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Mistakes You Can’t Afford to Make with Stock Options

248 points by DanielRibeiro 15y ago

dweekly 15y ago
Thanks for linking to this. The Guide embedded at the bottom has been on Hacker News, discussion at http://news.ycombinator.com/item?id=2573970 http://news.ycombinator.com/item?id=2573970 - happy to hear your feedback on this!
- alok-g 15y ago
  David, thanks for writing this as well as your excellent guide to stocks and options. I am convinced that I cannot miss any article by you.
herdrick 15y ago
Very good post, aside from this: "So if you join a startup and don’t exercise, you should probably try to stick it through to an exit." No. If you're thinking of quitting, presumably an exit which will make you rich is not imminent. Hanging on to a job when you have better alternatives elsewhere so as not to lose the possible value of your options usually is a tragic case of the 'endowment effect' bias in action.
- dweekly 15y ago
  Fair. I should probably have better written it: "If you join a startup and don't ever want to exercise, the only way to get to liquidity will be to stick it through to acquisition, which might be a long haul."
  - herdrick 15y ago
    I only bring it up because a lot of people do "try to stick it through to an exit" only due to that bias. It's a sad waste of talent. EDIT: In fact, I think that whole section should say the opposite: "2. Refusing to quit with unexercised options"
ScottBurson 15y ago
We've got to get this AMT thing fixed; it's nuts that people owe taxes on money they never had. At the very least, when the stock in such a situation actually becomes worthless, one should be able to file a 1040X for the year in which the AMT was triggered, erasing the excess tax bill and turning any excess tax paid into a credit. I can see wanting to tax people on paper gains as a way of closing loopholes -- but if the paper gain evaporates we should let them off the hook.
- dweekly 15y ago
  Totally agreed: AMT is nutty. I've had good friends bankrupted by it.
- maximilian 15y ago
  I have to admit I was quite surprised by this part of the article. Can someone give a slightly more detailed example of how this works and more specifically how most people manage it? Basically you get stock from your options (which you exercise) and then you have to pay tax on the worth of that stock, which gets counted as a sudden income? I guess it makes sense you get taxed somewhat on this, as it is in a sense part of your income at the company, but I don't really understand how this works.
  - DavidChouinard 15y ago
    Read the document attached to the bottom or the original post. Trust me, it'll all be much clearer.
- yummyfajitas 15y ago
  One very effective way to solve this would be to allow in-kind payments. If the IRS believes your shares are worth $X, and they think you owe 25% of X, they should be willing to accept 25% of your shares. This would solve a lot of other tax issues relating to transfers of illiquid equity. Consider the estate tax - a guy owns a business the IRS values at $10M and dies. The kids don't have $1.75M sitting around in cash (35% of $10MM-$5MM exclusion amount) so they are forced to liquidate the business. Instead, wouldn't it be better to allow the business to continue running, but pay the IRS 17.5% of dividends/pass through income? [edit: said profit, meant dividends. Thanks orijing.]
gfodor 15y ago
This is all 100% on the money and incredibly important. I'm actually kind of surprised in retrospect that something like this post has never come across my radar on HN before, as the tax implications of exercising stock options in the U.S. has a few common pitfalls that can make the difference between a windfall, a modest return, or bankruptcy, depending on when and how you exercise and if you remember to file your 83(b) at the appropriate time.
- dweekly 15y ago
  Glad you liked it! Would love your feedback on the Guide embedded at the bottom of the article, too. (http://www.scribd.com/doc/55945011/Intro-to-Stock-and-Options http://www.scribd.com/doc/55945011/Intro-to-Stock-and-Option...)
  - rdl 15y ago
    I think it doesn't include handling restricted stock grants (vs. options grants); everywhere I've worked has tried to do restricted stock for as many early-stage people as possible.
  - deleted 15y ago
    [deleted]
msort 15y ago
Great writing. One issue with "Forward exercise" tough: by forward-exercising and converting to "Restricted Stock Unit", you avoid the high tax risk, but you also need to pay a substantial amount of cash in advance and bet on the future value of the company. Let's say you get $10k options at strike price $20, you basically need to pay $200K in advance to forward exercise. If the company dies in the future without anexit, you basically lose your $200k. So perhaps the best strategy is to: 1) Forward exercise in several batches as you are gaining confidence of the company (but before the world has much confidence of the company...yet), and try to exercise before the next valuation increase. 2) Delay exercise as late as possible (closer to exit or IPO). But this usually works only if you join a late-stage startup, whose fate is more predictable. If you are a startup, try issue Restricted Stock Units, rather than Stock Options to poor and hard-working employees. That will make your company more employee-friendly. If you are looking for a startup to join, prefer those who issue Stock Units (e.g. Facebook, Twitter, which are not necessarily startups anymore though).
