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).
Question 1: In the case of exercising and ISO, you said that the spread amount is includable in income for purposes of calculating AMT. How is this spread determined? Is this where the company's 409a comes into play?
Question 2: This may be hard to answer, but generally speaking, if you're part of a company that you believe in, would you typically advise an employees to exercise his/her ISOs as soon as they vest in an effort to become eligible for LTCG in the long run? Or would you typically advise an employee to wait in order to avoid AMT issues? Again, this is likely case by base, but curious to get your thoughts.
The "spread" in this context always means the difference between your exercise price and the fair market value of the stock on the date of exercise. For example, you hold ISOs for which you can buy common stock at $.10/sh. You exercise them when the stock is worth $1.00/sh. The spread is the $.90 difference. (If this exercise involved 100K shares, the amount potentially includable in AMT would be $90K).
409A is an arbitrary (in my view) tax rule that imposes large penalties if a company undervalues items that are given as "deferred compensation" to employees. It is not affected by the spread on date of exercise but rather by the way a board values options on date of grant (to avoid penalties, a company must get an independent, outside appraisal of its stock in setting such a valuation - in practical terms, this becomes an issue typically after a first equity funding because, before that, there usually is no serious practical risk of the IRS being able to put an objective measure on the stock's value in an early-stage company so as to have a basis upon which to attempt to impose penalties).
As to Question 2, I normally urge people to strike a balance - the advantages of getting LTCG treatment justify taking moderate risks for most employees but don't do it if you have to part with a lot of cash and if you have to take AMT hits even if you do believe in the company (in my experience, it is too easy to get blind-sided in this area, no matter how promising a typical startup looks; more yet, option holders do ride the caboose when it comes to liquidity events and can sometimes lose even if the company wins). Bottom line: front-exercise if possible but always proceed with caution and only after you understand all the issues well (including tax).
Pre-A seems very relevant for most HN readers, either as founders or early key hires.
Most startups do not want to make immediate shareholders of new people as the company is growing. They want to test them first. Hence, the standard grant of options with one-year cliff.
Another important reason not to use restricted stock as the norm: you have to pay for the stock up front and (once you get beyond the founder pricing which normally is not offered to other early-stage people) this creates financial risks for employees who would rather not commit cash to the company until they see how it plays out (with options, you need pay only when you decide to exercise). tptacek makes this point well elsewhere in this thread.
This practice of limiting restricted grants to the founder group only is not legally required but is widely done as a prudential matter. I think it is a strongly held belief among founders and investors that it is unwise to be too loose in making people shareholders. Thus, getting a restricted-stock grant has, by custom and habit, become a sort of "founder's privilege."
We have had companies that use restricted stock freely beyond the founder group. In the right cases, this works fine and sometimes there are even special reasons why it is critical to use this approach (e.g., after a small equity round, to avoid 409A tax problems where the company wants to make grants at an aggressively low price but doesn't want to pay for an outside, independent appraisal to keep the grants within the 409A safe-harbor provisions - in such a case, using options can be dangerous while using restricted stock can avoid the tax problems).
Thanks for being such a useful contributor.
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.
Don't think of the AMT as something that could strike without warning, like lightning. It is absolutely possible to protect yourself against it as long as you understand the rules, or get advice from someone who does. Make sure to look into it before exercising any options.
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.)
I'm sorry for asking such a trivial question, but what does that mean?
I'm not saying it doesn't happen, but if it does I wonder if the persons harmed have fully explored their rights.
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.
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
* 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.
Anticipation of this sort of thing is why good lawyers are worth the money. But they're expensive, perhaps prohibitively for the amounts we're talking about here. So unless the majority shareholders are responsible, what shouldn't happen, does.
In part this is because they don't want to, but it's also because they probably can't. Companies can only offer and sell shares to reg-d accredited investors. The shares employees get are as compensation, which is explicitly exempted from SEC reporting regs.
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.
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:
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.
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.]
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.)
Today, they don't have to. Their incentive is exactly the opposite: overvalue things to get more tax out of it.
I think we can all agree the best thing is to take away ability to tax phantom money from IRS. Next best thing is to setup the rules so that IRS is on the hook if they overvalue phantom money.
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?
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.)
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.
Like any 17.5% shareholder, they are entitled to 17.5% of the profits (ignoring details like profits not immediately distributed to shareholders).
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.
PREFACE Check with a CPA before acting on this advice! I'm not a CPA.
* If you sell in the same calendar year as you exercise, it's considered a "disqualifying disposition"
* The tax is actually Max(regular income tax, AMT). Normally your AMT (on your regular income) is lower. So you can exercise and hold just enough shares to "bridge you" to the point where the AMT is equal to the regular income tax. This way you will still be eligible for long term capital gains tax.
REMINDER Check with a CPA before acting on this advice!
EDIT: In fact, I think that whole section should say the opposite: "2. Refusing to quit with unexercised options"
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).
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?
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.
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.
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.
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.
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).
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)?
A company can certainly do what you suggest (i think), but I dont think companies operate to personally screw ex-employees :)
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]
It really gave me a great overview and helped me make a more clear decision to leave and start my own company.