to add 3x-4x as many people with my title as they currently have, and I have a good track record + stellar performance reviews. There's plenty of turbulence in upper management (above my pay grade) and in other departments, though, and I'm concerned that the company culture is changing for the worse, so I'm getting a little skittish.

Also, I'm already ~70% vested, if it makes a difference.
posted by syzygy to Work & Money (19 answers total)
As a very generic rule you'd wait to exercise them until they're liquid if possible. There's no value in holding these shares for now unless, like you say, you leave the company for some reason. Even then, it depends on the price.

Valuing the shares is difficult as there may be more dilution of ownership right before any liquidity event (a public offering or being acquired) which can change you % ownership at the last moment.

You should get professional tax advice to assess the details of your specific situation. My experience of options has been that they're basically free until I exercised them, but people have been burned by option values before. There are a lot of details in these types of agreements that can make a big difference in how you'll be taxed, so any advice you get from other people may not be relevant.

If you want maximum optionality make sure to have sufficient cash savings on hand if you decide you do want to exercise these options before they're liquid for whatever reason. Generally cash+options is a much better position than owning private shares.
posted by GuyZero at 3:12 PM on May 5 [4 favorites]

First question is what is the grant price and how many shares? In many cases early employee options are granted at a penny or a few cents. If the exercise cost is minimal, then it becomes an almost free lottery ticket and you should exercise as soon as possible.

If the exercise cost is higher, it is generally high risk to exercise before the shares are liquid, that is, publicly traded. You are rarely going to get enough information to value the shares yourself, especially if there is future dilution from later rounds of funding.

The two cases are taxed differently. You first pay ordinary income tax on the difference between the grant price and the current price. So that would suggest exercising early in order to minimize ordinary income taxes. But then you have to pay capital gains tax when you sell the shares in the future, but at a lower rate.

If you delay exercising, then you pay ordinary income taxes on a bigger gain, but then when you sell the shares you have a lower capital gains tax.

So by exercising early, you may have a lower total tax. But don't let the tax tail wag the dog. You also increase the risk of losing money if the stock ends up lower than your exercise price.
posted by JackFlash at 3:26 PM on May 5 [1 favorite]

Unless you are on the board of the company or in senior management (tbh even if you are), it is very difficult for you to value your options properly. If these are like most stock options, they entitle you to a share of "common stock", meaning that if the company does quite well, and then either IPOs or gets acquired, you will get some percentage ownership in the company. But here's what you don't know:
  • The terms that your company has given the existing investors. Usually, venture capitalists get "preferred stock", so they have to get their investment back in full before the common stockholders get anything. Sometimes they get options that require them to make a certain amount of profit before the commons get anything. Sometimes they have "participating preferred" stock which means that they get back all their investment, PLUS a percentage of the company along with you.
  • The terms that your company will give future investors. It's easy for shareholders to get diluted over time, and usually each new round of investors gets at least as good of terms as the prior round. Sometimes later rounds will be structured as convertible debt, meaning that the amount of stock the investors get depends on how well the company does.
  • The financials of the company. If a company is growing fast, it could have to raise money at a disadvantageous time even if everything is going well from a product perspective. Sometimes VCs like this because it gives them another way to make money on their existing investment.
From a tax perspective, these could be ISOs or NSOs -- your company should be able to give you this information. If they are ISOs, the perfect time to exercise them is more than 1 year before you sell them -- in this case, you pay long-term capital gains tax on everything, otherwise you pay short term capital gains. But unless your options have a VERY LOW strike price or you are VERY CERTAIN that your company is going to the moon, exercising options in a private company is a quite risky thing to do.

