I’ve mentioned before that I’m an early-stage startup lifer. I’ve been there from the just-10-people-in-a-house phase to hitting the first 100 employees, and back again. One thing that’s consistent with every startup is the promise of potential payout, should the company become the next Facebook.
That promise is offered as stock options.
For anyone new to the #startupgrind, the idea is that if your company has an exit, you can cash in your stock options for a small fortune. This can happen in one of two ways: either your company is acquired, or files for IPO and goes public. Sounds great, right?
Well, sort of… The problem is there’s never a guarantee that you’re working for a real unicorn, let alone a company that will even get acquired. And if you are, who knows if you’ll still be able to get the benefit of those options by the time they have their exit?
I worked with my first startup for years, trading my 60+ hour work week not for silly things like a salary and benefits, but for stock options. I really believed in the company and the team, and got excited every time someone mentioned our next round of funding was this close to closing, or [[insert tech behemoth here]] is considering us for acquisition, and all of us would be fabulously wealthy at the end of the tunnel.
It wasn’t until the company more or less imploded that I learned my hard-earned shares never actually belonged to me, after all.
So let’s talk about it.
What are Stock Options anyway?
A lot of employees hear “stock options” and think they’re partial owners of the company. That’s not exactly the case. Stock options are literally the option to purchase company stock. You now have the ability to buy shares at a discounted rate, which is called a “strike price.”
ISOs vs. NSOs
Before we go further, I should say that there are two types of stock options. ISOs, or Incentivized Stock Options, are standard for employees. Your employer is trying to keep you motivated by offering them, so they come with a few strings attached. NSOs, or Non-Qualified Stock Options, are available to anyone – not just employees. There are a lot of finicky differences, most of which lie in how they are taxed. Because we’re talking about the startup employee experience, I’ll keep the rest of this to ISOs.
You can’t just buy your options willy-nilly. Your stock options aren’t yours as soon as you start with the company. Instead, they’re assigned a vesting schedule, or a timeline saying for every year you’re there, you receive a portion of your stock options.
The most common of these is a 4-year vesting schedule with a 1-year cliff. Each year you’d receive a quarter of your options, once you pass that cliff. If you don’t make it to the cliff, poof. They’re gone.
This makes perfect sense for your company, because it means their team is incentivized to stick around at least until their options vest. On top of that, it’s fair to the rest of the employees. A new hire that spends a week at the company shouldn’t own the same shares as someone who’s toiled away for 4 years, just because they were better at negotiating. You earn your stock options with the work you do, over time.
So if we have the option to buy shares, the actual process of purchasing is called exercising your shares. You would just have to write a check to your company for (# your shares) x (strike price), and boom. You’re a bonafide shareholder.
Of course, now that you’ve paid your company for the shares, Uncle Sam’s going to want a piece of the pie. It is considered a form of compensation, after all.
Stock options are notorious for being a tax headache, particularly for employees. You’re taxed when you exercise your shares, as well as when you eventually sell them. And depending on how and when you sell them, and for how much, you’ll be taxed differently.
Some of those finicky rules?
If you exercise your ISOs in a taxable year, you’re taxed based on the difference between your strike price and the fair value of your shares. This might trigger Alternate Minimum Tax.
When you sell your shares, your tax bill will depend on how long you held them since exercising. More than a year since exercising, AND more than two years since grant? Yay! It’s considered long term capital gains and taxed at a lower rate. If, however you don’t meet both of those terms, you’re stuck paying ordinary income tax on those gains. Boo.
Long story short, probably best to hire a CPA.
This one can hurt, especially if you’ve busted your butt building a company for several years. Your stock options are not yours forever. Once you leave, the clock starts ticking down on your time to exercise your options. The standard time for ISOs to expire is 90 days from the end of employment. If you don’t (or can’t) exercise them before those 90 days are up, your hard-earned shares go back into the pool, and you’re SOL.
Stock options are Schrodinger’s benefit. They’re both valuable and worthless, until proven otherwise. I’m not saying you should avoid them all together, but please, don’t reduce your value in exchange for stock options, unless you’re absolutely sure it’s worth it to you. There may be a pot of gold at the end of that rainbow, but don’t plan on it. Ye be warned.