5 ms·

I believe it… what are those implications?

nostrademons 4y ago
In a nutshell, the difference between the fair market value of options and the strike price is considered income. That means the employee has to pay taxes on it in the tax year of the grant. It's non-cash compensation, which means the employee may not have the cash to pay those taxes, which can leave employees in the bind of owing the U.S. government money that they don't actually have. In the example you give here, where it would cost $100K to exercise your options, you would probably owe $30-40K in taxes if they granted them to you at close to zero cost, and you would still have only illiquid stock options (not even stock, which is what you get when you exercise the options). From the company perspective, they have to book this as a compensation expense, which means that their earnings are lower (perhaps negative), their burn rate is higher, their runway is shorter - and these are all the metrics that investors look at to determine if they're going to give the company more money, which can sink the company.
- api 4y ago
  The whole system of option pricing and taxation is incredibly perverse. Why not just tax when liquidity is realized and cash is in the bank?
  - nostrademons 4y ago
    I agree with you, but I'll point out that there are a lot of voices today arguing to tax stocks, crypto, and other property the way stock options are today (eg. wealth tax; tax on crypto->crypto exchanges; proposed tax on unrealized capital gains). The idea that your wealth can increase without you being taxed on it seems to be very unpopular with the general population. Come to think of it, I wonder if the reason for taxing stock options the way they are is because otherwise there'd be a strong incentive to pay in stock rather than cash, and then everyone would be paying capital gains taxes instead of income, and then there'd be a strong call to tax capital gains at the same rates as income and the wealthy & powerful would not enjoy that.
    - deleted 4y ago
      [deleted]
  - s1artibartfast 4y ago
    Devils advocate: you are getting you something of value. What if your company payed you with 1,000 lotto tickets. Do you pay taxes on that only if you win? Options have a market value so they are compensation
    - api 4y ago
      Yeah, only if you win. Otherwise there isn’t any value. Do you pay taxes on a pat on the back?
      - s1artibartfast 4y ago
        Options and lotto tickets obviously have value. Options cost money to purchase on an stock exchange.
        api 4y ago
        You’re technically correct. The problem really is that taxing unrealized gains is regressive. The rich can afford to pay these taxes and thus can get and benefit from assets like options. The poor cannot and would therefore be cut out. In a regime where all options are taxed as income less wealthy startup employees for example would be cut out of exit gains. As is usually the case those who want to soak the rich end up soaking the middle class or reducing class mobility while leaving the already rich largely untouched.
        s1artibartfast 4y ago
        I agree it makes no sense to tax unrealized gains. however, receiving stock itself is a gain. If I gifted you 1000 shares of Apple today, that would be a gain for you. It would also be the basis cost for any future sale. Similarly, if I payed you with 10kg of gold, or a house, or land, it makes sense to tax that transfer event, not just if you sell for cash. In short, it makes sense to test asset transfers, but not appreciation while you hold it. I do agree with a tax deferment for asset transfers where there is no resale market like pre IPO stocks or options. Post IPO is a different story.
- erikpukinskis 4y ago
  Thank you for explaining, that cleared up a lot for me. One thing I don’t understand though… how can a “fair market value” be ascertained for tax purposes, when there is no market at all for the shares? If a company is not publicly traded, the value is whatever I could get someone to pay for them. But for a pre-IPO company who is to say what amount that is? And along those lines, if it’s so easy for me to sell the shares at that price, then I can just sell 40% of them to cover the tax bill right? It’s better to sell 40% than to potentially have to sell 100% in order to raise cash for the strike price, no?
  - nostrademons 4y ago
    There are two main ways: After a funding round, the valuation of a company is whatever the post-money valuation of the company is, by definition. Here there is a market - it's the market of investors willing to invest money into the company, and the shares are worth whatever the investors were willing to pay for them. Also, every 12 months startups are required to get a 409a valuation done [1]. Basically, they hire an appraiser (often an investment bank), and that appraiser comes up with a value for the company based on how they would value it if they were shopping it around for an acquisition. Usually this involves looking at comparable companies, previous funding rounds, financials, growth potential, etc. That's the value that stock options must be offered at. It's usually not easy (or even possible) for employees to sell shares at that price, for a couple reasons. First, anyone buying shares in a private company needs to be an accredited investor, which means they need a million in net worth, $200K in income for the last two years with a reasonable expectation of making that again, or the ability to pass a financial knowledge test. Second, companies usually want to keep their cap tables small (for a variety of reasons: it makes corporate governance simple, it makes the company more attractive to new investors, it eliminates potential roadblocks to an acquisition, and they can't go over 400 shareholders without needing to report financials as if they were a public company anyway), and so the stock agreements of most companies have covenants preventing you from selling your shares except with company permission, which they will usually not grant. That makes it hard or impossible for you to sell 40% of your stake to cover the tax bill. FWIW, if the company does have a liquid secondary market in its stock, you can do what's known as a "sell to cover" transaction, where you borrow the money needed to exercise the options, sell the shares immediately, and then pay back the money you borrowed to exercise the options, effectively just profiting the difference between strike price and market value. These are not uncommon; back when FANGs gave options rather than RSUs they were the most popular way to exercise stock options and sell them on the public market, because the transaction is simple, immediate, and has no risk to the employee. [1] https://learn.angellist.com/articles/409a-valuation https://learn.angellist.com/articles/409a-valuation