caf 15y ago
In section 4: 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. Isn't it likely that the company will actually leave you with your Restricted Stock until just before the vesting date, then buy it back (unless the company has completely tanked in the meantime, in which case they'll be happy to leave you with your worthless stock)?
- random42 15y ago
  I suppose the clause is to prevent the (hypothetical) case of an employee working 1 day and leaving with 4 years worth of potential stock options. A company can certainly do what you suggest (i think), but I dont think companies operate to personally screw ex-employees :)
- kelnos 15y ago
  Most early-exercise contracts have a time limit, on the order of 30 days or so. So if you quit, the company has a limited amount of time to buy the stock back, and if they don't, they lose the right.
jsherry 15y ago
From my understanding (disclaimer: I'm neither a lawyer nor an accountant, but I have been thoroughly advised by both on the topic), there is an important distinction between ISOs (Incentive Stock Options) and NSOs (Nonqualified Stock Options) when it comes to tax implications for the employee. First, ISOs are not taxed at the time of grant or exercise. Instead, they are taxed when the stock is sold. NSOs, on the other hand, are taxed immediately upon exercise on the difference in value between the fair market value of the stock and your exercise price. Second, ISOs are eligible for long-term capital gains treatment so long as the employee holds the stock for at least two years before selling. NSOs are always taxed as income. From the employer perspective, there are implications as well, but I'm less versed on that side of things. It has something to do with tax deductions for the business when issuing NSOs that are not received when issuing ISOs. For more info on this topic, here are a couple of links, but I'd of course recommend talking to a lawyer or accountant if you're serious about the topic: http://www.naffziger.net/blog/2007/03/31/startup-stock-options-isos-vs-nsos/ http://www.naffziger.net/blog/2007/03/31/startup-stock-optio... http://en.wikipedia.org/wiki/Non-qualified_stock_option http://en.wikipedia.org/wiki/Non-qualified_stock_option http://en.wikipedia.org/wiki/Incentive_stock_option http://en.wikipedia.org/wiki/Incentive_stock_option
- turbostalk 15y ago
  And for those of you trying to figure out how to report NSO's on a schedule D or a tax program like turbotax - not intuitive at all. Since most employers report NSO proceeds and taxes in your regular W-2 wages and taxes, the schedule D has to show a loss - basically the reported income on that line is a loss because of exercise fees. http://forums.kiplinger.com/showthread.php?1690-How-to-report-nonstatutory-stock-option http://forums.kiplinger.com/showthread.php?1690-How-to-repor...
tptacek 15y ago
This is good stuff, but I want to chime in with a warning. The major thrust of this piece is that you should exercise your options as soon as you can to start the tax clock ticking on them. That's true, as far as tax optimization goes. However, doing that costs money. You have to pay for the stock. Once you do that, you probably can't just get the money back. Be sure you really trust the company if you do this; in fact, not just the company, but also the board. I have friends who bought shares in companies that wiped out the common stock in acquisitions and did retention grants to keep current employees. Anybody who had left got shafted, even though they had put their own money into the company. (Full disclosure: I decided not to put my own money into shares of the last company I worked for, and that cost me a fair bit of money when they were acquired. I don't really regret the decision, though; I had a choice between investing in the company I was leaving and the company I was starting.)
- DrJokepu 15y ago
  > ... in companies that wiped out the common stock in acquisitions ... I'm sorry for asking such a trivial question, but what does that mean?
  - lemming 15y ago
    My understanding is that during an acquisition, deals can be made which drastically affect the value of existing stock. Often at this stage the company basically belongs to the investors, so they could decide to (for example) massively dilute the stock by issuing new stock until the existing stock has essentially no value. Then they can allow current employees to retain their value using a buyback, i.e. you allow whoever takes your fancy to buy the new stock back so that their proportion of the company is more or less what it was. Or not, clearly this can also be used to change ownership percentages in the same way (c.f. Eduardo Saverin). Of course, the one group of people who get no protection at all in this case are ex-employees.
    - chernevik 15y ago
