12 ms·

Stock options are complicated

231 points by luu 10y ago

richardhenry 10y ago
Regarding stock options expiring 3 months after leaving the company, it doesn't have to be this way and a lot of startups are moving in the direction of 10 year exercise periods. I think Quora was the first to do this: https://dangelo.quora.com/10-Year-Exercise-Periods-Make-Sense https://dangelo.quora.com/10-Year-Exercise-Periods-Make-Sens...
- matthewowen 10y ago
  Have any startups with 10 year exercise periods had a liquidity event yet? I'm genuinely interested to see how true to the idea they were, or whether they (eg) issued a bunch of new stock to current employees that diluted vested ex-employees.
  - doh 10y ago
    Some companies allow their employees to sell a portion of vested stocks whenever they're doing a new round. SpaceX is one of the top examples I know of. This is how they retain the top talent.
- smoodles 10y ago
  I'm not sure about "a lot of startups", I'm personally only aware of a very few that are doing this. Word on the street that I hear is that maaaaybe your current employer might do this for employees they like, but not as a consistent policy. Many board members, founders, etc... feel they will take a retention hit if they were to implement something like this. I personally think the status quo is insane, and I will never take another role with a options component of the package that does not have a policy like this.
  - doh 10y ago
    We do it. And I know of many startups that also followed Quora's example. Definitely not everybody does it, but also it's more than 0.
    - x0x0 10y ago
      Good for you all (not sarcastic!) but as someone who did a job search recently, the number of startups that offer this is much much closer to 0% than 100%. A late edit: and you will get pushback for even asking. Apparently we're all supposed to pretend that we're never going to leave the company / we owe them our undying loyalty. I've previously taken the honest route when asked why I was leaving a job and said the ceo didn't deliver on her promises (growth, revenue), so why would I stay? That approach does not necessarily work well =P
      - randycupertino 10y ago
        > Apparently we're all supposed to pretend that we're never going to leave the company / we owe them our undying loyalty. I've previously taken the honest route when asked why I was leaving a job and said the ceo didn't deliver on her promises (growth, revenue), so why would I stay? I mean, part of getting promoted and learning how to rise politically in your career is learning how to lie. Why did you expect honesty to work? You have to learn how to play the game, say the right things that people want to hear.
    - smoodles 10y ago
      Oh I know there are more than a few these days. My point was the majority of startups I'm aware of are still very hesitant to do this. From the conversations I've had its less that the founders of these firms are morally opposed to the idea, but that their VCs really don't like the idea as a global policy.
- birken 10y ago
  Zach Holman has a great article about it: https://zachholman.com/posts/fuck-your-90-day-exercise-window/ https://zachholman.com/posts/fuck-your-90-day-exercise-windo... And keeps an ongoing list of companies that offer extended exercise windows: https://github.com/holman/extended-exercise-windows https://github.com/holman/extended-exercise-windows As somebody who has personally experienced every aspect of the stock option lifecycle (which fortunately worked out for me), I would never take a job at a company [1] if they didn't have an extended exercise window. The 90 day expiration period creates a massive gap between the risk/reward of equity for founders and the risk/reward of equity for employees, when the whole point of giving equity is to align those. 1: Assuming it was the type of company that compensated people with stock options
- chimeracoder 10y ago
  > Regarding stock options expiring 3 months after leaving the company, it doesn't have to be this way and a lot of startups are moving in the direction of 10 year exercise periods. This requires converting all options to NSOs, and the tax implications of NSOs are not pretty. (From a tax perspective, ISOs aren't great[0], but they're much better for employees, by design). [0] You have to pay AMT on the spread between the option price and current value at the time you exercise, whether or not the equity is liquid, so you could end up paying a large tax bill only to find that the company goes bankrupt before you have the opportunity to ever sell your equity.
  - epa 10y ago
    The kicker here is that the option life is 10 years, even if you have left the company. So you can avoid tax by not exercising until you plan to sell. It becomes a personal choice between 1) do i want the option still, even if i quit, and 2) do i plan to have ownership in the company for a period longer than a year before i sell. Typically most people would prefer 1 over 2. Keep in mind for someone reading this comment, this is about private companies.
    - beagle3 10y ago
      The other thing to keep in mind is that stock options (especially those given to employees) tend to be much less protected than shares. If you exercised, and another shareholder got unfair preferential treatment, you have reason to seek compensation or sue. If you haven't exercised yet, .... well ... not so much. Also, many option contracts give you the right to buy X shares at price Y and do not make special consideration for stock splits - e.g. a 2:1 split would likely make your options worthless by halving the share price, and by halving the percentage of the company that X represents. So, waiting to exercise until you sell is a very good strategy, except when it isn't - not very common, but you rarely get notified about these issues beforehand, especially if you are no longer involved with the company.
  - ssalazar 10y ago
    What are the tax implications of NSOs? ISOs are a pretty huge gamble, basically a lotto ticket, if you leave before a liquidity event occurs or is known to be on the near horizon.
- tpaschalis 10y ago
  What is the general view on this? I don't have an economics background, but.. Well, the 'startup scene' isn't necessarily mature and/or tested enough for employees to be able to take a 10 year risk. In a sense, for a failing startup, stock options might as well be monopoly money.
  - st3v3r 10y ago
    It's not really a 10 year risk, as you keep the options that have vested whether or not you're still with the company. And if the startup fails, if you haven't exercised, you shouldn't be out any money.
LouisSayers 10y ago
I can't help but feel the system is highly rigged in favour of investors. Many countries have tax incentives for investors, but when it comes to people actually joining startups, investing their time and effort, then all you get is a tax bill - and mostly at a highly inconvenient time to pay it! It very much feels like the system is designed to keep the rich rich, and to put the working (wo)man in their place.
