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Really nice write-up explaining stock options. A few added thoughts sparked by some of the comments already made in this thread and otherwise:

1. The value of options is inextricably linked to tax and you need to understand the tax basics in evaluating the economic risks and benefits of holding and exercising any kind of option. With NQOs, you are taxed on the spread as ordinary income on the date of exercise (meaning, on the difference between what the stock is worth and what you pay to exercise). With ISOs, the value of the spread becomes subject to AMT and you can wind up paying large taxes that way in spite of the supposed tax benefits of ISOs. The way to avoid having a large spread subjecting you to such tax risks is to exercise as early as possible before the company value goes up much but you then need to take the economic risk associated with having to pay hard cash for stock whose long-term value is highly uncertain. Moreover, early exercise is not possible if your options haven't vested unless you specifically get an early exercise privilege as part of your grant. With an early exercise privilege, and particularly if the grant is made for a bargain price, you can early-exercise, file an 83(b), and (as long as you hold the stock for at least 2 years) get the equivalent of a restricted stock grant by which you pay no further tax until you eventually sell the stock at a liquidation event. In that case, you are also taxed at the lower long-term capital gains rates. Of course, in the early-exercise scenario, you do not get to bypass vesting and your shares remain subject to their original vesting requirements and can thus be forfeited in whole or in part if those requirements are not met. But early exercise does provide an elegant solution to most of the tax risks associated with options provided you are willing to assume the economic risks of paying for the stock up front.

2. Other than the early-exercise scenario, 83(b) elections are not required for option grants. Under 83(a) of the Internal Revenue Code, any service provider who gets property in exchange for services is taxed at ordinary income rates on the value of the property received. For example, if you do work for a startup and are paid in stock when you complete the deliverable, you are taxed on the value of the stock received. You are taxed on the value of that stock as it exists as of the date you receive it in payment for such services. So, if you do development work tied to a milestone, and you meet that milestone, and you get 100,000 shares for the work, you would be taxed on, say, the $1.00/sh that the stock is worth on the day six months or a year (or whatever) out when the milestone is met, and not on the $.01/sh that it was worth when the contract terms began. In contrast to this performance-based form of incentive, let us say that you get a time-based incentive by which you buy the stock up front for a nominal price but you must earn it out over time. With such a time-based performance incentive, which is what is called "restricted stock", you own the stock up front and you pay no tax at the time of purchase in the normal case where the amount you pay for it equals its fair value on the date of the grant. Because the stock must be earned out as part of a continuing service relationship, and is hence subject to a "substantial risk of forfeiture", there is a very important technical question under section 83(a) on what the date is on which you are deemed to have received the stock in exchange for your services. Well, the default rule under 83(a) is that you receive it on the date it is no longer subject to a substantial risk of forfeiture and that then becomes the relevant date on which the value of the stock is measured for purpose of computing the taxable service income on which you must pay tax. So, if you get your 100,000 share grant at $.01/sh, and you pay $.01 share, you pay no tax at inception. But, as that grant vests at, say, a monthly ratable rate over four years, the IRS treats you as having received 48 separate grants (one each month) over the four-year period. Thus, at each vesting point, you are treated as having received property in exchange for services under 83(a) and you pay tax on the difference between the value of the property received and what you paid for it. If you paid $.01 per share, and if the stock is worth $1.00 at a given vesting point, you realize $.99 worth of taxable income per share. In a venture whose value is rising quickly, in the absence of any saving mechanism, you might have as many as 48 separate tax hits (basically, having to pay tax on the difference between what you paid for your grant and the 409A valuation price placed on the common) just for the privilege of holding a piece of paper that may or may not ever have an ultimate cash value of any type. It is in this type of scenario, and only here, that 83(b) comes into play by providing that, in lieu of having to suffer under the default rule of 83(a), you can elect to pay all taxes up front on the grant and not be subjected to the often onerous workings of the default rule. This means that, for an 83(b) election even to be relevant, you must first own your stock (or other property) and that stock or property must be subject to a substantial risk of forfeiture. If you hold only an unexercised option, you do not yet own the stock and it is not subject to forfeiture (hence, 83(b) is not relevant). If you do an early exercise, though, and get stock under terms where it must still vest out and can be forfeited, then 83(b) does apply. But that is the only case normally where it becomes relevant at all to options.

3. Options really shine when they wind up on a level playing field with the preferred stock and they tend to dim commensurately to the extent they do not. Optimum case is IPO when all stock is (typically) forced to convert to common prior to the public offering and, thus, all shares participate equally in the benefits. This can happen too in big-scale M&A exits but a drop-off occurs on lesser ones in at least two ways: (a) where the total acquisition price is largely gobbled up by the liquidation preferences and/or management incentive plans; (b) where an acqui-hire occurs in which a few founders get a disproportionate share of the total value through employment arrangements made on the other side of the deal.