      Maybe I'm not understanding you, or the terms of the deal, but this does not sound right to me. "Massive dilution of the stock" amounts to giving the company to someone else. The documentation ought to prevent this sort of thing. I'm not saying it doesn't happen, but if it does I wonder if the persons harmed have fully explored their rights.
btilly 15y ago
Forward exercising seems to me to be a horrible idea. When you forward exercise, you're putting all of your financial eggs in one basket. This is the best way to get majorly rich in a hurry. It is also a good way to lose your shirt. A large fraction of your income is already tied up with the success of the company. Standard financial advice is to seek to diversify at every opportunity.
- dadkins 15y ago
  Forward exercising in an early stage startup is a great idea. The company doesn't yet have a meaningful valuation so you can exercise for next to nothing. The board typically sets the strike price of options low so that employees don't wonder if their options are already underwater. Also, by exercising early you pretty much guarantee that there is no difference between strike price and value at time of exercise, so you owe no taxes up front. Later, near IPO, when the value is much higher and set by external factors, it's no longer a good idea. By exercising early, you effectively own stock at the date of exercise. If the company goes public or gets acquired, your gains are already long term capital gains as long as it's been a year. Also, you don't have to wait once the company goes public to exercise your options, then wait a year... you can sell right away, lock-up periods aside. To summarize, early exercise is a cheap way to avoid paying taxes on your options until you sell the shares later. And then you're paying the long term capital gains rate on cash earned, instead of short term capital gains on a volatile stock which could easily go down in value.
  - btilly 15y ago
    From a tax point of view, sure. As a personal financial risk, no way. If the startup works out, you'll probably have enough money to cover the risk. If it fails, you've thrown good money after bad. The #2 piece of advice about investment (after #1, which is to make sure that you are living within your means first) is to diversify your investments.
    - jtheory 15y ago
      "The company doesn't yet have a meaningful valuation so you can exercise for next to nothing." The missing bit here is a definition of "next to nothing". What's the normal scenario here? How much money are we talking about? Is "next to nothing" still in the tens of thousands, or could it actually be a few hundred bucks? The principle of diversifying investments, etc. is good advice when you're talking about your primary investments, but irrelevant here if it's really "next to nothing" that's under discussion.
grellas 15y ago
Very nice piece. A few technical points on tax (of course, check with your professional advisor for any real-world case): 1. IRC 83(a) sets the baseline: you are taxed on the value of property (stock) received in exchange for services as ordinary income. IRC 83(b) says that you do not receive such property immediately if it is subject to a "substantial risk of forfeiture" and that you will be taxed on it only when the forfeiture risk lapses and you truly own it. Thus, with restricted stock, you are subject to tax at ordinary income rates on the difference between what you paid for it and what its value is at each vesting point. If your 1M shares vest at 1/48th per month over 4 years, and you paid $.001/sh, you would have to pay tax on the "spread' at each vesting point as long as the price exceeded $.001/sh at that point. This theoretically could mean that you have as many as 48 taxable events during the 4-year period of vesting. All of this, of course, is done away with if you file a timely 83(b) election. In that case, you normally pay no tax up front and you pay only capital-gains tax on the stock as you later sell it. This is the optimum tax treatment for most startups but is normally made available only to founders. 2. Now what about options. The default rule here concerns so-called "non-qualified" options (NQOs, sometimes called NSOs as well, for "non-statutory options"). The substantive law rules relating to such options are the same as any other options and they are "non-qualified" only in the sense that they don't qualify for the special tax advantage of "incentive stock options" or ISOs, which are special types of options that get special tax advantages. To understand ISOs, you need to understand how all options are taxed apart from any special tax-advantaged rules. 3. With NQOs, you get a right to buy company stock at a fixed strike price exercisable as your options vest over a prescribed period. If your strike price is $.001/sh, and you exercise 1M options, you pay $1,000 to get 1M shares of stock. If the fair market value of that stock is $.001/sh at the time you exercise, you pay $1,000 for stock worth $1,000 and you realize no taxable income. If, however, the fair value of the stock is worth more (let us say, $.20/sh) and you exercise your first increment of (say) 250K shares at year one of vesting on a 4-year plan, then you realize $49,750 worth of taxable income upon your exercise. This is taxed at ordinary income tax rates and the amount is factored into your employment income so that you effectively pay all normal employment taxes on it as well (social security, etc.). Hence, with NQOs, you pay tax on the "spread" at ordinary income tax rates upon each exercise. When the transaction is done, you very likely will hold illiquid stock, you will have no cash from the transaction with which to pay the tax, and you are generally in a highly disadvantageous tax position. Once you make the exercise, any later appreciation on it is not taxed until you sell it and, at that time, you will be taxed on that subsequent appreciation at capital gains rates. 