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5 Mistakes You Can’t Afford to Make with Stock Options

Income tax Monopoly boardDisclaimer: I am not a lawyer or tax attorney. Please consult with one before making any financial decisions as to what to do or not do with your options.

Stock options are complicated; the paperwork that accompanies them can sometimes be a full inch thick of financial legalese. Most employees are just glad to get some ownership in the company — and maybe a lottery ticket if the startup does really well. But most employees don’t recognize what their options really are, nor do they understand that there are some catastrophic choices they can make with those options that could leave them bankrupt or worse.

For the executive summary: If you can afford it, forward-exercise 100 percent of your options the week you join a startup and file an 83(b) election immediately.

Here are five common mistakes employees make, as well as why they spell bad news.

1. Believe that a fortune awaits

Many employees join a startup and work incredibly hard at a sub-market salary for years in the hopes of “striking gold.” The sobering math around startup exits, however, is that unless you’re one of the very first few employees, you’re probably not going to get more than a nice hiring bonus, even if the company does pretty well for itself.

Let’s say you’re employee No. 20 at a Valley startup. By usual Valley standards, if you’re a fabulous developer, you’ll probably get a four-year option package worth about 0.2 percent of the company. Two years after you join, the company sells for $30 million. Wow, that sounds like a lot of money! You’re rich! Right?

Not so fast. If the company has taken $10 million of financing (at a 1x preference) that leaves $20 million to be split among the shareholders. You’ve vested half your 0.2 percent, so you get 0.1 percent, or $20,000 before taxes. Since exits are taxed federally as income (~25 percent) and you live in California (~9 percent state tax), you get to keep $13,200. That’s $550 for each of the 24 months you just worked your ass off. Oh, and in many deals, most of this money is not doled out right away to employees. It’s only offered after one to three years of successful employment at the acquiring company, to keep you around. Oy.

So if you join a startup, you should do so because you love the environment, the problems and your coworkers, not because there’s a giant pot of gold at the end of the rainbow.

2. Quit with unexercised options

Most employees don’t realize that that the unexercised options they worked so hard to vest completely vaporize after they leave the company, usually after 90 days. If you haven’t exercised your vested options, your ownership goes to zero. Even if the startup eventually gets acquired for a billion dollars, you get zilch. So if you join a startup and don’t exercise, you should probably try to stick it through to an exit.

3. Wait until the company is doing really well to exercise

This mistake can catch a lot of otherwise smart people. They join a startup, work hard and see the company grow. Then after a few years they say: “Wow, the company just raised a huge round or has promising prospects to be acquired for a lot of money or file for IPO! I should exercise those stock options I haven’t been thinking about!” These people usually don’t bother to talk to a tax attorney or even a mentor; they just fill out their options paperwork, write a small check, and the company duly processes it. The employee feels not only pumped but really, really smart. After all, they just paid this tiny price to exercise their options, and in return they get this big wad of super-valuable stock!

They usually don’t realize – at least, not for some time — that the IRS considers this exercise a taxable event under the Alternative Minimum Tax because they just got something that’s worth more than what they spent on it. The IRS does not care that you don’t actually have the cash on hand to pay this tax. Nor do they care that you can’t even sell off some of the stock to pay for the tax. They are brutal.

In two cases, friends of mine had to arrange for a decade-long repayment period to the IRS for hundreds of thousands of dollars, wiping out their savings and their next decade of earnings. In both cases the stock that my friends exercised was ultimately rendered illiquid/worthless. Ouch.

4. Fail to early exercise

Most startup employees don’t realize that it’s possible to ask to “forward exercise” their unvested options immediately after receiving their options grant. “But wait!” they cry, “with a one-year cliff, my boss told me none of my options will vest at all until I’ve worked a year!”

Perfectly true. But follow this carefully: Your option vesting schedule covers your right (“option”) to purchase Common Stock. If you exercise your option before it vests, you’ll receive not Common Stock but Restricted Stock instead. Restricted Stock can be purchased back from you by the company at the amount you paid for it if you quit.

Let’s say you think you’re really clever and join a company. The next day, you forward-exercise your four-year option package and quit. The company will simply buy back all of your restricted stock, and you’ll end up with nothing. The restricted stock vests into common stock at the same schedule as your options vest. So if you did a forward exercise, on your one-year anniversary a quarter of your restricted shares “magically” (with no paperwork to fill out or action to take) become common shares that the company cannot force you to sell if you leave.

This also means you get to start the clock ticking on long-term capital gains, which is currently 15 percent in the US! So if your company does end up hitting a liquidity event, a much smaller portion of your gains will be taxable. Indeed, if you hold on to your stock for more than five years, you might be eligible to roll over all of the proceeds into another qualified small business completely tax-free!

