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.