Guide to understanding your job offer with stock options. Congratulations! You just landed your dream job. However, you might have one big puzzle to solve. Your compensation package includes a combination of a base salary and stock options. The news is exciting but also a bit confusing. What does owning stock options mean for your finances and career prospects?
The rules of stock options can be quite complex. Early decisions can substantially impact your future earnings and tax burden.
In this article, I try to break down some of the key points you need to understand before accepting the job offer with stock options.
What are Employee Stock Options?
Employee Stock Options are a type of equity compensation. Many employers and startups, especially in the tech and biotech space, use stock options to reward and retain talented employees in a competitive hiring environment.
The options give you the right to buy company shares at a specific exercise price during your employment period. By exercising your stock options, you will become a shareholder of your company and participate in future success.
Being a shareholder of a successful company can guarantee your future financial prosperity. However, owning stock options and company share will require a great degree of tax and financial planning.
What type of stock options – NSO or ISO?
There are two main types of employee stock options – Incentive Stock Options and Non-Qualified Stock Options. I have written two articles explaining each type.
Comparing the two types, ISOs generally have a better preferential tax treatment over NSOs. The exercise of ISOs does not create a taxable income, but you may owe an Alternative Minimum Tax based on your overall annual income. The IRS allows you to treat your total realized gain as long-term capital gains as long as you hold your shares for 2 years after the grant date and 1 year after exercise.
For comparison, the NSO exercise will automatically trigger a taxable event. You will immediately owe income taxes on the difference between the fair market value and exercise price.
Another significant difference between the two types is that ISO can only be rewarded to employees. In contrast, companies can grant NSOs to both employees, vendors, and other third parties.
What is your share of the equity?
Your job offer will include a specific number of shares you could own once you exercise your stock options. As high as that number may look, it is a lot more important to know your percentage stake. You need to ask your future employer what is the company’s total number of outstanding shares. The number of your shares divided by the total number of the company’s shares will give your stake at the company. Also, keep in mind that your employer may issue new shares to external investors and VCs in the future, which can be dilutive to your ownership stake.
This information is critical, especially if you are joining an early-stage startup where the number of shares can be very fluid initially.
Receiving the option grant does not immediately make you a shareholder. You can only exercise your stock options once they are vested. The vesting represents the transfer of ownership from your company to you. Your employer will give you a vesting schedule with a series of dates. On each date or employment anniversary, you will receive ownership of a specific lot or percentage of stock options.
Keep in mind that you must exercise your stock options to own the company shares. Non exercised option can potentially expire, and you will lose your ability to become a shareholder.
Strike price or exercise price is the value at which you can buy the company shares once you exercise your stock options. You will be responsible for purchasing the shares. Fortunately, most startups set up the strike price near the $1 range. And most likely, the total cost will be deducted directly from your paycheck. The strike price is important because it will set the stage for your tax dues, depending on the type of stock option you own.
Fair Market Value
The Fair Market Value (FMV) is the price at which your company shares are valued at any given point in time. Your employer should provide you with a fair market value at the time of the stock option exercise.
The FMV of a publicly-traded company is straightforward. It’s typically the end of day market price on the stock exchange.
However, getting the FMV of a private company can be tricky. You will not have a publicly available price. For that reason, startups will hire a third-party expert to calculate the FMV based on recent rounds of funding, comparable company analysis, discounted cash flows, and expected revenue growth projections.
When evaluating your job offer, you can ask if your employer will allow for your stock options’ early exercise. Under IRC § 83(b) election, you can exercise your stock grants early and recognize them as compensation. This election can potentially save you taxes in the long run. The early exercise is especially advantageous for employees and founders of early-stage startups. By choosing early exercise, you pay income taxes at the low fair market value now. No income tax will be due at the time of vesting. When you sell your shares, you will owe capital gain taxes on the difference between the sale price and the early exercise price.
Liquidity and exit strategy
If your future employer is a public corporation, you can easily sell your shares upon exercise. Selling shares can help you pay taxes on your earnings and diversify your investments.
The liquidity challenge occurs when you are working for a private company. There will be no public market for the stock. You must plan for holding your shares for a long period. Furthermore, exercising stock options can trigger certain taxable, which you will have to cover from your personal savings.
Vesting if the company is acquired.
Often startups are getting acquired before going public. Before you accept the job offer, you may want to know what will happen with your outstanding shares and stock options if your company gets acquired. In the most likely outcome, the acquiring company will cash in all your shares and options. It’s also possible that the acquiring company will exchange your employee shares and stock options for their own.
What happens with my stock options if I decide to leave the company? Usually, you will have 90 days from your departure to exercise your vested stock options. Unfortunately, you will lose any nonvested stock options. It will be up to you to keep or sell any outstanding shares of the company.
Finally, let’s talk about taxes. You will be responsible for all taxes resulting from the exercising of your stock options and selling your shares. Depending on the exact option type, you can owe ordinary income tax, short term, long-term capital gain tax, or Alternative Minimum Tax.
In some cases, when exercising NSOs, your employer will automatically sell shares to cover all federal and state income taxes. In other cases, especially with private companies, you will have to pay taxes directly from your bank account.
Stock options taxes can be complex. You may face multiple scenarios depending on your company’s success. I strongly encourage you to be proactive and work with an experienced CPA or financial advisor who can objectively guide you through the tax planning process.