5. Fail to file an 83(b) election

Some folks who are clever enough to realize that they can exercise early unfortunately forget that they need to tell the IRS to recognize the event with a form called an 83(b) election. Without an 83(b), your vesting is counted as income under AMT since your restricted stock that you paid $X for is converting into common stock that’s worth more ($Y>$X), since hopefully the company is getting more valuable.

The 83(b) tells the IRS that you’d like to immediately “fast forward” all of the tax impact, so pretty please tax you now for your gains. But since you’re paying fair market value for the common stock, there are no gains, so you pay no taxes at all! Clever you. As long as you file your 83(b) with the IRS within 30 days of your forward exercise and include it again in your annual personal income tax return, you’ll be in the clear regarding AMT.

If you found this helpful, check out my Guide to Stock & Options, embedded below.
[scribd id=55945011 key=key-dabr15b167c296f9mi5 mode=list]

A Stanford CS grad, David Weekly has been coding since he was five and loves bringing people together and starting things, including PBworks, SuperHappyDevHouse, Hacker Dojo, and Mexican.VC. He is an award-winning mentor for Founder Institute, i/o ventures, and 500 Startups. He is @dweekly on Twitter and can be reached at [email protected]

Image courtesy of Flickr user alancleaver_2000

16 Responses to “5 Mistakes You Can’t Afford to Make with Stock Options”

  1. Dave, I recently had to get creative with compensation at my company, so ended up building We were paying people startup wages and, once revenues started coming in, we faced a problem: if we increase salaries, we don’t invest into scaling the business. Stock-options and equity distribution were not a good short-term solution, so I tried to implement a program that:

    A. compensates people for the effort that they put in
    B. gives people a feeling of ownership in the company

    The way I’ve set things up is that I say to the team: everyone will own a portion of a compensation pool. The compensation pool is a set percentage from the profit margin. Your ownership is a function of how long you’ve been with the company, your level in the company (e.g. senior developers max out owning more than junior developers). Once you start working with us, your ownership will increase to its maximum over a period of 2 years. Once you leave, your ownership will go down to 0 over 2 years. We are using the logistic curve to calculate growth of ownership over time.

    Here is a sample scenario: if P1 and P2 start working together and there is a payout in a year with P1 at level 1 and P2 at level 2, then P1 gets 1/3rd of the pool and P2 gets 2/3rds. Then P2 says “screw this” and leaves. P1 then hires P3. A year from then, P1 is at 2, P2 is at 1, P3 is at 0.25. And so each gets their portion: P1=2/3.25, P2=1/3.25, P3=0.25/3.25.

    In the end, the idea is simple: if you work hard, you don’t have to stay with the company to profit. At the same time, if you did something valuable today and the company gets a lot of money 10 years from now, you don’t really deserve that much credit, if any. Moreover, you have a career path (going up levels) and then there can be a performance multiplier allowing management to rate your performance.

    Sorry for the long post, but I thought you may find this interesting and am very curious about your thoughts on this. I don’t see FairSetup as a replacement for stock options, but as something that could provide a simple short-term model that provides a strong incentive getting people to work on the company as their own while preserving cash for operations.

  2. I agree with most of what this article, but the “early exercise”
    advice has some HUGE caveats.

    Assume that the strike price of your options is at the current price
    of the stock (if they aren’t there are tax implications). The whole
    point of options is to let you buy stock at a lower price than the stock is currently. If you exercise them immediately upon receipt, you will have to pay the company exactly what the stock is worth. You
    just became an investor, and a start-up would have to be pretty hot
    for you to say that the privilege of investing in the company is
    compensation for being an employee (most likely, as mentioned, at a
    salary less than market).

    What’s worse is that the event that someone have to use to establish
    the company’s value is most likely the latest investment of Preferred
    Stock. You will be receiving common stock and unless the strike price
    was set very thoughtfully (taking into account liquidation preferences
    sitting above common and the other substantial rights that preferred
    has common), you are probably actually paying a premium over what the
    company’s investors paid. That doesn’t sound too much like
    compensation now, does it?

    The whole point of options is that if the company tanks you will have
    paid nothing for the chance to participate in the upside. Its finance
    101: Tax implications aside, an un-exercised option is ALWAYS worth
    more than the difference between the strike price and stock price.
    Early exercise is not a decision to take lightly, the idea is to
    maximize your NPV, not just your future tax liability.

    • Jeff,

      In an early-stage startup, the fair market price of Common is usually set to between 1/4 and 1/8 of the price of the last Preferred round, so I’m not seeing how that comes out to be “a premium over what the company’s investors paid”. In the formation stages, Common might even be priced at fractions of a penny! Consequently, while you are making a bet, it is a bet that is cheaper to make sooner rather than later (when serious tax consequences could come into play).