- hkmurakami 10y ago
  Our perspective depends on the relative value/scarcity of capital. If capital is scarce and valuable, it makes sense for a system to be designed to reward and protect capital risk. But the "standard terms" haven't changed much since the 80's and capital is definitely more abundant today than it was before. Valuations for early companies are ~10x what they used to be decades ago. Founders give up a fraction of ownership compared to what they used to. The question is where the right balance point is given current parameters. Also, wages have never been higher for tech employees. I'm happy to have a 2x wage level conspared to 15 years ago rather than have the same wage but 2x equity (obviously a simplification), so something's at least working well here wrt labor gaining some ground on capital.
  - LouisSayers 10y ago
    There are two different things going on here though - one is whether we offer incentives for investors. The other is how the tax system works when people receive options / equity. The problem with 'receiving' equity is that 1) Current laws treat equity as if it was cash - but it's not. 2) Whether employees should be compensated and recognised for their potential opportunity costs - essentially given a similar deal to investors. Keep in mind that many startups will offer equity in lieu of the salary that they would otherwise command. Also, if you're offered a significant portion of equity in a startup, then taxes currently make a large disincentive for people to accept and join the startup.
    - hkmurakami 10y ago
      I definitely think (1) is in need of reform. Could you elaborate on (2) on what you mean by "given a similar deal to investors"?
bogomipz 10y ago
This is great write up. Kudos to the author for taking the time. I did have a question about the following sentence: >"If an employer gives you straight-up shares, then the IRS will tax the shares (at ordinary income rates) when they vest." What would be treated as income and taxes here, the strike price x the number of options vesting? Is that correct? For regular worker bees this not very much though right? For instance say an employee has 25 shares vest in a quarter and their stick price is $20. 20 x 25 would be $500 more being taxes as income. Or am I completely not understanding something? If it is not the strike price being taxes as income what is it, since the the value of an option is often unknown to rank and file employees let alone the IRS.
- idunno246 10y ago
  Shares vested x fair market value at vest. So you get 1000 shares when you join, worth $1/share. 250 vest on your first year, and that's when tax is due. But say the company grows and shares are $5/share. 5x250 is 1250 taxed income on the anniversary. Normally at early stages you're talking many thousands of shares though, that can increase rapidly. The fmv is recalculated every year, or on any fundraise events. It needs to be a defensible number or the irs will be upset
  - bogomipz 10y ago
    >"The fmv is recalculated every year, or on any fundraise events." This is the piece I was missing. Thank you for the clear explanation. That being said it would be interesting to buy exercise them just to see what the company is actually valuing those options at, since this is often opaque to the average worker. I wonder if it's possible to exercise a single option and use it as a barometer of sorts to quantify you actual compensation? My guess is no.
    - idunno246 10y ago
      I've never had a company refuse to give me the 409a valuation if I asked point blank for it(just say you're considering exercising and it's important for tax planning). It's important to keep in mind though they tend to purposely depress that value. But investors get a premium because their stock has legitimately more value than yours(liquidation preferences, board seats, etc). And without a liquid market, if you do sell privately you end up taking a large discount. I think the opacity is largely that it's difficult to value things, not so much nefariousness
dkhenry 10y ago
Stock options are not complicated. Most people who look into the details of them will find them very plain and actually quite simple. The issue is you don't often deal with this area of finance so it looks foreign until you spend some time looking into the terms. Your options are a contract between you and the company for you to buy shares at a given price. If the value of the shares is worth more then you pay, the difference is income. "Value" is a 409a valuation ask your CFO what it when you execute. Enter the accountant who will tell you how much your liability is for that income ( it varies no more then a dozen other factors affecting your yearly taxes ) Your shares are illiquid, and likely worthless. VC's and other institutional investors have contracts with the company that means they will get paid well before and much better then you. This should really be the first point since you should have known this when accepting your compensation package.
- hkmurakami 10y ago
  Agreed. Takes maybe a few hours to understand the terms. BUT, most technical folks are very uninformed about investing and finance in general. Many brilliant engineers at my previous employers were utterly confused about their options as well as their decision making after IPO. So I think the difficulty also stems from a lack of development in financial acumen generally.
  - dkhenry 10y ago
    +1 for development of financial acumen. We can often point to people taking out 18% APY car loans, or going to Payday loan vendors and say how silly they are for not understanding finance, but we turn a blind eye when its the finance that effects us ( even though one could argue that compounding interest on a payday loan is probably more complex then your basic stock option grant )
- dfabulich 10y ago
  > If the value of the shares is worth more then you pay, the difference is income. This turns out to be true, but I think it overlooks hidden complexity. 1) You'll find a bunch of stuff online that says you don't have to pay tax on that difference if you're getting ISOs. Options newbies who believe that ISOs have no tax burden, newbies who don't know that AMT is a thing, are going to have a bad time. 2) Since AMT is a thing, it's difficult ("complex") to use options safely, if only in the sense that it requires making a prediction about the future. Exercise early and you could lose your investment if the company fails. Exercise late but pre-IPO and you can find yourself in huge trouble, on the hook for hundreds of thousands in taxes with no way to sell your stock to pay your taxes. If you exercise post-IPO and sell on day one and you'll more tax than you would if you hold for a year. Making the right choice here can be difficult.