If company leadership is very transparent, here are some questions they will give you straight answers on. I would make sure that I had reliable answers to them before exercising options:
  • At what valuation did the company last raise money? Don't put too much stock in the answer because, again, it's easy to manipulate headline valuation by changing the terms of the deal, but you need to know this at bare minimum.
  • What percentage of the company do my options entitle me to, fully diluted?
  • Can I see a "waterfall chart" for my options? (This is a chart graphing the value of your options against the company sale price.)
  • When do you next expect to raise additional funding? (If this answer is "within 6 months", wait until after that!)
  • How much of the company is owned by our investors as opposed to founders and employees? (the higher this is, the harder it is for your options to make money.)
  • What is the company's most recent 409(a) valuation? (This is a per-share fair valuation for common stock that you can compare to your option strike price. The company tries to push this down as low as possible because ISOs must be issued at the 409(a) price, but they have to do it in good faith, so if the 409(a) price is below or comparable to your strike price, don't exercise!)
Probably your best bet is to assume these options aren't worth anything and then to be surprised if they are. Good luck!
posted by goingonit at 3:29 PM on May 5 [4 favorites]

(The other relevant tax thing about ISOs is their treatment for AMT, but thanks to the Trump changes to deductions, it is much less likely that this is relevant to you than it was pre-2018.)
posted by goingonit at 3:30 PM on May 5 [2 favorites]

If your options are ISOs, one option is to try to convince your employer to allow you to convert them to NSOs which only expire 10 years after they were issued. Pinterest made this switch, for example.

If you have NSOs that expire later, then you can wait to exercise until there's some kind of liquidity event (like an acquisition or IPO) and the options are actually worth some money. And then you're free to keep the options when you leave the company without having to exercise them.
posted by oranger at 3:37 PM on May 5 [1 favorite]

Response by poster: Additional context:

The current strike price is a fraction of a penny. It would cost me practically nothing to buy the whole lot. I'm not clear how their value would be determined for purposes of taxation, though.

I believe these are NSOs, but the agreement says I have a limited window in which to sell them if I leave. It also says I'll have to pay taxes on them as soon as I exercise them.
posted by syzygy at 3:50 PM on May 5

Response by poster: Strike that about NSOs. After doing some more research, these are almost certainly ISOs.
posted by syzygy at 3:57 PM on May 5

One thing you can do is a partial exercise. Like, buy 1 cent worth of stock. If you own even a tiny bit of the stock, then you are entitled to know the current valuation, etc. Also if your company uses a platform like Carta to manage options, you can run taxation scenarios on their web page.

Really, though, I don't think you need to worry about it until you leave the company or there's some kind of liquidity event (buyout, IPO, etc.). Pretend like the options are worth nothing (there's a pretty good chance it's true) and if it turns out they *are* worth something, sell them and take the cash and think, what a very nice treat!
posted by mskyle at 4:15 PM on May 5 [1 favorite]

The only downside of exercising ISOs earlier is the price. So if it will cost you a reasonable amount of cash, it can be worth it.
posted by goingonit at 4:31 PM on May 5

Exercising early may trigger AMT. I’ve been bitten by this. Consult a tax pro.
posted by jeffamaphone at 4:36 PM on May 5

Response by poster: Correction to earlier correction: These are NSOs (the title of the plan uses a different but synonymous term), but many of the restrictions surrounding them (like having to sell within X days after leaving the company) are similar to restrictions usually placed on ISOs.
posted by syzygy at 4:43 PM on May 5

The current strike price is a fraction of a penny ... These are NSOs.

So what you need to do is ask HR or a company officer the current Fair Market Value (FMV) of the stock. For non-public companies this is usually done by the board of directors quarterly. (Note that this FMV set by the board is not necessarily a realistic number, but it is the number you have to work with. Take it with a grain of salt as to future value).

If you exercise tomorrow, the difference between the grant price and the current fair market value becomes ordinary income. So if you have a grant for 1000 shares at a penny and the current fair market value is one dollar, you will have $1,000 added to your income for this year. You will be taxed at your marginal tax rate, say, 24%, which means an extra $240 in taxes. Then let's say the stock goes public at $10 a year later and you sell. You will then have a capital gain that is the sell price, $10, minus your exercise price, $1. That is $10,000 - $1,000 = $9,000. Your capital gains tax is 15% of that or $1,350. So all in, you will pocket $10,000 - $240 - $1,350 = $8,410.