4. Given all of the above, and given that IPOs remain at far below the old bubble levels in frequency, it can be risky to lay out any excessive cash to exercise at any time before a liquidity event. Too many things can happen by which a seeming "sure thing" winds up evaporating before your very eyes, leaving you with no more than a pretty lousy capital loss that you get the privilege of deducting at the rate of no more than $3,000 per year unless you can find other capital gains to offset it against.

5. The 90-day tail for exercise upon termination of a service relationship applies only to ISOs and not to NQOs but, of course, ISOs have other advantages and they are what is typically offered in VC-backed ventures. In other types of ventures, where the company value is already somewhat high at the time of grant, I have seen executives bargain for and get NQOs with long exercise periods following termination just to have the flexibility to leave the venture if needed without being forced to forfeit the options.

6. In light of all of the above, having to pay an angel backer 25 or 30% of your gains to provide you with a risk-free exercise in an otherwise high-risk situation may be worth it even though the cost seems high on its face. It is a matter of preserving some decent part of your potential upside while giving up the rest to make the upside potential even a possibility for you given the tax risks involved. If IPOs come back strong some day, then you may be giving up too much at such a cost because they are the great leveler when it comes to weighing the value of options against other forms of equity holdings. Until that day comes, however, options remain a valuable but relatively high-risk way of deriving value from a startup if you need to part with any significant cash (either for the purchase or for the associate tax) for the privilege of hoping to profit from a startup. Again, for those who need to weigh their choices, this piece provides great insights and stands head and shoulders above the typical discussion of such issues. Great work by the author in making an otherwise dry and even formidable subject pretty accessible.

having been through this a bunch of times my simple rule is:

- if you can afford, and think it's a good bet it buy the stock when it is granted to lock in the capital gains and avoid income tax

- otherwise go the exercise and sell route and pay tax at your marginal rate

anything in between IMHO is quite possibly a mistake .... don't forget all those people in the .com crash who'd been granted options at 10c, exercised at 2$ and found themselves at the end of the year without a job and a huge tax bill (and remember, without a job) on increases in value of shares that were now worthless - there are traps here

yeah the us system where you can end up with worthless shares but have a huge tax bill is just bizarre its a huge disincentive for employees to have a stake in their employer.

Why are not the CA senators and congressmen being told to sort that out ASAP by their constituents.

It is a problem that the employers force risk on their employees. No tax law fix needed, the law is correct. The employers should allow employees to sell back 35%ish of their optioned stocked, at "market" price, to cover the taxes. This is how RSUs (can) work, auto sale for taxes on the day the stock is transferred.

How is it correct its perverse for many reasons.

1 How can I owe tax on something that has no value.

2 I think we can all agree that Employee ownership is considered a good thing therefore any law which penalizes this is bad law if not actively immoral.

The law should only tax you when you have an actual +ve capital gain. (the need for sensible vesting and taper relive to avoid tax avoidance is of course a given).

On point 2 even the UK's SWP (Socialist Workers Party) allow members to take part in share option schemes.

Well the answer to 1 is that you owe tax on the increase of value from 10c to $2 (your option price and the current value of the stock when your bought it at 10c a share - if you have 10k shares you might pay $1k to exercise the options and find yourself owing roughly 1/3 of 10k*$1.90 or ~$6k in tax on your paper gain.

The usual reason you are doing this is because you expect the stock to appreciate further say to $10 and you want to lock in the long term capital gains tax (25%) rather than your marginal rate (30somethingish %) when you sell it.

Now when the company goes under your stock goes to 0 you can claim back the loss ($20k) in a subsequent year's tax return, but only as an offset against some other investment income - something that might not be happening if you don;t have a job (though if you can't use this loss it might be a great time to tap your 401k/IRA and get that money out essentially tax free if you can)

That is a capital gain not income and just saying you can claim the loss next year doesn't do you much good if your bankrupt or unemployed.

By your argument all US pension funds should pay income tax on any capital gains.

And just saying well you cant pay your tax we will take your pension is just taking the piss (to be blunt).

Forget reforming the NSA/CIA its the IRS I would be worried about

In the US capital gains are by default taxed as income, you can claim a special lower capital gains tax rate if you hold an asset for greater than a minimum time (2 years?)- stock options are a bit special in that you don't actually 'hold them' until they vest - what you have to do if you buy them early is file with the IRS and tell them that you have made this investment, specify how many shares and what the value was - it is explicitly to get this lower capital gains tax rate that people do the early purchase thing.

US pension funds (at least personal funds like IRAs and 401Ks) are pre-tax - that is the money you put into them comes from your gross, before you pay tax on it - you still have to pay the tax when you withdraw money (including any increase) from them - the idea is that you put money in to avoid tax at your highest marginal rate, and remove it and pay tax at a much lower marginal rate when you are retired. However you do still have to pay income tax on money earned in pension plans.

As to the fact that you can't claim the tax loss if you're unemployed or bankrupt, that was part of the thing I was trying to point out, buying your options after their value has increased can put you into a dangerous situation (I wasn't trying to justify it, just explain to the unwary that it can, and has, happened)

What an awesome comment. Thanks for explaining the subtleties of ISO, RSU and 83b elections. I thought I understood it all quite well but I just learned something new in point 2 above about how and why 83b elections are not applicable to ISO except for early exercise. Bookmarked for when I need a refresher on this stuff.