calcsam 10y ago
Stock options are definitely complicated, but so are your taxes. In fact, your taxes are much more complicated. However, there exist reasonably good software tools, eg TurboTax, to represent your taxes as a decision tree, and to walk you through it. The problem isn't really that stock options are complex -- it's that there doesn't exist comparably good software for stock options. I'm actually building software to solve this: http://www.optionvalue.io http://www.optionvalue.io. Right now it covers value in exit scenarios, but am currently building out exercise / tax scenarios.
xt00 10y ago
In my experience most people at startups who leave end up not exercising their options due to the cost of exercising them coupled with the fact that they may be underpaid due to the assumption that their options may end up quite valuable. So basically they pay somebody 90k/year then give them ~20k/year in options. Then they quit after 2 years and have 90 days to buy like 50k worth of stock at the strike price they were promised. So they end up paying 50k to buy some common shares (not preferred). An investor who paid 50k to invest in the company most likely got preferred shares, so the young guy who paid 50k who probably can barely afford that is now taking way more risk for a much smaller percentage of the company. If the company goes under the preferred shareholders have a chance to get their money back during a firesale of assets or IP or whatever, but the common shares are screwed. So I tell virtually everybody unless there is a well established secondary market to sell your shares of your particular company, then don't take the options. I honestly think the 90 day exercise is totally ludicrous in the startup world. I think that should be a major negotiation point with anybody who is joining a startup. They should just insist on it no matter what.
- draw_down 10y ago
  At this point, anybody offering those terms is well-aware it's not in the employee's best interest. And they don't give a shit. I agree, 90 days is totally ridiculous.
  - zenlikethat 10y ago
    A 90-day window might be better for you if you want to stick around at a company for a while and there were other people that came before you, but left. "Dead equity" of startup employees who have left but not exercised means that they can let you do all of the work while they dilute the available equity pool (i.e., take money directly out of your pocket). This a16z article goes into this: http://a16z.com/2016/06/23/options-timing/ http://a16z.com/2016/06/23/options-timing/ (Though I'm not saying I agree 100% with their naturally biased position) An extended exercise window is not an end-all-be-all solution. Other solutions that don't have the dead equity problem include: 1. Actually pay startup employees reasonable salaries and don't pretend their equity is 100% certain to lead to great riches since it is a risk 2. IRS / Congress could fix tax treatment in this situation, since it is not serving the purpose it was intended to (avoid rich people dodging taxes) 3. Startups actually IPO / get liquid faster instead of contributing to our existing private equity bubble where liquidity events are delayed indefinitely, rendering equity useless. More liquid cash flying around is generally better for everyone as long as it's not a dotcom-era bubble. Employees have just as much of a responsibility to learn this stuff as their employers do to act generally ethically. They're your employer, not your parents.
helper 10y ago
AMT and the 90 day limit on exercising after leaving a company are the main things that make options painful. There has been some movement in the industry to get away from the 90 day limit (by converting from ISOs to NSOs), but has there been any recent attempts to get the AMT rules changed for ISOs? Does anyone think the current AMT rules for stock options are fair? I'm curious how this is viewed by people outside the industry.
- mahyarm 10y ago
  Supposedly getting rid of AMT is one of trumps campaign promises: http://www.investopedia.com/articles/taxes/010417/can-trump-kill-alternative-minimum-tax-amt.asp http://www.investopedia.com/articles/taxes/010417/can-trump-... Most people think AMT is a badly thought out disaster, but it brings in too much tax revenue and effects the upper middle class, so there isn't much sympathy / political capital for it. AMT also ignores state income tax deductions, which is pretty screwed up!
- hkmurakami 10y ago
  I'm curious how ISOs can be abused without the existence of AMT (which gets at the same question from a different angle). Maybe for executive compensation?
- smoodles 10y ago
  There was an effort last year to pass a bill to fix the AMT horror show with regards to options last year. https://www.congress.gov/bill/114th-congress/house-bill/5719 https://www.congress.gov/bill/114th-congress/house-bill/5719 I think ironically to the bubble many of us live in the Silicon Valley, this was proposed by a Republican and passed in the House. Never made it in the Senate. A refreshing reminder good ideas still come from all slices of our political spectrum.
  - dragonwriter 10y ago
    Everyone hates the AMT; very roughly Democrats think it's a broken tool for addressing a real problem, and Republicans see the problem it addresses as a good thing.
Veratyr 10y ago
I'm getting into trading options but I don't work for an employer who grants them to me. I'm curious, can you sell your options without exercising them or are the kinds of options you get from an employer not the kind of options you buy from an exchange?
- jnwatson 10y ago
  The two types of options are similar in that they have the same general terms. However, you cannot sell your ISOs on the CBOE, because they differ in details, the most important one being that the exchanges only trade in options for publicly traded companies. That doesn't mean you can't sell your ISOs to someone else; there just isn't a marketplace for it.
TheGRS 10y ago
I still think start-ups should offer the equity, it helps motivation and retention. But also offering a well-defined bonus program would give a lot of the benefits to employees while not having to pay out as much in equity. Then employees are getting the benefits of the company doing well even if their stocks are still effectively worthless.
luisrudge 10y ago
Just a bit off topic: I'm from Brazil, working as a contractor for a company in the US. They offered me stock options and I'm totally lost about this. Not only because this isn't normal in Brazil, but, the majority of the articles in the wild only focus in the US scene. I want to know more about how this works when you're not in the same country as the company. Will I be double taxed (in US and Brazil)? On what rules I'll be able to exercise my options?
jonthepirate 10y ago
This HN post nails it.
charlieegan3 10y ago