4. With ISOs, when you exercise your options, you are not subject to an immediate tax based on ordinary income tax rates and this is the special tax advantage that ISOs have. The idea is that, with these tax-advantaged options, employees should feel free to buy their shares by exercising their options whenever they like (once they have vested) and will only be subject to tax at the time they ultimately sell the shares. Having exercised and bought the shares, your holding period begins to run and, if you hold them for the prescribed period (which, in the case of ISOs, is 2 years), you pay LTCG rates - all in all, a huge advantage over the NQO tax treatment. But there is a clinker with ISOs and this is the AMT, or alternative minimum tax. With an ISO exercise, the spread amount is includable in your income for purposes of calculating your AMT and, therefore, even though you may not have to pay tax at ordinary income tax rates on the value of the spread, you may wind up paying a substantial tax under the alternative measure applied by U.S. tax laws. This means that, in a high-value company, you definitely need to check with your tax advisor to determine your tax hit prior to doing such an exercise. 5. ISOs granted with an early-exercise privilege (as noted in this piece) are taxed substantially the same as restricted stock and this is a huge advantage. However, startups do not normally offer this privilege for various reasons (mainly because it is a mistake to make large numbers of employees instant shareholders) and so it is not really a practical answer to most such situations. 6. Thus, restricted stock is near-ideal from a tax standpoint, avoiding most tax risks and positioning your holdings for LTCG treatment, but is normally granted only to a very few people (mostly founders). ISOs avoid ordinary income but may subject you to an AMT tax hit - in addition, they can be used only with employees. NQOs are least favorable, subjecting you to an ordinary income tax hit on any spread as of the date of exercise, but these are valuable for their flexibility (they can be used for contractors, directors, and others besides employees).
Matt_Cutts 15y ago
Great article. If you start or join a startup, you really need to educate yourself on this topic. When I started at Google, I bought a book called Consider Your Options: http://www.fairmark.com/books/consider.htm http://www.fairmark.com/books/consider.htm It's quite good. I also have a copy of Piaw Na's book: http://books.piaw.net/guide/index.html http://books.piaw.net/guide/index.html (An Engineer's Guide to Silicon Valley Startups) but I have to admit that I haven't read it yet because most of my finances are in order at this point.
lpolovets 15y ago
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 forward exercise 100k options at $.01/option (total price = $1000). You forget the 83(b) form. Jan 1, 2004: you quit on your 4 year anniversary, and the (still private) stock you own is now worth $1/share, which means the FMV of your stock is $100k. 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? Capital gains on $1 million - $100k and AMT on $100k - 1k? Something else?
X-Istence 15y ago
I've got certain stock options as an employee incentive program, how do those compare? What is a strike price? What is an exercise price? They vested immediately and I can technically exercise them today does that mean anything for me? As someone that is new to this (at age 23) some non-professional guidance would be helpful. I understand that a good CPA would be much better at advising me in my situation, but I really don't have the money for that (student loans are KILLING me).
cpg 15y ago
This is nice. One thing I did to really learn assimilate all this was code it all in a big excel spreadsheet with all the meaningful scenarios I could think of for me and for the company. It really gave me a great overview and helped me make a more clear decision to leave and start my own company.
dannylipsitz 15y ago
But in most cases, common stock can only be sold if and when an IPO takes place. VC investors won't want common stock, thus the employee must sell on a secondary market, back to the company, or patiently wait for an IPO. The first two options usually feature inherently dubious pricing due to reduced liquidity. Are there any other possibilities?
kirubakaran 15y ago
Can you please give a non-scribd direct link to the embedded pdf? Edit: Never mind, found it from an earlier post http://news.ycombinator.com/item?id=2574323 http://news.ycombinator.com/item?id=2574323 [thanks to http://news.ycombinator.com/item?id=2623292 http://news.ycombinator.com/item?id=2623292]
deleted 15y ago
[deleted]

