ISOs: Incentive Stock Options
PLEASE NOTE: All of the following content was captured from the sources at the end of this post. None of it is my own work, aside from how the content is organized.
With that preface aside, I researched this topic because I wanted insight into how to maximize the value of the ISOs I was offered as part of my employment compensation with Lunar Energy.
The below content is not exhaustive or thorough - it is a collection of points that caught my attention as I learned broadly about the topic. I highly suggest you do your own research, and if desired, seek out professional guidance.
ISO Value Assessment
Section 409A requires the value of stock options be determined “by the reasonable application of a reasonable valuation method” with two caveats: 1) the grant price must reflect material information, often referred to as a value creation event (i.e. the price paid in a recent financing); and 2), the calculation of value must not be more than 12 months old. In practice, private companies pursue 409A appraisals from independent qualified valuation firms either immediately after completion of a financing or other significant financial transaction (e.g. merger or acquisition), or, six to nine months of elapsed time since the prior appraisal, whichever comes sooner (more mature companies tend to pursue appraisals more frequently).
How to Give Them Out
Yet while complex, several online guides provide compensation benchmarks that help founders think about the size of each slice of the company they give away when recruiting talent. Index Ventures, for instance, has published a handbook aimed at helping entrepreneurs figure out option grants at the seed level. At a company’s earliest stages, expect to give a senior engineer as much as 1% of a company, the handbook advises, but an experienced business development employee is typically given a .35% cut. An engineer coming in at the mid-level can expect .45% versus .15% for a junior engineer. A junior biz dev person should expect .05%, which is the same for a junior person coming in as a designer or in marketing.
When Shukla was building her team at RewardsPay, she gave the earliest engineers joining her team an equity share of between .5% and 1%, depending on both experience and a person’s salary requirements. Some were willing and able to work for a minimal salary and higher equity, whereas others asked for higher cash compensation because of their personal circumstances. Regardless, Shulka says, “the early team you put together definitely gets a lot more stock than later employees.”
Indeed, in many circumstances, the timing of an employee’s decision to join has a disproportionate impact on how much equity is offered. It makes sense: the earlier someone commits to your startup, the more risk the hire is taking on.
If a key hire is the third person joining a two-person team, he or she can almost be considered a co-founder and may get as much as 10% of the company. But if a head of sales or VP of marketing joins once a startup has a product to sell and promote, they may get between 1% and 2%, depending on experience.
“The percentages really vary dramatically,” Beninato says. “I don’t want to say it’s like a decaying exponential, but it’s something like that. The first people get more, and it goes down over time.”
After a seed round, you want to have that employee pool at around 10% or 12%, plus or minus.
Most startups reserve between 10 percent and 20 percent of equity for their option pools.
As you divide those pools among the staff you need, it’s worth giving special thought to how much you give to key employees early on. As a rule of thumb, a VP of engineering or head of sales who joins at the earliest stages might get between 1 percent and 2 percent. Other senior roles may warrant a half a percent.
What are ISOs?
ISOs are also known as Qualified Stock Options. That’s to distinguish them from what are known as Non-Qualified Stock Options. ISOs come with more favorable tax treatment than non-qualified stock options. Non-qualified stock options don’t “qualify” for the same income tax break that ISOs enjoy. They don’t come with that bargain element that makes ISOs so attractive. Instead, employees must report as regular income the difference between the price they pay for company shares (the grant price) and the market value for those shares. Non-qualified stock options are easier for employers to administer. Plus, employers can deduct the cost as a business expense. Not surprisingly, non-qualified stock options are more common than ISOs.
Incentive stock options are a type of deferred compensation used to motivate and retain key employees. Since you need to hold on to your ISOs for a period of time, the only way to capitalize on these benefits is to stay with your firm for the long haul. Also, the higher your company’s share price rises, the greater the reward from your stock options. This encourages high productivity from key employees as they directly benefit from the company’s success.
incentive stock options (ISOs) are for employees only
With ISOs, you only pay taxes when you sell the shares, either ordinary income or capital gains, depending on how long you held the shares first.
Your ability to exercise your options is determined by a vesting schedule
It all starts on the grant date, which is the day you receive a stock option contract from your employer. The contract designates how many company shares you’re eligible to purchase at a certain price (the strike price, also known as the exercise price) after waiting until a particular time (the vesting date).
ISOs aren’t taxed when granted, upon vesting or when exercised. Taxes are deferred until shares are sold, and if you meet certain holding requirements, ISOs are subject only to capital gains taxes.
ISOs are usually seen as more advantageous for the employee, in part because the exercise date isn’t a taxable event (though higher-earning employees have to make an alternative minimum tax, or AMT, adjustment based on the difference between the current market price and the exercise price).