  3. Nunzio Fiore

    This article is perfect. Is exactly the same I told to every startup who promised me wonderful magical stock insteade of the real value of a super work. Great David

  4. Leo P

    Does anyone happen to know the tax consequences of forgetting the 83b?

    For example: Jan 1, 2000: it’s day 1 of a new job and you get a grant for 100k options at a $.01 strike price).

    Jan 1, 2004: It’s your 4 year anniversary, and you exercise your options and quit your job. The stock price is still $.01/share, so you pay $1k and there are no gains. You forget to file an 83(b).

    Jan 1, 2009: your company IPOs at $10/share, so the FMV of your stock is now $1 million.

    What is your tax status? Do you pay capital gains on $1 million – $1k? Income tax on $1 million – $1k? Something else?

    • 83b only serves to accelerate when the shares are included in income when the shares are subject to risk of forfeiture. There is no risk of forfeiture in your example so no 83b is needed. So you’d pay LT Cap Gains Tax on $1M.

      However there is also 1202 Implications here might mean that you pay 0% Capital gains tax. But that’s another Story.

  5. Jon W

    If you exercise vested options, the taxable event is always at exercise, for regular tax as well as AMT. Only when you exercise unvested options does 83b and AMT come into effect, because it regulates the treatment of vesting as taxable event.
    When you join a start-up, consider asking for a signing bonus to cover (after tax) the pre-exercise! (I wish I’d thought of that in the past :-)

  6. Tyler A.

    Don’t take this the wrong way, but your disclaimer that you are not a lawyer or tax attorney is a very important one, as this article is incorrect in several important respects, only a couple of which I will touch on. I will preface this by saying I am a tax attorney, but this information does not constitute tax or legal advice. Please consult a tax professional.

    1. The recognition income from the exercise of an option depends on the type of option. There are two main types of options Incentive Stock Options (ISOs, also called statutory options) and Non-Qualified Stock Options (Non-quals). If certain holding period requirements are met then there is no income recognized from its exercise, contrast non-quals in which there is income recognized equal to the intrinsic value of the stock received, fair market value less price paid to exercise. I won’t get into the differences in basis and the resulting capital gain or loss on sale.

    2. The income from exercising an option is gross income for both regular tax and alternative minimum tax (AMT) purposes. AMT is an alternative system that starts with regular taxable income and makes certain adjustments and preferences, but at the base both AMT and regular tax rely on gross income under IRC Section 61. Just saying that the exercises are “taxable events under the Alternative minimum tax,” while correct, is misleadingly underinclusive.

    3. Many companies provide way to mitigate the tax that may be due upon the exercise of a 83(b) election or taxable option exercise, including trading in some of your options for cash to pay the taxes on the options exercised. Everyone should consult with a tax professional before exercising any substantial amount of options. If we’re only talking a few hundred or even couple thousand dollars it might not be worth it, but much more than that and you can save yourself a lot of trouble.

    4. It completely depends on your option if you have the ability to convert to restricted stock before you can exercise, but in my experience that would be rare. In addition to options companies can also issue Restricted Stock Awards or Units (RSAs and RSUs). These are different than options in that they are actual stock, with restrictions, i.e., a substantial risk of forfeiture if you don’t maintain certain conditions such as employment. Another difference is with regard to when the income is recognized for tax purposes. Income from non-quals for instance, are recognized upon you exercising the option – you decided to exercise and paid cash or performed a cashless exercise, while for restricted stock there is no cash due and vesting happens automatically based on the deferred compensation plan. It’s incorrect to say that the company is buying back the restricted stock if you leave before it vests, as you never really had clear title to it before. The restriction on the stock was that you have to give it back if you leave, which leads to the substantial risk of forfeiture that prevents it from being income when received.

    5. Filing an IRC Section 83(b) election is an important consideration and should not be taken lightly. An 83(b) election, which applies to restricted stock, changes the character of the future income from the sale of the stock. For example, if you receive RSAs/RSUs and do not make an 83(b) election when the stock vests you recognize ordinary income equal to the fair market value (FMV) of the stock on the vesting date. Ordinary income is taxed at the highest rates, 35%. When you subsequently sold it you would recognize a smaller capital gain (if any), taxed at a lower 15% rate. However, if you had made an 83(b) election at the date of grant you would recognize only ordinary income equal to the FMV of the shares at the grant date, and only recognize capital gain or loss when sold. But, and this is a big but, if the stock goes down in value you could have some trouble. On subsequent sale you would recognize a capital loss, which, is severely restricted in your ability to deduct those losses. You may have just picked up ordinary income in the year of grant but then be severely limited in your ability to recognize a loss on the sale.

    • Tyler,

      Firstly, thank you so much for taking the time to put together your feedback on this article – it’s awesome to get some feedback from a real tax attorney! I’m looking forward to writing future editions of the Guide (embedded above) to ensure it’s as correct *and* approachable as possible.