Your comments are incredibly awesome. I find myself coming to the comments here after a post like this specifically to see your take on things. Bookmarked.

This is great information and I too would consider long and hard before laying out significant sums of cash early on. You're completely subject to market risk and you've just handed over some of your own money. Everyone's appetite for risk here is different...

That being said, my own personal opinion is, if you're in early enough that options are on the table, you've basically taken a bet on the company anyway and you're probably already sacrificing salary for equity. I wouldn't go mortgaging the house to purchase your options, but it's unlikely that's necessary and if you're seeing strike prices of under a couple of dollars per share, then you're probably talking about very affordable options.

In Ireland, the main tax differential is income tax (effective rate of 52%) or CGT (@30%). I didn't pay enough attention to this, so word to the wise of anyone going through this. Go talk to someone now, not when your company is IPO'ing.

Some interesting tidbits here from an Irish perspective which probably applies to lots of other non-US countries on options in US companies:

* Pre-IPO, the fair market value of the share is calculated and reported to the revenue commissioner along with an FX (USD -> EUR) rate set by the ECB. Talk to your finance/accounts dept. who are obliged to report this periodically. This fair market value determines the amount of tax you pay.

* The difference between the fair market value of the share and the strike price is essentially counted as income (not BIK, not CGI) when you exercise. In a lot of cases (Facebook, Twitter, Google, LinkedIn, Workday) the fair market value of the share was substantially less pre-IPO (12 months, 24 months) than post-IPO. That means exercising early in most of these situations would have been to your advantage if you were at these companies. Be aware you're completely subject to market risk here.

* Once you exercise the options and own the stock, then increases are subject to capital gains. An example here might be if the strike price on your options is $1, the fair market value is $2 & your company IPOs at some point in the future at $10. If you purchased options at the earlier milestone with a fair market value of $2 and sold at IPO, you'd pay 52% tax on $1 ($2 - $1) and CGT (30%) on $8 ($10 - $2). If you purchased at IPO and sold immediately, you'd pay income tax on $9 ($10 - $1). However, you need to actually hand over cash to exercise options and pay the tax, so be very aware that this is essentially now an investment.

* FX (USD/EUR) fluctuations can be just as important as stock fluctuations. Make sure you take that in to account. Right now, for example, this isn't quite in your favour, with the USD to EUR rate at high 1.35's/1.37's lately. Look at the currency history. You have options to sell and hold your money in USD (banks in Europe will typically open you a USD account) in which case you can hold until you believe the FX rate comes in line with what you expect. Again, you are subject to market risk here (your investments may go up as well as down!). In Ireland, gains via FX like this are also subject to CGT.

I'm not a tax advisor, but what I hope I'm convincing most people here is that if you do think you just hopped on a rocket ship (a Twitter, Google, Facebook) and you're a non-US resident with a reasonably significant amount of options (1,000+), I'd go talk with a tax consultant immediately and consider at least purchasing some of your options up-front if you've got cash that you're willing to bet with.

We've had a number of high profile IPO's here in Dublin recently (LinkedIn, Facebook, Workday & Twitter) so hopefully this convinces someone who jumps on the next one to go talk to a tax advisor.

Thanks for this, didn't expect to get advice for someone working in Ireland with options in a US company in the comments.

Just be aware I completely oversimplified the tax calculations here :-)

Happy to pass on details in Dublin for some folks I got advice from. I'll stick my email in my profile

So it's always better to own the stock ASAP (with risk of forfeiture) and get the 83(b) set up? Are most startups willing to arrange this for early employees?

You risk losing a lot with early exercise. The expected return on a $1 investment in option exercise is ??? hard to say.

What's even worse though is three years into employment deciding you hate your job and that you want to leave, realizing that staying and being alive are incompatible. And here we get real hypothetical ... you think the company has legs and that your stock might be worth something. But your strike price is $.05 per share and fair market value on Common Shares now is $1.50 per share. If you exercise your three years of options at this point hoping for the likely $10 per share IPO, you're stuck paying immediate regular income tax rates on your $1.45 per share immediate paper gain. And you may not have enough money to pay those taxes because they far outweigh your outlay for the stock exercise itself. And then you also risk the company going bust and you may end up with deducting max $3k/year in capital losses for the rest of your life.

That scenario is why I like buying up front in an early exercise.

In my last company I did the early exercise, though. And I stuck around for a long time. And that early stock was highly diluted and ended up being a small fraction of my overall stock option grant. I'm not sure it was worth it but we finally were acquired.

When it comes to ISOs, are there any tricks/loopholes to avoid the cash commitment required for early exercise but also somehow become qualified for long term capital gain tax treatment at the time of liquidation? I understand that is having one's cake and eating it too, but figured worth asking. Thank you.

Exercise early enough that the spread between your strike price and the value is small. :)

Wonderful comment. Please write a book so I don't have to search HN posts for nuggets of wisdom.

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