$100,000 ISO limit. An employer is limited in the amount of ISOs it can grant to each employee during any calendar year. If the fair market value of the stock exceeds $100,000, the options above the limit are treated as NSOs.
Instead, you settle up with the IRS when you actually sell your shares down the road. If you’ve held the stock for more than a year, you’ll incur the long-term capital gains tax on the difference between the exercise price and the eventual sale price.
In order to get the preferred tax treatment, ISOs must be held for two years from the date they are granted and at least one year from the exercise date. Otherwise, a “disqualifying disposition” occurs, and the difference between the grant price and market value on the exercise date is subject to ordinary income tax.
ISOs are subject to a holding period of one year post exercise — and two years post grant — in order to qualify for favorable tax treatment. Once a company files for an IPO, it generally takes several months to prepare before the actual listing. Immediately upon listing, employees of the company going public are typically subject to a lock-up period where they are restricted from selling shares for up to six months after listing. By exercising your options at the time of filing, the combined time period from filing until post-lock-up period will hopefully coincide with when you can also satisfy the eligibility requirements to benefit from preferential tax treatment.
If your income for the year already places you in a high income tax bracket, or additional income from stock options could push you into a higher income tax bracket, you may want to delay exercising your options or spread the exercise of options out over a few — potentially lower tax — years.
For ISOs with a qualifying disposition, there’s no tax upon exercise — you’re only taxed once you sell your company shares. If you’re holding company shares in order to receive favorable tax treatment, the bargain element could trigger AMT.
Long-term capital gains tax rate | Your income
0% | $0 to $40,000
15% | $40,001 to $441,450
20% | $441,451 or more
AMT Related
Alternative Minimum Tax (AMT). The AMT is designed to capture some income taxes from folks who have a lot of tax-free income. ISOs can trigger payment of the AMT, so it’s important to make sure you’re doing your taxes carefully for each year you hold ISOs. The bargain element of an ISO is the difference between the price you pay for the stock and its market value. You must report the bargain element as an income adjustment for AMT purposes when you purchase the stock. Later, when you sell the shares, you may have to pay the AMT.
The AMT rate is 28%.
California does have an alternative minimum tax, which operates similarly to the federal tax, but at a rate of 7% (rather than the 28% federal rate).
If we assume that, without any ISO exercises, a taxpayer’s regular tax is higher than his or her AMT for a given year, then the ideal strategy would be to exercise ISOs up to the point where the AMT rises to be equal with the regular tax. This is commonly called the AMT crossover point and is basically the point beyond which you will start to pay AMT on additional ISO exercises. You can essentially start your long-term holding period for a portion of your ISO shares on a tax-free basis as long as you don’t go beyond this crossover point.
IPO Related
If you decide to sell your ISOs or if you’re forced to (if, for example, your company is acquired) before you’ve met the one- and two-year holding requirements, then you trigger a disqualifying disposition and are taxed at ordinary income rates.
There is usually a period of three to four months between when a company files its initial registration statement to go public with the SEC until its stock trades publicly. That is followed by a period during which employees are forbidden from selling their shares for six months post-offering due to underwriter lockups. Therefore, even if you wanted to sell your stock you would be unable to for at least nine to ten months from the date your company files to go public. Twelve months is not a long time to wait if you think your company’s stock is likely to trade above your current market value in the two or three months post-IPO lockup release.
If you are in a position to know your employer’s financial results before the general public then you might be required to participate in a “10b5-1 plan.” According to Wikipedia, SEC Rule 10b5-1 is a regulation enacted by the United States Securities and Exchange Commission (SEC) to resolve an unsettled issue over the definition of insider trading. 10b5-1 plans allow employees to sell a predetermined number of shares at a predetermined time so as to avoid accusations of insider trading. If you are required to participate in a 10b5-1 plan then you will need to have a plan thought out in advance of your company’s IPO lockup release.
In our post, Winning VC Strategies To Help You Sell Tech IPO Stock, we presented proprietary research that found for the most part only companies that exhibited three notable characteristics traded above their IPO price post-lockup-release (which should be greater than your options’ current market value prior to the IPO). These characteristics included meeting their pre-IPO earnings guidance on their first two earnings calls, consistent revenue growth and expanding margins. Based on these findings, you should only exercise early if you are highly confident your employer can meet all three requirements.
Contract Details
For those unfamiliar, call rights give the company, or in the case of put rights, the employee, the right but not the obligation to ask for the stock underlying the option to be returned. If a stock option has a call attached to it, the company granting the option can require the employee to give their options back. Since ownership never really passes until the call provision is eliminated, there is no ownership right and therefore no value to the options. Similarly, if an employee can require a company to buy the option back (a put), then ownership doesn’t exist and there would be no value to the options. In practice exceptionally few companies issue options with put or call rights.