248 points by DanielRibeiro 15y ago

Thanks for linking to this. The Guide embedded at the bottom has been on Hacker News, discussion at http://news.ycombinator.com/item?id=2573970 http://news.ycombinator.com/item?id=2573970 - happy to hear your feedback on this!

alok-g 15y ago
David, thanks for writing this as well as your excellent guide to stocks and options. I am convinced that I cannot miss any article by you.

herdrick 15y ago

Very good post, aside from this: "So if you join a startup and don’t exercise, you should probably try to stick it through to an exit." No. If you're thinking of quitting, presumably an exit which will make you rich is not imminent. Hanging on to a job when you have better alternatives elsewhere so as not to lose the possible value of your options usually is a tragic case of the 'endowment effect' bias in action.

dweekly 15y ago
Fair. I should probably have better written it: "If you join a startup and don't ever want to exercise, the only way to get to liquidity will be to stick it through to acquisition, which might be a long haul."
- herdrick 15y ago
  I only bring it up because a lot of people do "try to stick it through to an exit" only due to that bias. It's a sad waste of talent. EDIT: In fact, I think that whole section should say the opposite: "2. Refusing to quit with unexercised options"

ScottBurson 15y ago

We've got to get this AMT thing fixed; it's nuts that people owe taxes on money they never had. At the very least, when the stock in such a situation actually becomes worthless, one should be able to file a 1040X for the year in which the AMT was triggered, erasing the excess tax bill and turning any excess tax paid into a credit. I can see wanting to tax people on paper gains as a way of closing loopholes -- but if the paper gain evaporates we should let them off the hook.

dweekly 15y ago
Totally agreed: AMT is nutty. I've had good friends bankrupted by it.
maximilian 15y ago
I have to admit I was quite surprised by this part of the article. Can someone give a slightly more detailed example of how this works and more specifically how most people manage it? Basically you get stock from your options (which you exercise) and then you have to pay tax on the worth of that stock, which gets counted as a sudden income? I guess it makes sense you get taxed somewhat on this, as it is in a sense part of your income at the company, but I don't really understand how this works.
- DavidChouinard 15y ago
  Read the document attached to the bottom or the original post. Trust me, it'll all be much clearer.
yummyfajitas 15y ago
One very effective way to solve this would be to allow in-kind payments. If the IRS believes your shares are worth $X, and they think you owe 25% of X, they should be willing to accept 25% of your shares. This would solve a lot of other tax issues relating to transfers of illiquid equity. Consider the estate tax - a guy owns a business the IRS values at $10M and dies. The kids don't have $1.75M sitting around in cash (35% of $10MM-$5MM exclusion amount) so they are forced to liquidate the business. Instead, wouldn't it be better to allow the business to continue running, but pay the IRS 17.5% of dividends/pass through income? [edit: said profit, meant dividends. Thanks orijing.]

gfodor 15y ago

This is all 100% on the money and incredibly important. I'm actually kind of surprised in retrospect that something like this post has never come across my radar on HN before, as the tax implications of exercising stock options in the U.S. has a few common pitfalls that can make the difference between a windfall, a modest return, or bankruptcy, depending on when and how you exercise and if you remember to file your 83(b) at the appropriate time.

dweekly 15y ago
Glad you liked it! Would love your feedback on the Guide embedded at the bottom of the article, too. (http://www.scribd.com/doc/55945011/Intro-to-Stock-and-Options http://www.scribd.com/doc/55945011/Intro-to-Stock-and-Option...)
- rdl 15y ago
  I think it doesn't include handling restricted stock grants (vs. options grants); everywhere I've worked has tried to do restricted stock for as many early-stage people as possible.
- deleted 15y ago
  [deleted]

msort 15y ago

Great writing. One issue with "Forward exercise" tough: by forward-exercising and converting to "Restricted Stock Unit", you avoid the high tax risk, but you also need to pay a substantial amount of cash in advance and bet on the future value of the company. Let's say you get $10k options at strike price $20, you basically need to pay $200K in advance to forward exercise. If the company dies in the future without anexit, you basically lose your $200k. So perhaps the best strategy is to: 1) Forward exercise in several batches as you are gaining confidence of the company (but before the world has much confidence of the company...yet), and try to exercise before the next valuation increase. 2) Delay exercise as late as possible (closer to exit or IPO). But this usually works only if you join a late-stage startup, whose fate is more predictable. If you are a startup, try issue Restricted Stock Units, rather than Stock Options to poor and hard-working employees. That will make your company more employee-friendly. If you are looking for a startup to join, prefer those who issue Stock Units (e.g. Facebook, Twitter, which are not necessarily startups anymore though).

