
Mistakes You Can’t Afford to Make with Stock Options - DanielRibeiro
http://gigaom.com/2011/06/05/5-mistakes-you-cant-afford-to-make-with-stock-options/
======
grellas
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).

~~~
ootachi
This makes it sound like shares are far too risky from a tax standpoint to be
worth it for anyone but founders. Startups are risky enough from a career
standpoint without having the threat of _personal bankruptcy_ hanging over
employees' heads. Is this generally the case or is there a way out?

~~~
grellas
Options for employees usually work well in spite of the tax risks. Most
employees get ISOs and exercise them without incident and without AMT. They
take some modest financial risk in paying for the stock but these amounts are
usually small.

Problems arise if you are terminated in your employment (or quit) and you face
a 90-day window to exercise options that will otherwise expire in a company
that is promising but not established. For example, a former client of mine
did this (after being terminated) in a solar startup in which he had been
employed and got hit with a $600K tax bill. The company is all the rage among
some VCs but completely unproven in the market and the stock itself has no
liquidity and will not likely have any for years to come. If the company makes
it big as hoped, this man will be rich; if not, he will have run the risk of a
personal bankruptcy.

I would say that extremely risky situations occasionally arise involving
employees and options but these are the exception and not the rule. In most
cases, the risks are limited and manageable and the use of options is an
excellent vehicle for the employees as a key financial incentive. The key,
though, is to know what you are doing and to understand the risks before
undertaking them. Beyond that, it is up to each individual and his own sense
of risk tolerance.

------
tptacek
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
> ... 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
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
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.

~~~
euroclydon
Let's say a company has 1 million shares and actually issues 1,000. You, as an
employee may have ten. Hey sweet. You own one percent of the company at that
moment, because the company owns the other 999,000 shares. But members of the
board, who have a voting majority, decide to issue the remaining 999,000
shares to themselves. They don't incur hardly any capital gains, I imagine,
because the overall value of their shares hasn't change much at all, though
yours have just lost 99.9% of their value.

~~~
chernevik
All shares should receive equal treatment -- if the majority-owned shares get
a distribution, stock or cash, minority-owned should get the same deal.

If minority shareholders don't have protection against this, the company is
poorly documented.

I'm not saying it didn't / doesn't happen, just that it shouldn't be easily
accomplished.

~~~
tptacek
The fact that all shares in a startup are _not_ equal is VC 101. VC doesn't
get common shares. They get preferred shares. It's right there in the name.

Jacking non-employee holders of common stock in a private company is easily
accomplished, through:

* Deal structure (non-employees don't participate in earnouts)

* Participating preferred liquidation preferences

* Antidilution

* Retention grants

Your stock purchase agreement is a document carefully crafted to denude you of
troublesome rights that will compromise the best interests of the company.
That's not conspiracy-theoretic; it's just good business.

The structure of any deal that brings liquidity to shares is a negotiation
that occurs entirely between the board and the acquiring company. Any vote on
the terms of that deal is a formality, since every VC-funded company of them
--- _every_ one of them --- is itself structured to ensure the board has
control over the company.

There is no entity with less power and fewer rights in a startup than a former
employee holding shares.

~~~
chernevik
Further clarifying, thank you.

------
Matt_Cutts
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> It's quite
good.

I also have a copy of Piaw Na's book: <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.

------
jsherry
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-
optio...](http://www.naffziger.net/blog/2007/03/31/startup-stock-options-isos-
vs-nsos/)

<http://en.wikipedia.org/wiki/Non-qualified_stock_option>

<http://en.wikipedia.org/wiki/Incentive_stock_option>

~~~
turbostalk
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-
repor...](http://forums.kiplinger.com/showthread.php?1690-How-to-report-
nonstatutory-stock-option)

------
ScottBurson
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.

~~~
yummyfajitas
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.]

~~~
random42
IRS is a revenue collecting body, not a VC firm. Why would they want to take
undue risk?

I see the following reasons (atleast), the proposed solution is a no-go.

a. 17.5% cash >> 17.5% shares of a business, which is struggling to pay 17.5%
cash.

b. what happens if the business goes under and IRS owns 100% shares of the
business?

c. What happens if all IRS get in payment is shares. How the country economy
is supposed to run? (with foreign trade etc.)

~~~
yummyfajitas
_17.5% cash >> 17.5% shares of a business, which is struggling to pay 17.5%
cash._

If 17.5% of a business is worth less than $1.75M then 100% of the business is
worth less than $10M. Thus the tax bill should be lower than $1.75M.

 _what happens if the business goes under and IRS owns 100% shares of the
business?_

Then the IRS's initial valuation of $10M was inaccurate. Why should the
business owner pay for mistakes made by the IRS?

~~~
random42
_If 17.5% of a business is worth less than $1.75M then 100% of the business is
worth less than $10M. Thus the tax bill should be lower than $1.75M._

No, The point I was trying to make was that shares of a struggling business is
always less in value (due to inherit risk), as compared to hard cash (Which is
equal, irrespective of its genesis.)

 _Then the IRS's initial valuation of $10M was inaccurate. Why should the
business owner pay for mistakes made by the IRS?_

No reason. Similarly IRS has no reason to take the investment risks (as its
interested in collecting revenues, not funding companies).

I just gave a potential risk of scenario, where the business is unable to pay
to the IRS money (due to lack of enough cashflow in the business), but still
getaway with it. (When it eventually does get bust, but at the cost of
IRS/government/Taxpayers, not the owners.)

~~~
yummyfajitas
The point you are making is that the IRS's assessed value is higher than the
value of the business. I.e., the IRS is charging the business owner taxes on
$10MM even though they don't really believe his business is worth $10MM.

You gave a potential risk scenario where the IRS declares a company is worth a
lot, but in reality it is worth very little. You then advocated that a
taxpayer (the business owner) should suffer for this mistake by paying cash
(some percentage of an incorrect valuation) instead of equity.

But that's silly - if the business is about to go belly up (i.e., it's really
worthless), the taxpayer should owe very little in tax. Forcing the IRS to
take equity is a self enforcing way to prevent the IRS from overtaxing people.

------
gfodor
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
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-Option...](http://www.scribd.com/doc/55945011/Intro-to-Stock-and-
Options))

~~~
rdl
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.

------
herdrick
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
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
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"

------
msort
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).

------
lpolovets
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?

------
btilly
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
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
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
"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.

------
dweekly
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> \-
happy to hear your feedback on this!

~~~
alok-g
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.

------
X-Istence
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).

------
caf
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
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 :)

------
dannylipsitz
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
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> [thanks to
<http://news.ycombinator.com/item?id=2623292>]

------
cpg
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.