In a nutshell, the difference between the fair market value of options and the strike price is considered income. That means the employee has to pay taxes on it in the tax year of the grant. It's non-cash compensation, which means the employee may not have the cash to pay those taxes, which can leave employees in the bind of owing the U.S. government money that they don't actually have. In the example you give here, where it would cost $100K to exercise your options, you would probably owe $30-40K in taxes if they granted them to you at close to zero cost, and you would still have only illiquid stock options (not even stock, which is what you get when you exercise the options). From the company perspective, they have to book this as a compensation expense, which means that their earnings are lower (perhaps negative), their burn rate is higher, their runway is shorter - and these are all the metrics that investors look at to determine if they're going to give the company more money, which can sink the company.

api 4y ago
The whole system of option pricing and taxation is incredibly perverse. Why not just tax when liquidity is realized and cash is in the bank?
- nostrademons 4y ago
  I agree with you, but I'll point out that there are a lot of voices today arguing to tax stocks, crypto, and other property the way stock options are today (eg. wealth tax; tax on crypto->crypto exchanges; proposed tax on unrealized capital gains). The idea that your wealth can increase without you being taxed on it seems to be very unpopular with the general population. Come to think of it, I wonder if the reason for taxing stock options the way they are is because otherwise there'd be a strong incentive to pay in stock rather than cash, and then everyone would be paying capital gains taxes instead of income, and then there'd be a strong call to tax capital gains at the same rates as income and the wealthy & powerful would not enjoy that.
  - deleted 4y ago
    [deleted]
- s1artibartfast 4y ago
  Devils advocate: you are getting you something of value. What if your company payed you with 1,000 lotto tickets. Do you pay taxes on that only if you win? Options have a market value so they are compensation
  - api 4y ago
    Yeah, only if you win. Otherwise there isn’t any value. Do you pay taxes on a pat on the back?
    - s1artibartfast 4y ago
      Options and lotto tickets obviously have value. Options cost money to purchase on an stock exchange.
      - api 4y ago
        You’re technically correct. The problem really is that taxing unrealized gains is regressive. The rich can afford to pay these taxes and thus can get and benefit from assets like options. The poor cannot and would therefore be cut out. In a regime where all options are taxed as income less wealthy startup employees for example would be cut out of exit gains. As is usually the case those who want to soak the rich end up soaking the middle class or reducing class mobility while leaving the already rich largely untouched.
        s1artibartfast 4y ago
        I agree it makes no sense to tax unrealized gains. however, receiving stock itself is a gain. If I gifted you 1000 shares of Apple today, that would be a gain for you. It would also be the basis cost for any future sale. Similarly, if I payed you with 10kg of gold, or a house, or land, it makes sense to tax that transfer event, not just if you sell for cash. In short, it makes sense to test asset transfers, but not appreciation while you hold it. I do agree with a tax deferment for asset transfers where there is no resale market like pre IPO stocks or options. Post IPO is a different story.
erikpukinskis 4y ago
Thank you for explaining, that cleared up a lot for me. One thing I don’t understand though… how can a “fair market value” be ascertained for tax purposes, when there is no market at all for the shares? If a company is not publicly traded, the value is whatever I could get someone to pay for them. But for a pre-IPO company who is to say what amount that is? And along those lines, if it’s so easy for me to sell the shares at that price, then I can just sell 40% of them to cover the tax bill right? It’s better to sell 40% than to potentially have to sell 100% in order to raise cash for the strike price, no?
- nostrademons 4y ago
  There are two main ways: After a funding round, the valuation of a company is whatever the post-money valuation of the company is, by definition. Here there is a market - it's the market of investors willing to invest money into the company, and the shares are worth whatever the investors were willing to pay for them. Also, every 12 months startups are required to get a 409a valuation done [1]. Basically, they hire an appraiser (often an investment bank), and that appraiser comes up with a value for the company based on how they would value it if they were shopping it around for an acquisition. Usually this involves looking at comparable companies, previous funding rounds, financials, growth potential, etc. That's the value that stock options must be offered at. It's usually not easy (or even possible) for employees to sell shares at that price, for a couple reasons. First, anyone buying shares in a private company needs to be an accredited investor, which means they need a million in net worth, $200K in income for the last two years with a reasonable expectation of making that again, or the ability to pass a financial knowledge test. Second, companies usually want to keep their cap tables small (for a variety of reasons: it makes corporate governance simple, it makes the company more attractive to new investors, it eliminates potential roadblocks to an acquisition, and they can't go over 400 shareholders without needing to report financials as if they were a public company anyway), and so the stock agreements of most companies have covenants preventing you from selling your shares except with company permission, which they will usually not grant. That makes it hard or impossible for you to sell 40% of your stake to cover the tax bill. FWIW, if the company does have a liquid secondary market in its stock, you can do what's known as a "sell to cover" transaction, where you borrow the money needed to exercise the options, sell the shares immediately, and then pay back the money you borrowed to exercise the options, effectively just profiting the difference between strike price and market value. These are not uncommon; back when FANGs gave options rather than RSUs they were the most popular way to exercise stock options and sell them on the public market, because the transaction is simple, immediate, and has no risk to the employee. [1] https://learn.angellist.com/articles/409a-valuation https://learn.angellist.com/articles/409a-valuation