caf 15y ago

In section 4: 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. Isn't it likely that the company will actually leave you with your Restricted Stock until just before the vesting date, then buy it back (unless the company has completely tanked in the meantime, in which case they'll be happy to leave you with your worthless stock)?

random42 15y ago
I suppose the clause is to prevent the (hypothetical) case of an employee working 1 day and leaving with 4 years worth of potential stock options. A company can certainly do what you suggest (i think), but I dont think companies operate to personally screw ex-employees :)
kelnos 15y ago
Most early-exercise contracts have a time limit, on the order of 30 days or so. So if you quit, the company has a limited amount of time to buy the stock back, and if they don't, they lose the right.

jsherry 15y ago

From my understanding (disclaimer: I'm neither a lawyer nor an accountant, but I have been thoroughly advised by both on the topic), there is an important distinction between ISOs (Incentive Stock Options) and NSOs (Nonqualified Stock Options) when it comes to tax implications for the employee. First, ISOs are not taxed at the time of grant or exercise. Instead, they are taxed when the stock is sold. NSOs, on the other hand, are taxed immediately upon exercise on the difference in value between the fair market value of the stock and your exercise price. Second, ISOs are eligible for long-term capital gains treatment so long as the employee holds the stock for at least two years before selling. NSOs are always taxed as income. From the employer perspective, there are implications as well, but I'm less versed on that side of things. It has something to do with tax deductions for the business when issuing NSOs that are not received when issuing ISOs. For more info on this topic, here are a couple of links, but I'd of course recommend talking to a lawyer or accountant if you're serious about the topic: http://www.naffziger.net/blog/2007/03/31/startup-stock-options-isos-vs-nsos/ http://www.naffziger.net/blog/2007/03/31/startup-stock-optio... http://en.wikipedia.org/wiki/Non-qualified_stock_option http://en.wikipedia.org/wiki/Non-qualified_stock_option http://en.wikipedia.org/wiki/Incentive_stock_option http://en.wikipedia.org/wiki/Incentive_stock_option

turbostalk 15y ago
And for those of you trying to figure out how to report NSO's on a schedule D or a tax program like turbotax - not intuitive at all. Since most employers report NSO proceeds and taxes in your regular W-2 wages and taxes, the schedule D has to show a loss - basically the reported income on that line is a loss because of exercise fees. http://forums.kiplinger.com/showthread.php?1690-How-to-report-nonstatutory-stock-option http://forums.kiplinger.com/showthread.php?1690-How-to-repor...

tptacek 15y ago

This is good stuff, but I want to chime in with a warning. The major thrust of this piece is that you should exercise your options as soon as you can to start the tax clock ticking on them. That's true, as far as tax optimization goes. However, doing that costs money. You have to pay for the stock. Once you do that, you probably can't just get the money back. Be sure you really trust the company if you do this; in fact, not just the company, but also the board. I have friends who bought shares in companies that wiped out the common stock in acquisitions and did retention grants to keep current employees. Anybody who had left got shafted, even though they had put their own money into the company. (Full disclosure: I decided not to put my own money into shares of the last company I worked for, and that cost me a fair bit of money when they were acquired. I don't really regret the decision, though; I had a choice between investing in the company I was leaving and the company I was starting.)

DrJokepu 15y ago
> ... in companies that wiped out the common stock in acquisitions ... I'm sorry for asking such a trivial question, but what does that mean?
- lemming 15y ago
  My understanding is that during an acquisition, deals can be made which drastically affect the value of existing stock. Often at this stage the company basically belongs to the investors, so they could decide to (for example) massively dilute the stock by issuing new stock until the existing stock has essentially no value. Then they can allow current employees to retain their value using a buyback, i.e. you allow whoever takes your fancy to buy the new stock back so that their proportion of the company is more or less what it was. Or not, clearly this can also be used to change ownership percentages in the same way (c.f. Eduardo Saverin). Of course, the one group of people who get no protection at all in this case are ex-employees.
  - chernevik 15y ago
    Maybe I'm not understanding you, or the terms of the deal, but this does not sound right to me. "Massive dilution of the stock" amounts to giving the company to someone else. The documentation ought to prevent this sort of thing. I'm not saying it doesn't happen, but if it does I wonder if the persons harmed have fully explored their rights.