I listened to a software engineering daily episode where this: https://github.com/jlevy/og-equity-compensation#introduction https://github.com/jlevy/og-equity-compensation#introduction was discussed. Found it cleared some things up.
up_and_up 10y ago
After working at 4 different startups over the past 10 years I can tell you with a very high certainty that the only people who will make much $$$ from options are founders and investors. Early Employees generally are shafted. Don't think your 20-200 basis points will be worth anything at the end of it. Make a decent salary and avoid companies that work you to death. Take it as a learning experience and look at the options as pure monopoly money. EVERYTHING is skewed towards founders and investors.
- ThrustVectoring 10y ago
  Do you have voice and power in future negotiations about the direction and equity breakdown of the company? If so, the promises are worth something. If not, they likely are only worth enough to convince you to not sue about it, because that's what the actual incentives are in future capital negotiations.
msencenb 10y ago
I (respectfully) disagree entirely with this conclusion. If you want to do analysis like this, you need to weight these numbers against the possibility of it happening to get the expected value of each column. You have also simplified the smaller exit values to not include investor preferences (which means investors are first in line to get money, founders second, employees dead last). Additionally, most contracts do not allow for early exercise so lots of these ideas are moot. If you do not have early exercise in your contract and you leave the company it's usually a leading indicator of failure. Either the company laid you off to reduce burn (do not under any circumstances buy stock if you have been laid off), or you left the company for a moral/business/whatever reason. In the latter case, it seems unwise to put your money where your heart isn't. If you are optimizing your life for the best chance of striking it rich do not be a startup employee. Be a founder. Better yet, be an investor. There are lots of reasons to be a startup employee, but being in it for the options is not one of them. Treat them as worth $0 and negotiate for more cash or things you care about like vacation or part time hours.
- harryh 10y ago
  Founders and investors are generally at the same place in line. Both hold common shares.
  - msencenb 10y ago
    If your investors have liquidation preferences, that's not true and can leave founders with nothing depending on the exit. If there are no liquidation preferences, then you are correct.
    - harryh 10y ago
      sigh I meant to write founders and employees. Not founders and investors. Sorry. Not sure I screwed that up. The screwup made my statement completely wrong. Investors, as you helpfully point out, generally have preferred stock with liquidation preferences and hence are "first in line."
mcfunley 10y ago
This doesn't mention transfer restrictions at all, and that's an altogether different reason that options are complicated. It's a bad idea to assume that you'll be able to sell private company shares, even if the company is popular and you've heard of other people selling. The existence of a market for the shares doesn't guarantee that you'll be allowed to get rid of them, because the company can enforce all manner of restrictions on sales. The market for stock in a private company tends to be very small. Existing investors and prospective investors in the company can comprise most or all of it. Those folks care more about relationships with the company than getting their hands on a handful of employee shares. What this means practically is that if the company doesn't want you to sell for any reason, the buyers won't cooperate with you either. If you're planning on selling, you should feel comfortable communicating this to the company. And they should agree to it. And that assent should be very recent and in writing. You can find startups out there willing to buy derivatives on your exercised shares, which is functionally similar to selling shares. But this is a mixed bag, and you should read those terms carefully. Read your option agreement. You'll note that among other things, it says that the agreement can be amended by the company at any time to say anything at all. Good luck!
- greenleafjacob 10y ago
  > Read your option agreement. You'll note that among other things, it says that the agreement can be amended by the company at any time to say anything at all. Good luck! That is likely not actually usable because there may be no consideration [1]. [1] https://en.wikipedia.org/wiki/United_States_contract_law#Consideration_and_estoppel https://en.wikipedia.org/wiki/United_States_contract_law#Con...
jogjayr 10y ago
Serious question: why does the IRS insist on valuing private company stock on the basis of a 409a valuation without taking into account whether a market for it even exists? The 409a is paid for by the company which (as the article mentioned) has an interest in keeping it lower. And holders of common stock in private companies, in most cases, can't actually liquidate their holdings (leaving apart cases like pre-IPO Facebook which traded in secondary markets). So the stock is effectively worthless no matter what the 409a says. There shouldn't be tax due until there's a liquidation event that allows shares to be sold.
- brians 10y ago
  Given the tax scheme is published well in advance, they certainly seem to be worth something---else who would take them?
  - jogjayr 10y ago
    Stock options and private stock are taken in the hope that they'll be worth something someday, not because they're necessarily worth anything at present. It's all well and good to say "X is the fair market value of this stock based on factors y, z and a"* . But when no market exists (or severely restricted ones where sellers have to take a loss) then that value is not relevant (or should be discounted appropriately). * I tried looking up (briefly) whether the absence or presence of a market for the company's stock is taken into account for a 409a valuation but couldn't find anything.
deleted 10y ago
[deleted]
compsciphd 10y ago
I wish I could purchase my ISOs within my IRA, avoid all these tax issues.
javitury 10y ago
The recommendation to immediately transform your options to shares and sell them is the exception rather than the rule. In this context, it is assumed that options are very illiquid. But in general, if you want to recover as much as you can, you should sell your options directly. That is why the value of an American and a European option tends to be the same. https://en.m.wikipedia.org/wiki/Option_style#Difference_in_value https://en.m.wikipedia.org/wiki/Option_style#Difference_in_v...
puredlx 10y ago
In case you're holding stock options of a US company but need to pay your taxes in Germany I can highly recommend this article (in german): http://www.pinkernell.de/esop.htm http://www.pinkernell.de/esop.htm