Early Exercise Related
A less obvious impact of a 409A appraisal is that most companies will not allow you to early exercise your options when a new appraisal is underway or a financing is about to close that will trigger a new appraisal. That’s because the IRS could interpret the fair market value of your stock as the one calculated in the new appraisal which if higher than your current exercise price would lead to taxable compensation. That’s why you don’t want to wait too long after a 409A appraisal to make your early exercise decision.
The best time to exercise ISO can be summed up in one word: Early.
Exercise early, and file an 83(b) if you have the opportunity.
Early Exercise or 83(b) Election
Almost all stock option grants have vesting restrictions. However, many companies offer you the opportunity to exercise your shares before they’ve vested. This is commonly known as the right to “early exercise.” If your stock plan allows for early exercise, section 83(b) of the Internal Revenue Code permits you to make an election whereby you accelerate the income tax consequences of your grant to the time of exercise (rather than vesting) and start the capital gains holding clock at your time of purchase, before your vesting occurs. As a result the future appreciation (even that which occurs before vesting) will all be subject to the capital gains rules and potentially the preferential long-term capital gains tax rates. Note that you must file the 83(b) election form within 30 days of purchasing your unvested options to execute this strategy. Any spread between your exercise price and the value of the underlying common stock at time of grant will become taxable income to you at the time you file the 83(b) election.
Your company may allow you to exercise employee stock options early, prior to vesting. This means you would go ahead and pay to purchase company shares, but you’d still be subject to the original vesting schedule before the shares become officially yours and are able to be sold.
It may seem counterintuitive to pay for something before it becomes yours. And, exercising early comes with additional risk: The shares may never reach the value that you want.
So, why would anyone consider exercising early? Because it starts the holding period clock for ISOs to qualify for favorable tax treatment.
Early exercise could help you sidestep taxes. If you’re able to purchase company shares when the strike price is close to the market price, you can file an 83(b) election to request that the IRS recognize your income at this point in time — before the shares appreciate further. Since you’ll have earned little to no income, you’ll pay less tax than if taxes are levied after the shares grow in value down the road. But note, you'll need to file the 83(b) election within 30 days of exercise.
You will owe no taxes at the time of exercise if you exercise your stock options when their fair market value is equal to their exercise price and you file a form 83(b) election on time. Any future appreciation will be taxed at long-term capital gains rates if you hold your stock for more than one year post exercise and two years post date-of-grant before selling. If you sell in less than one year then you will be taxed at ordinary income rates.
The most important variables to consider in deciding when to exercise your stock option are taxes and the amount of money you are willing to put at risk.
Most companies offer you the opportunity to exercise your stock options early (i.e. before they are fully vested). If you decide to leave your company prior to being fully vested and you early-exercised all your options then your employer will buy back your unvested stock at your exercise price. The benefit to exercising your options early is that you start the clock on qualifying for long-term capital gains treatment earlier. The risk is that your company doesn’t succeed and you are never able to sell your stock despite having invested the money to exercise your options (and perhaps having paid AMT).
How the Above Informs How I Think of ISOs
derp
Sources
Basic/Decent
https://www.investopedia.com/managing-wealth/get-most-out-employee-stock-options/
https://www.nerdwallet.com/article/investing/exercise-stock-options
Worth the Read
https://kbfinancialadvisors.com/exercising-stock-options-private-company/
https://www.holloway.com/g/equity-compensation
https://kbfinancialadvisors.com/3-reasons-january-is-the-best-month-to-exercise-iso/
http://kbfinancialadvisors.com/how-incentive-stock-options-and-the-alternative-minimum-tax-work/
https://kbfinancialadvisors.com/should-i-exercise-my-private-companys-stock-options/
https://kbfinancialadvisors.com/how-does-the-minimum-tax-credit-work-an-easy-follow-guide-on-mtc-incentive-stock-options/
http://www.amtadvisor.com/Minimum_Tax_Credit.html
https://www.investopedia.com/articles/active-trading/061615/how-stock-options-are-taxed-reported.asp
https://blog.wealthfront.com/when-to-exercise-stock-options/
https://blog.wealthfront.com/always-file-your-83b/
https://blog.wealthfront.com/stock-options-15-crucial-questions/
https://blog.wealthfront.com/409a/
https://blog.wealthfront.com/improving-tax-results-stock-option-restricted-stock-grant/
https://blog.wealthfront.com/improving-tax-results-stock-options-restricted-stock-grants/
https://blog.wealthfront.com/improving-tax-results-stock-options-restricted-stock-grants-2/
https://www.nerdwallet.com/article/investing/upcoming-ipos#ipo-explainer
Decent Negotiation Advice
https://candor.co/guides/salary-negotiation
https://candor.co/guides/performance-reviews
https://www.inc.com/jim-schleckser/the-3-moves-to-make-in-every-negotiation-flinch-reflect-go-silent.html