In the alternative case you wait until the stock goes public at $10 and exercise and sell on the same day. In that case you pay ordinary income tax on your entire gain, that is $10,000 minus pennies. So at 24% tax rate you pay $2,400 leaving you with $7,600.

This is less than if you exercise now, but that is assuming the stock rises in value. If you exercise now you pay the $250 no matter what. If for some reason the stock tanks you are out that $250 and get nothing.
posted by JackFlash at 5:04 PM on May 5 [3 favorites]

JackFlash has given the gist of it but one more important thing to note is that if the stock value drops after you buy it (e.g. the company goes public but you end up selling the stock for less than what it was valued when you purchased it, or the company goes out of business and the stock becomes worthless), you can claim that loss on your taxes and it can offset either other capital gains (if you have any that year) or ordinary income if you don't have capital gains.
posted by mskyle at 5:38 PM on May 5 [1 favorite]

Adding one more caution to JackFlash's explanation of NSO's. With that kind of option, the "taxable event" occurs when you exercise, thus your US income tax liability is set by the difference between the grant price and the fair market value as of that date.

If you exercise and sell (what most people do,) your taxes are paid by withholding some of your profits. But, if you exercise and hold (i.e. decide to keep the shares) please remember your tax liability was still determined by that original exercise "profit". If the stock price drops substantially, you could find yourself owing thousands in taxes on those 'paper profits' but only having hundreds in suddenly devalued stock to pay them!

Best to ask an accountant or tax-savvy financial advisor about your specific situation before you pull the trigger on those options.
posted by ReferenceDesk at 5:39 PM on May 5 [3 favorites]

But, if you exercise and hold (i.e. decide to keep the shares) please remember your tax liability was still determined by that original exercise "profit". If the stock price drops substantially, you could find yourself owing thousands in taxes on those 'paper profits' but only having hundreds in suddenly devalued stock to pay them!

The classic case was thousands of Microsoft employees caught in the 2000 dot com meltdown. Many of them had hundreds of thousands or even millions in paper gains when they exercised their options and held the stock and then had to pay enormous tax bills at the end of the year on them even though the stock had losses.
posted by JackFlash at 7:58 PM on May 5 [2 favorites]

I think that the nightmare scenarios involving AMT when there was no actual profit are mostly gone, but options can be complicated. The difference between having them taxed as ordinary income vs. capital gains might be significant to your life. Especially if there's any question about what type they are, I can't see trying to tackle this on my own. Get a pro.
posted by wnissen at 6:48 AM on May 6 [1 favorite]

I think that the nightmare scenarios involving AMT when there was no actual profit are mostly gone

The OP is talking about NSOs not ICOs. AMT is not the issue for NSOs because they are taxed as ordinary income regardless.
posted by JackFlash at 9:03 AM on May 6 [1 favorite]

The OP is talking about NSOs not ICOs. AMT is not the issue for NSOs because they are taxed as ordinary income regardless.
Well, it seems like that that, but there is some confusion.
posted by wnissen at 6:36 AM on May 7

Response by poster: Sorry for the confusion. The problem is that the document lays out restrictions that (in my limited understanding) are usually associated with ISOs (e.g. must exercise options within 3 months after leaving, non transferrable). But the title of the document calls them Non-statutory Stock Options, and it says the employee must be prepared to pay taxes when the options are exercised. So, I think they're NSOs for tax purposes, but with some ISO-like restrictions.

Strike price and FMV are both very low, so I will probably exercise them ASAP.

Thanks all, for the excellent advice, so far!
posted by syzygy at 10:59 AM on May 7

« Older Looking for a sci-fi book from the 60s or early...   |   Cheap cell numbers for annoyance validations? Newer »

You are not logged in, either login or create an account to post comments