231 points by luu 10y ago

Regarding stock options expiring 3 months after leaving the company, it doesn't have to be this way and a lot of startups are moving in the direction of 10 year exercise periods. I think Quora was the first to do this: https://dangelo.quora.com/10-Year-Exercise-Periods-Make-Sense https://dangelo.quora.com/10-Year-Exercise-Periods-Make-Sens...

matthewowen 10y ago
Have any startups with 10 year exercise periods had a liquidity event yet? I'm genuinely interested to see how true to the idea they were, or whether they (eg) issued a bunch of new stock to current employees that diluted vested ex-employees.
- doh 10y ago
  Some companies allow their employees to sell a portion of vested stocks whenever they're doing a new round. SpaceX is one of the top examples I know of. This is how they retain the top talent.
smoodles 10y ago
I'm not sure about "a lot of startups", I'm personally only aware of a very few that are doing this. Word on the street that I hear is that maaaaybe your current employer might do this for employees they like, but not as a consistent policy. Many board members, founders, etc... feel they will take a retention hit if they were to implement something like this. I personally think the status quo is insane, and I will never take another role with a options component of the package that does not have a policy like this.
- doh 10y ago
  We do it. And I know of many startups that also followed Quora's example. Definitely not everybody does it, but also it's more than 0.
  - x0x0 10y ago
    Good for you all (not sarcastic!) but as someone who did a job search recently, the number of startups that offer this is much much closer to 0% than 100%. A late edit: and you will get pushback for even asking. Apparently we're all supposed to pretend that we're never going to leave the company / we owe them our undying loyalty. I've previously taken the honest route when asked why I was leaving a job and said the ceo didn't deliver on her promises (growth, revenue), so why would I stay? That approach does not necessarily work well =P
    - randycupertino 10y ago
      > Apparently we're all supposed to pretend that we're never going to leave the company / we owe them our undying loyalty. I've previously taken the honest route when asked why I was leaving a job and said the ceo didn't deliver on her promises (growth, revenue), so why would I stay? I mean, part of getting promoted and learning how to rise politically in your career is learning how to lie. Why did you expect honesty to work? You have to learn how to play the game, say the right things that people want to hear.
  - smoodles 10y ago
    Oh I know there are more than a few these days. My point was the majority of startups I'm aware of are still very hesitant to do this. From the conversations I've had its less that the founders of these firms are morally opposed to the idea, but that their VCs really don't like the idea as a global policy.
birken 10y ago
Zach Holman has a great article about it: https://zachholman.com/posts/fuck-your-90-day-exercise-window/ https://zachholman.com/posts/fuck-your-90-day-exercise-windo... And keeps an ongoing list of companies that offer extended exercise windows: https://github.com/holman/extended-exercise-windows https://github.com/holman/extended-exercise-windows As somebody who has personally experienced every aspect of the stock option lifecycle (which fortunately worked out for me), I would never take a job at a company [1] if they didn't have an extended exercise window. The 90 day expiration period creates a massive gap between the risk/reward of equity for founders and the risk/reward of equity for employees, when the whole point of giving equity is to align those. 1: Assuming it was the type of company that compensated people with stock options
chimeracoder 10y ago
> Regarding stock options expiring 3 months after leaving the company, it doesn't have to be this way and a lot of startups are moving in the direction of 10 year exercise periods. This requires converting all options to NSOs, and the tax implications of NSOs are not pretty. (From a tax perspective, ISOs aren't great[0], but they're much better for employees, by design). [0] You have to pay AMT on the spread between the option price and current value at the time you exercise, whether or not the equity is liquid, so you could end up paying a large tax bill only to find that the company goes bankrupt before you have the opportunity to ever sell your equity.
- epa 10y ago
  The kicker here is that the option life is 10 years, even if you have left the company. So you can avoid tax by not exercising until you plan to sell. It becomes a personal choice between 1) do i want the option still, even if i quit, and 2) do i plan to have ownership in the company for a period longer than a year before i sell. Typically most people would prefer 1 over 2. Keep in mind for someone reading this comment, this is about private companies.
  - beagle3 10y ago
    The other thing to keep in mind is that stock options (especially those given to employees) tend to be much less protected than shares. If you exercised, and another shareholder got unfair preferential treatment, you have reason to seek compensation or sue. If you haven't exercised yet, .... well ... not so much. Also, many option contracts give you the right to buy X shares at price Y and do not make special consideration for stock splits - e.g. a 2:1 split would likely make your options worthless by halving the share price, and by halving the percentage of the company that X represents. So, waiting to exercise until you sell is a very good strategy, except when it isn't - not very common, but you rarely get notified about these issues beforehand, especially if you are no longer involved with the company.
- ssalazar 10y ago
  What are the tax implications of NSOs? ISOs are a pretty huge gamble, basically a lotto ticket, if you leave before a liquidity event occurs or is known to be on the near horizon.
tpaschalis 10y ago
What is the general view on this? I don't have an economics background, but.. Well, the 'startup scene' isn't necessarily mature and/or tested enough for employees to be able to take a 10 year risk. In a sense, for a failing startup, stock options might as well be monopoly money.
- st3v3r 10y ago
  It's not really a 10 year risk, as you keep the options that have vested whether or not you're still with the company. And if the startup fails, if you haven't exercised, you shouldn't be out any money.