      The thing that I didn’t succeed in clarifying in this article is that I’m really targeting my advice towards founders and relatively early employees of Silicon Valley companies. RE: #1, Most employees will only ever encounter ISOs, so I (as you note) omit a substantive treatment of NSOs to keep the conversation focused on situations likely to be more commonly applicable. Continuing this theme of wanting to focus on the likely scenarios that a startup employee will face, most startup options are priced at FMV and thus don’t have any exercise income to recognize if a forward exercise is done relatively expediently (since the FMV has not had a chance to tick upward between when the employee was hired vs exercised), which should address your point #2. #3 (having a company allow the employee to cash in some options to take care of the AMT due from the exercise) sounds like a really cool / sweet thing for a company do to help out employees, but I’ve not often seen this done – is this a practice you’ve seen commonly? Conversely with #4, I’ve seen early exercises fairly commonly permitted at startups, whereas RSAs/RSUs tend to be more relevant for late stage (public or near-public) companies. Finally with #5, at an early stage startup common will be pretty violently discounted, in theory making a full early exercise relatively inexpensive (a few thousand dollars) – the tradeoff is starting the long-term cap gains tax (and avoiding AMT) vs the very real possibility of losing the full principal – and you’re obviously totally right that you could only write off such a loss as a capital one. So it’s admittedly a gamble, but it’s one that keeps things simpler for the employee IMHO.

      If there are things I’ve written that are Wrong (vs simply not inclusive of situations less likely relevant to startups), I’d be delighted to incorporate your corrections (with credit) in the next of the document! The first edition got a number of such bits of constructive feedback that were incorporated into the second edition of the Guide embedded above. It’d be awesome to have the fixes of a real tax lawyer in there.


      • Tyler A.

        Just to preface my responses with saying I don’t practice in the individual tax area, as my clients are all corporations, mainly public. However, under IRC 83(h) a company’s tax deduction is limited to the amount of income reported on a employees W-2 as income, so I’m decently well versed on their treatment. Also, since most of my clients are medium/large publics, I haven’t seen the startup phase very often. I did have a few other comments to your responses:

        1. ISOs are becoming less and less common, especially as companies grow. Many of my large clients have abandoned ISOs. Under ISOs an individual includes income, and the company only gets the tax deduction. when there is a disqualifying disposition (DD). However, a lot of people will fail to report the DD if they can sell the stock publicly, and as a result the issuers lose the tax deduction. Admittedly this isn’t likely a problem for a startup, but becomes an issue later on. Even non-public companies are limiting uses of ISOs anticipating future problems. Nevertheless, I think its important to point out there is a distinction.

        2. I see your point about the AMT as it relates to ISOs and the bargain purchase element. I wasn’t aware of this issue, as I don’t deal with individual tax. My comments were directed more towards the non-qual side because its what affects companies more and because I’ve started seeing fewer ISOs issued. I do think some clarification could be made to with respect to the holding period for ISOs.

        3.a. On the 83(b) election side, I don’t think there is an AMT issue here because it relates to restricted stock rather than ISOs. The vesting of restricted stock is income, and I don’t think there is any bargain purchase element. The reason for the income is under 83(c)(1) – substantial risk of forfeiture. Basically until the stock is vested you may have to return it, and because of this substantial risk of forfeiture you don’t have to pick up the income for regular tax purposes. Upon the lapsing of the restriction, i.e., vesting, you’re free to do with the stock as you wish (ideally, though for non-publics there are going to be restrictive legends determining who you can sell it to, but this shouldn’t affect the tax treatment) and then you pickup the income on your return.

        b. In the second paragraph of 5 you said that you won’t have any tax because you’re paying fair market value for the stock, but since RSUs/RSAs are compensatory in every case i’ve seen you don’t pay anything, its basically a form of salary. You are merely awarded the stock subject to vesting. Therefore when they vest you pickup the income, or, if at grant you file an 83(b) election, you pickup income equal to FMV of the stock.

        c. Another consideration is the deferral of tax. As some have said, “a tax delayed is a tax not paid.” If you’re not expecting the value of the stock to increase dramatically over the vesting period, then you end up paying tax earlier rather than later, and with the time value of money you end up paying more tax than you otherwise would. Though this is a gamble. Additionally, if you are granted restricted stock, make an 83(b) election, and then quit or the stock is otherwise forfeited, you paid tax that you won’t get back. I think my point is not that its never a good idea to make one, it certainly is in a good number of circumstances, only that there should be careful consideration of if the 83(b) should be made. Based only on anecdotal evidence (i.e., looking at vesting reports that list 83(b) elections) I would say at least for large companies, only a fraction of people make 83(b) elections. Whether this is because of lack of knowledge on the part of the recipients or some other reason, I can’t say.