btilly 15y ago

Forward exercising seems to me to be a horrible idea. When you forward exercise, you're putting all of your financial eggs in one basket. This is the best way to get majorly rich in a hurry. It is also a good way to lose your shirt. A large fraction of your income is already tied up with the success of the company. Standard financial advice is to seek to diversify at every opportunity.

dadkins 15y ago
Forward exercising in an early stage startup is a great idea. The company doesn't yet have a meaningful valuation so you can exercise for next to nothing. The board typically sets the strike price of options low so that employees don't wonder if their options are already underwater. Also, by exercising early you pretty much guarantee that there is no difference between strike price and value at time of exercise, so you owe no taxes up front. Later, near IPO, when the value is much higher and set by external factors, it's no longer a good idea. By exercising early, you effectively own stock at the date of exercise. If the company goes public or gets acquired, your gains are already long term capital gains as long as it's been a year. Also, you don't have to wait once the company goes public to exercise your options, then wait a year... you can sell right away, lock-up periods aside. To summarize, early exercise is a cheap way to avoid paying taxes on your options until you sell the shares later. And then you're paying the long term capital gains rate on cash earned, instead of short term capital gains on a volatile stock which could easily go down in value.
- btilly 15y ago
  From a tax point of view, sure. As a personal financial risk, no way. If the startup works out, you'll probably have enough money to cover the risk. If it fails, you've thrown good money after bad. The #2 piece of advice about investment (after #1, which is to make sure that you are living within your means first) is to diversify your investments.
  - jtheory 15y ago
    "The company doesn't yet have a meaningful valuation so you can exercise for next to nothing." The missing bit here is a definition of "next to nothing". What's the normal scenario here? How much money are we talking about? Is "next to nothing" still in the tens of thousands, or could it actually be a few hundred bucks? The principle of diversifying investments, etc. is good advice when you're talking about your primary investments, but irrelevant here if it's really "next to nothing" that's under discussion.