LouisSayers 10y ago

I can't help but feel the system is highly rigged in favour of investors. Many countries have tax incentives for investors, but when it comes to people actually joining startups, investing their time and effort, then all you get is a tax bill - and mostly at a highly inconvenient time to pay it! It very much feels like the system is designed to keep the rich rich, and to put the working (wo)man in their place.

hkmurakami 10y ago
Our perspective depends on the relative value/scarcity of capital. If capital is scarce and valuable, it makes sense for a system to be designed to reward and protect capital risk. But the "standard terms" haven't changed much since the 80's and capital is definitely more abundant today than it was before. Valuations for early companies are ~10x what they used to be decades ago. Founders give up a fraction of ownership compared to what they used to. The question is where the right balance point is given current parameters. Also, wages have never been higher for tech employees. I'm happy to have a 2x wage level conspared to 15 years ago rather than have the same wage but 2x equity (obviously a simplification), so something's at least working well here wrt labor gaining some ground on capital.
- LouisSayers 10y ago
  There are two different things going on here though - one is whether we offer incentives for investors. The other is how the tax system works when people receive options / equity. The problem with 'receiving' equity is that 1) Current laws treat equity as if it was cash - but it's not. 2) Whether employees should be compensated and recognised for their potential opportunity costs - essentially given a similar deal to investors. Keep in mind that many startups will offer equity in lieu of the salary that they would otherwise command. Also, if you're offered a significant portion of equity in a startup, then taxes currently make a large disincentive for people to accept and join the startup.
  - hkmurakami 10y ago
    I definitely think (1) is in need of reform. Could you elaborate on (2) on what you mean by "given a similar deal to investors"?

bogomipz 10y ago

This is great write up. Kudos to the author for taking the time. I did have a question about the following sentence: >"If an employer gives you straight-up shares, then the IRS will tax the shares (at ordinary income rates) when they vest." What would be treated as income and taxes here, the strike price x the number of options vesting? Is that correct? For regular worker bees this not very much though right? For instance say an employee has 25 shares vest in a quarter and their stick price is $20. 20 x 25 would be $500 more being taxes as income. Or am I completely not understanding something? If it is not the strike price being taxes as income what is it, since the the value of an option is often unknown to rank and file employees let alone the IRS.

idunno246 10y ago
Shares vested x fair market value at vest. So you get 1000 shares when you join, worth $1/share. 250 vest on your first year, and that's when tax is due. But say the company grows and shares are $5/share. 5x250 is 1250 taxed income on the anniversary. Normally at early stages you're talking many thousands of shares though, that can increase rapidly. The fmv is recalculated every year, or on any fundraise events. It needs to be a defensible number or the irs will be upset
- bogomipz 10y ago
  >"The fmv is recalculated every year, or on any fundraise events." This is the piece I was missing. Thank you for the clear explanation. That being said it would be interesting to buy exercise them just to see what the company is actually valuing those options at, since this is often opaque to the average worker. I wonder if it's possible to exercise a single option and use it as a barometer of sorts to quantify you actual compensation? My guess is no.
  - idunno246 10y ago
    I've never had a company refuse to give me the 409a valuation if I asked point blank for it(just say you're considering exercising and it's important for tax planning). It's important to keep in mind though they tend to purposely depress that value. But investors get a premium because their stock has legitimately more value than yours(liquidation preferences, board seats, etc). And without a liquid market, if you do sell privately you end up taking a large discount. I think the opacity is largely that it's difficult to value things, not so much nefariousness

dkhenry 10y ago

Stock options are not complicated. Most people who look into the details of them will find them very plain and actually quite simple. The issue is you don't often deal with this area of finance so it looks foreign until you spend some time looking into the terms. Your options are a contract between you and the company for you to buy shares at a given price. If the value of the shares is worth more then you pay, the difference is income. "Value" is a 409a valuation ask your CFO what it when you execute. Enter the accountant who will tell you how much your liability is for that income ( it varies no more then a dozen other factors affecting your yearly taxes ) Your shares are illiquid, and likely worthless. VC's and other institutional investors have contracts with the company that means they will get paid well before and much better then you. This should really be the first point since you should have known this when accepting your compensation package.

hkmurakami 10y ago
Agreed. Takes maybe a few hours to understand the terms. BUT, most technical folks are very uninformed about investing and finance in general. Many brilliant engineers at my previous employers were utterly confused about their options as well as their decision making after IPO. So I think the difficulty also stems from a lack of development in financial acumen generally.
- dkhenry 10y ago
  +1 for development of financial acumen. We can often point to people taking out 18% APY car loans, or going to Payday loan vendors and say how silly they are for not understanding finance, but we turn a blind eye when its the finance that effects us ( even though one could argue that compounding interest on a payday loan is probably more complex then your basic stock option grant )
dfabulich 10y ago
> If the value of the shares is worth more then you pay, the difference is income. This turns out to be true, but I think it overlooks hidden complexity. 1) You'll find a bunch of stuff online that says you don't have to pay tax on that difference if you're getting ISOs. Options newbies who believe that ISOs have no tax burden, newbies who don't know that AMT is a thing, are going to have a bad time. 2) Since AMT is a thing, it's difficult ("complex") to use options safely, if only in the sense that it requires making a prediction about the future. Exercise early and you could lose your investment if the company fails. Exercise late but pre-IPO and you can find yourself in huge trouble, on the hook for hundreds of thousands in taxes with no way to sell your stock to pay your taxes. If you exercise post-IPO and sell on day one and you'll more tax than you would if you hold for a year. Making the right choice here can be difficult.

