This is the exciting part. You’re pondering a new job. You’re on the brink of potential — career-wise and money-wise. Typically startups use options as a way to lure top talent. It works for them because a new company likely has to be tighter with money, so they can offer a lower salary that includes options. It works for you because you have the chance to be part of something big (read: you could stand to make way more money with your options).
Should you take the job, be sure to check out the strike price in your new hire paperwork. This is the cost to turn your option into a share in the company.
Now you’re getting into the groove of your new job. Usually, the longer you stay at a company, the more vested you are. It makes sense because your employer wants to keep you at the company longer. Typically, you vest at 25% a year. What does this mean, exactly?
After 1 year, you are entitled to 25% of your option. After 2 years, 50% and so on. In this case, you aren’t fully vested until four years in.
And what’s wrong with that? Nothing. Except, the average startup tenure is only two years. So, when you’re mulling over your offer, factor in that you may leave before you can purchase all of your options.
Though the words sometimes get thrown around interchangeably, they are not the same thing. An option is essentially a chance to be a shareholder in the company. So, if you exercise your option, that means you pay the strike price of that option, and then you own a share in the company.
Keep in mind:
You have to meet certain conditions to exercise your options, such as being vested in the company.
If you’re like a typical employee, you won’t exercise your options along the way. Maybe you’re thinking you can just wait until the company makes it big or until you decide to leave. (Of course, you also need to be there long enough to have vested any options in the first place.)
Whether you’re laid off or decide to leave on your own, most companies only give you 90 days to exercise any options that have vested. And many people are just so unsure about what to do that they do nothing. In fact, a recent Schwab survey shows 76% of people don’t exercise their options.
One reason is that you actually have to buy them. Remember that strike price? Say yours for Supercool Startup was $1 and you got 20,000 options as part of your offer. To exercise your options, you would owe Supercool Startup $20,000. Your first consideration is what a share is worth now. Usually you’ll find the Fair Market Value (FMV), which is also called the 409a valuation, through a company-sponsored tool like Solium Shareworks or Carta. If the share price is less than your strike price, you wouldn’t want to spend the money.
If the share is more than your strike price, you may want to buy. The difference between the share price and your strike price is called the bargain element.
Ok, so the big question is, How much will Uncle Sam demand? The answer, like answers to big questions, is it depends.
The type of options you have plus how long you wait to sell your shares will determine how much in taxes you’ll pay. How do you know what type of option you have? Check your paperwork or ask your HR team. It should be documented along with the strike price.
With NSOs, or Non-Statuatory Stock Options, you have to pay ordinary income tax on your bargain element — the difference between your strike price and the current share price — when you buy your options. For ISOs, or Incentive Stock Options, the taxes might be seen as more favorable because you don’t pay this ordinary income tax when you exercise. However, something called Alternative Minimum Tax (AMT) is usually triggered when you exercise ISOs and you need to make a payment similar to what you would with an NSO anyway.
Regardless of if you have ISOs or NSOs, you will have to pay tax when you sell your shares, assuming, of course, that you make a profit. If you keep your shares for at least 1 year after exercising your options and 2 years after the grant date (e.g., your start date), your profits will be taxed as long-term capital gains, ranging from 0 to 23.8% depending on your income. If you don’t wait that long, you pay short-term gains, taxed as ordinary income, ranging from 10 to 37%.
Shondra and Wendy are BFFs. They do everything together. They both get new jobs, Shondra at Sl@ck and Wendy at WheeWork, and start the same day in January 2015. They both get 10,000 options and a strike price of $10. Amazing!
They both decide to leave exactly two years later in January of 2017 when they are 50% vested and have the option to buy 5,000 shares (50% of their original 10,000). The price of a WheeWork share and a Sl@ck share is $15.
How much will it cost?
Shondra and Wendy will have to spend $50K for their shares ($10 per option x 5,000 vested options).
But wait, there’s more!
Because both Shondra and Wendy have NSOs, the IRS looks at this and says, the current value of those shares is $75K (the $15 January 2017 price x 5,000) and therefore, Shondra and Wendy made $25K. In other words, they bought something worth $75K for $50K. This $25K is taxed at ~30%, which is another $7K. So the total cost to exercise the options is $57K. That’s a big chunk of change with no guarantee that you’ll sell those shares.
Is it worth it?
This is where Shondra and Wendy’s stories diverge. Shondra holds onto her shares until Sl@ck goes public in June 2019. After her lockup period, which is typically 90-180 days that you have to wait to sell, she immediately sells for $35/share. With her 5,000 shares, she makes $125K. Remember, she did spend $57K to purchase her options, so her profit is $68K ($125K-$57K). A pretty good deal for doing almost nothing.
Wendy, on the other hand, is dealing with an in-flux WheeWork, whose shares are now worth just $8. She paid more for her shares than they are currently worth, so she can’t make a profit. Right now, she’s out $57K. All Wendy can do is wait and hope that WheeWork goes public and is valued higher — or that her BFF might literally share the wealth.