grellas 15y ago

Very nice piece. A few technical points on tax (of course, check with your professional advisor for any real-world case): 1. IRC 83(a) sets the baseline: you are taxed on the value of property (stock) received in exchange for services as ordinary income. IRC 83(b) says that you do not receive such property immediately if it is subject to a "substantial risk of forfeiture" and that you will be taxed on it only when the forfeiture risk lapses and you truly own it. Thus, with restricted stock, you are subject to tax at ordinary income rates on the difference between what you paid for it and what its value is at each vesting point. If your 1M shares vest at 1/48th per month over 4 years, and you paid $.001/sh, you would have to pay tax on the "spread' at each vesting point as long as the price exceeded $.001/sh at that point. This theoretically could mean that you have as many as 48 taxable events during the 4-year period of vesting. All of this, of course, is done away with if you file a timely 83(b) election. In that case, you normally pay no tax up front and you pay only capital-gains tax on the stock as you later sell it. This is the optimum tax treatment for most startups but is normally made available only to founders. 2. Now what about options. The default rule here concerns so-called "non-qualified" options (NQOs, sometimes called NSOs as well, for "non-statutory options"). The substantive law rules relating to such options are the same as any other options and they are "non-qualified" only in the sense that they don't qualify for the special tax advantage of "incentive stock options" or ISOs, which are special types of options that get special tax advantages. To understand ISOs, you need to understand how all options are taxed apart from any special tax-advantaged rules. 3. With NQOs, you get a right to buy company stock at a fixed strike price exercisable as your options vest over a prescribed period. If your strike price is $.001/sh, and you exercise 1M options, you pay $1,000 to get 1M shares of stock. If the fair market value of that stock is $.001/sh at the time you exercise, you pay $1,000 for stock worth $1,000 and you realize no taxable income. If, however, the fair value of the stock is worth more (let us say, $.20/sh) and you exercise your first increment of (say) 250K shares at year one of vesting on a 4-year plan, then you realize $49,750 worth of taxable income upon your exercise. This is taxed at ordinary income tax rates and the amount is factored into your employment income so that you effectively pay all normal employment taxes on it as well (social security, etc.). Hence, with NQOs, you pay tax on the "spread" at ordinary income tax rates upon each exercise. When the transaction is done, you very likely will hold illiquid stock, you will have no cash from the transaction with which to pay the tax, and you are generally in a highly disadvantageous tax position. Once you make the exercise, any later appreciation on it is not taxed until you sell it and, at that time, you will be taxed on that subsequent appreciation at capital gains rates. 4. With ISOs, when you exercise your options, you are not subject to an immediate tax based on ordinary income tax rates and this is the special tax advantage that ISOs have. The idea is that, with these tax-advantaged options, employees should feel free to buy their shares by exercising their options whenever they like (once they have vested) and will only be subject to tax at the time they ultimately sell the shares. Having exercised and bought the shares, your holding period begins to run and, if you hold them for the prescribed period (which, in the case of ISOs, is 2 years), you pay LTCG rates - all in all, a huge advantage over the NQO tax treatment. But there is a clinker with ISOs and this is the AMT, or alternative minimum tax. With an ISO exercise, the spread amount is includable in your income for purposes of calculating your AMT and, therefore, even though you may not have to pay tax at ordinary income tax rates on the value of the spread, you may wind up paying a substantial tax under the alternative measure applied by U.S. tax laws. This means that, in a high-value company, you definitely need to check with your tax advisor to determine your tax hit prior to doing such an exercise. 5. ISOs granted with an early-exercise privilege (as noted in this piece) are taxed substantially the same as restricted stock and this is a huge advantage. However, startups do not normally offer this privilege for various reasons (mainly because it is a mistake to make large numbers of employees instant shareholders) and so it is not really a practical answer to most such situations. 6. Thus, restricted stock is near-ideal from a tax standpoint, avoiding most tax risks and positioning your holdings for LTCG treatment, but is normally granted only to a very few people (mostly founders). ISOs avoid ordinary income but may subject you to an AMT tax hit - in addition, they can be used only with employees. NQOs are least favorable, subjecting you to an ordinary income tax hit on any spread as of the date of exercise, but these are valuable for their flexibility (they can be used for contractors, directors, and others besides employees).

Matt_Cutts 15y ago

Great article. If you start or join a startup, you really need to educate yourself on this topic. When I started at Google, I bought a book called Consider Your Options: http://www.fairmark.com/books/consider.htm http://www.fairmark.com/books/consider.htm It's quite good. I also have a copy of Piaw Na's book: http://books.piaw.net/guide/index.html http://books.piaw.net/guide/index.html (An Engineer's Guide to Silicon Valley Startups) but I have to admit that I haven't read it yet because most of my finances are in order at this point.

lpolovets 15y ago

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 forward exercise 100k options at $.01/option (total price = $1000). You forget the 83(b) form. Jan 1, 2004: you quit on your 4 year anniversary, and the (still private) stock you own is now worth $1/share, which means the FMV of your stock is $100k. 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? Capital gains on $1 million - $100k and AMT on $100k - 1k? Something else?

X-Istence 15y ago

I've got certain stock options as an employee incentive program, how do those compare? What is a strike price? What is an exercise price? They vested immediately and I can technically exercise them today does that mean anything for me? As someone that is new to this (at age 23) some non-professional guidance would be helpful. I understand that a good CPA would be much better at advising me in my situation, but I really don't have the money for that (student loans are KILLING me).

cpg 15y ago

This is nice. One thing I did to really learn assimilate all this was code it all in a big excel spreadsheet with all the meaningful scenarios I could think of for me and for the company. It really gave me a great overview and helped me make a more clear decision to leave and start my own company.

dannylipsitz 15y ago

But in most cases, common stock can only be sold if and when an IPO takes place. VC investors won't want common stock, thus the employee must sell on a secondary market, back to the company, or patiently wait for an IPO. The first two options usually feature inherently dubious pricing due to reduced liquidity. Are there any other possibilities?

kirubakaran 15y ago

Can you please give a non-scribd direct link to the embedded pdf? Edit: Never mind, found it from an earlier post http://news.ycombinator.com/item?id=2574323 http://news.ycombinator.com/item?id=2574323 [thanks to http://news.ycombinator.com/item?id=2623292 http://news.ycombinator.com/item?id=2623292]

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