calcsam 10y ago

Stock options are definitely complicated, but so are your taxes. In fact, your taxes are much more complicated. However, there exist reasonably good software tools, eg TurboTax, to represent your taxes as a decision tree, and to walk you through it. The problem isn't really that stock options are complex -- it's that there doesn't exist comparably good software for stock options. I'm actually building software to solve this: http://www.optionvalue.io http://www.optionvalue.io. Right now it covers value in exit scenarios, but am currently building out exercise / tax scenarios.

xt00 10y ago

In my experience most people at startups who leave end up not exercising their options due to the cost of exercising them coupled with the fact that they may be underpaid due to the assumption that their options may end up quite valuable. So basically they pay somebody 90k/year then give them ~20k/year in options. Then they quit after 2 years and have 90 days to buy like 50k worth of stock at the strike price they were promised. So they end up paying 50k to buy some common shares (not preferred). An investor who paid 50k to invest in the company most likely got preferred shares, so the young guy who paid 50k who probably can barely afford that is now taking way more risk for a much smaller percentage of the company. If the company goes under the preferred shareholders have a chance to get their money back during a firesale of assets or IP or whatever, but the common shares are screwed. So I tell virtually everybody unless there is a well established secondary market to sell your shares of your particular company, then don't take the options. I honestly think the 90 day exercise is totally ludicrous in the startup world. I think that should be a major negotiation point with anybody who is joining a startup. They should just insist on it no matter what.

draw_down 10y ago
At this point, anybody offering those terms is well-aware it's not in the employee's best interest. And they don't give a shit. I agree, 90 days is totally ridiculous.
- zenlikethat 10y ago
  A 90-day window might be better for you if you want to stick around at a company for a while and there were other people that came before you, but left. "Dead equity" of startup employees who have left but not exercised means that they can let you do all of the work while they dilute the available equity pool (i.e., take money directly out of your pocket). This a16z article goes into this: http://a16z.com/2016/06/23/options-timing/ http://a16z.com/2016/06/23/options-timing/ (Though I'm not saying I agree 100% with their naturally biased position) An extended exercise window is not an end-all-be-all solution. Other solutions that don't have the dead equity problem include: 1. Actually pay startup employees reasonable salaries and don't pretend their equity is 100% certain to lead to great riches since it is a risk 2. IRS / Congress could fix tax treatment in this situation, since it is not serving the purpose it was intended to (avoid rich people dodging taxes) 3. Startups actually IPO / get liquid faster instead of contributing to our existing private equity bubble where liquidity events are delayed indefinitely, rendering equity useless. More liquid cash flying around is generally better for everyone as long as it's not a dotcom-era bubble. Employees have just as much of a responsibility to learn this stuff as their employers do to act generally ethically. They're your employer, not your parents.

helper 10y ago

AMT and the 90 day limit on exercising after leaving a company are the main things that make options painful. There has been some movement in the industry to get away from the 90 day limit (by converting from ISOs to NSOs), but has there been any recent attempts to get the AMT rules changed for ISOs? Does anyone think the current AMT rules for stock options are fair? I'm curious how this is viewed by people outside the industry.

mahyarm 10y ago
Supposedly getting rid of AMT is one of trumps campaign promises: http://www.investopedia.com/articles/taxes/010417/can-trump-kill-alternative-minimum-tax-amt.asp http://www.investopedia.com/articles/taxes/010417/can-trump-... Most people think AMT is a badly thought out disaster, but it brings in too much tax revenue and effects the upper middle class, so there isn't much sympathy / political capital for it. AMT also ignores state income tax deductions, which is pretty screwed up!
hkmurakami 10y ago
I'm curious how ISOs can be abused without the existence of AMT (which gets at the same question from a different angle). Maybe for executive compensation?
smoodles 10y ago
There was an effort last year to pass a bill to fix the AMT horror show with regards to options last year. https://www.congress.gov/bill/114th-congress/house-bill/5719 https://www.congress.gov/bill/114th-congress/house-bill/5719 I think ironically to the bubble many of us live in the Silicon Valley, this was proposed by a Republican and passed in the House. Never made it in the Senate. A refreshing reminder good ideas still come from all slices of our political spectrum.
- dragonwriter 10y ago
  Everyone hates the AMT; very roughly Democrats think it's a broken tool for addressing a real problem, and Republicans see the problem it addresses as a good thing.

Veratyr 10y ago

I'm getting into trading options but I don't work for an employer who grants them to me. I'm curious, can you sell your options without exercising them or are the kinds of options you get from an employer not the kind of options you buy from an exchange?

jnwatson 10y ago
The two types of options are similar in that they have the same general terms. However, you cannot sell your ISOs on the CBOE, because they differ in details, the most important one being that the exchanges only trade in options for publicly traded companies. That doesn't mean you can't sell your ISOs to someone else; there just isn't a marketplace for it.

TheGRS 10y ago

I still think start-ups should offer the equity, it helps motivation and retention. But also offering a well-defined bonus program would give a lot of the benefits to employees while not having to pay out as much in equity. Then employees are getting the benefits of the company doing well even if their stocks are still effectively worthless.

luisrudge 10y ago

Just a bit off topic: I'm from Brazil, working as a contractor for a company in the US. They offered me stock options and I'm totally lost about this. Not only because this isn't normal in Brazil, but, the majority of the articles in the wild only focus in the US scene. I want to know more about how this works when you're not in the same country as the company. Will I be double taxed (in US and Brazil)? On what rules I'll be able to exercise my options?

jonthepirate 10y ago

This HN post nails it.

charlieegan3 10y ago

I listened to a software engineering daily episode where this: https://github.com/jlevy/og-equity-compensation#introduction https://github.com/jlevy/og-equity-compensation#introduction was discussed. Found it cleared some things up.

up_and_up 10y ago

After working at 4 different startups over the past 10 years I can tell you with a very high certainty that the only people who will make much $$$ from options are founders and investors. Early Employees generally are shafted. Don't think your 20-200 basis points will be worth anything at the end of it. Make a decent salary and avoid companies that work you to death. Take it as a learning experience and look at the options as pure monopoly money. EVERYTHING is skewed towards founders and investors.

ThrustVectoring 10y ago
Do you have voice and power in future negotiations about the direction and equity breakdown of the company? If so, the promises are worth something. If not, they likely are only worth enough to convince you to not sue about it, because that's what the actual incentives are in future capital negotiations.

msencenb 10y ago

I (respectfully) disagree entirely with this conclusion. If you want to do analysis like this, you need to weight these numbers against the possibility of it happening to get the expected value of each column. You have also simplified the smaller exit values to not include investor preferences (which means investors are first in line to get money, founders second, employees dead last). Additionally, most contracts do not allow for early exercise so lots of these ideas are moot. If you do not have early exercise in your contract and you leave the company it's usually a leading indicator of failure. Either the company laid you off to reduce burn (do not under any circumstances buy stock if you have been laid off), or you left the company for a moral/business/whatever reason. In the latter case, it seems unwise to put your money where your heart isn't. If you are optimizing your life for the best chance of striking it rich do not be a startup employee. Be a founder. Better yet, be an investor. There are lots of reasons to be a startup employee, but being in it for the options is not one of them. Treat them as worth $0 and negotiate for more cash or things you care about like vacation or part time hours.

harryh 10y ago
Founders and investors are generally at the same place in line. Both hold common shares.
- msencenb 10y ago
  If your investors have liquidation preferences, that's not true and can leave founders with nothing depending on the exit. If there are no liquidation preferences, then you are correct.
  - harryh 10y ago
    sigh I meant to write founders and employees. Not founders and investors. Sorry. Not sure I screwed that up. The screwup made my statement completely wrong. Investors, as you helpfully point out, generally have preferred stock with liquidation preferences and hence are "first in line."

mcfunley 10y ago

This doesn't mention transfer restrictions at all, and that's an altogether different reason that options are complicated. It's a bad idea to assume that you'll be able to sell private company shares, even if the company is popular and you've heard of other people selling. The existence of a market for the shares doesn't guarantee that you'll be allowed to get rid of them, because the company can enforce all manner of restrictions on sales. The market for stock in a private company tends to be very small. Existing investors and prospective investors in the company can comprise most or all of it. Those folks care more about relationships with the company than getting their hands on a handful of employee shares. What this means practically is that if the company doesn't want you to sell for any reason, the buyers won't cooperate with you either. If you're planning on selling, you should feel comfortable communicating this to the company. And they should agree to it. And that assent should be very recent and in writing. You can find startups out there willing to buy derivatives on your exercised shares, which is functionally similar to selling shares. But this is a mixed bag, and you should read those terms carefully. Read your option agreement. You'll note that among other things, it says that the agreement can be amended by the company at any time to say anything at all. Good luck!

greenleafjacob 10y ago
> Read your option agreement. You'll note that among other things, it says that the agreement can be amended by the company at any time to say anything at all. Good luck! That is likely not actually usable because there may be no consideration [1]. [1] https://en.wikipedia.org/wiki/United_States_contract_law#Consideration_and_estoppel https://en.wikipedia.org/wiki/United_States_contract_law#Con...

jogjayr 10y ago

Serious question: why does the IRS insist on valuing private company stock on the basis of a 409a valuation without taking into account whether a market for it even exists? The 409a is paid for by the company which (as the article mentioned) has an interest in keeping it lower. And holders of common stock in private companies, in most cases, can't actually liquidate their holdings (leaving apart cases like pre-IPO Facebook which traded in secondary markets). So the stock is effectively worthless no matter what the 409a says. There shouldn't be tax due until there's a liquidation event that allows shares to be sold.

brians 10y ago
Given the tax scheme is published well in advance, they certainly seem to be worth something---else who would take them?
- jogjayr 10y ago
  Stock options and private stock are taken in the hope that they'll be worth something someday, not because they're necessarily worth anything at present. It's all well and good to say "X is the fair market value of this stock based on factors y, z and a"* . But when no market exists (or severely restricted ones where sellers have to take a loss) then that value is not relevant (or should be discounted appropriately). * I tried looking up (briefly) whether the absence or presence of a market for the company's stock is taken into account for a 409a valuation but couldn't find anything.

deleted 10y ago

[deleted]

compsciphd 10y ago

I wish I could purchase my ISOs within my IRA, avoid all these tax issues.

javitury 10y ago

The recommendation to immediately transform your options to shares and sell them is the exception rather than the rule. In this context, it is assumed that options are very illiquid. But in general, if you want to recover as much as you can, you should sell your options directly. That is why the value of an American and a European option tends to be the same. https://en.m.wikipedia.org/wiki/Option_style#Difference_in_value https://en.m.wikipedia.org/wiki/Option_style#Difference_in_v...

puredlx 10y ago

In case you're holding stock options of a US company but need to pay your taxes in Germany I can highly recommend this article (in german): http://www.pinkernell.de/esop.htm http://www.pinkernell.de/esop.htm