1. U.S. tax law requires that incentive stock options (ISOs) have a 90-day termination tail on them - that is, the options do not qualify as ISOs if they are not issued under an enforceable agreement by which all vested options must be exercised within 90 days of termination of employment or expire.
2. As a direct result of point 1, the near-universal practice that startups use when issuing stock options is to require employees to sign documentation by which they agree that they lose even their vested options if they do not exercise them within 90 days of their termination date.
3. The original idea behind ISOs (the reason for distinguishing them from "non-statutory" or "non-qualified" options) is that they can be exercised at any time after they vest without triggering ordinary income tax for the exercising employee at the time of exercise (subject to certain monetary limits).
4. However, the "benefit" note in item 3 above, though a very real benefit in days gone by, is often illusory today because the exercise of ISOs requires that the amount of the spread (difference between exercise price and fair market value of the stock at the time of exercise) be included as an item of AMT - meaning that a so-called "ISO" exercise can result in a huge AMT tax. What this means is that an employee holding vested options in a startup whose value has risen greatly faces a dilemma. "Do I exercise now, pay a huge tax, hold only a piece of paper that may or may not be worth anything down the road, and hope that the stock price holds? Or do I wait until a liquidation event, exercise at that time, and thus eliminate the large tax risk of exercising before that time?"
5. Of course, many such employees chose to wait. If you cannot sell your stock right away, it is a very high risk to pay a massive tax on an option exercise only to wind up holding illiquid stock that may become valueless if things don't go right. This is no small issue. People committed suicide during the dot-bust era a decade or so ago after having made the wrong decision.
6. The problem is exacerbated by the 90-day expiration rule on employee termination. It is one thing to wait and wait until the liquidation event. But what if it is a long time in coming? Many employees are trapped in their employment when they face the above dilemma because leaving their employment will force them to exercise or lose potentially valuable options if they don't exercise within 90 days of termination. Even worse, if their employment is terminated by the company, they are put in the horrible position of losing something they worked very hard for because of a seemingly arbitrary and stupid rule saying that the options expire within 90 days of termination.
7. Well, guess what, the rule is stupid and arbitrary in many ways. Why? Because, though the law requires that it be made part of any ISO grant, this does not mean that the startup cannot modify the agreement for the benefit of the employee to eliminate the 90-day expiration provision and to give the employee room to exercise for an extended period. What happens when the company does this in spite of the tax rules? Well, it means that the option loses its character as an ISO. But it does not lose its character as a legally enforceable stock option. It just means that it is taxed as an NQO (non-qualified option). So, in a worst case, the employee exercising an NQO gets immediately taxed on the spread at the time of exercise. But, if that modification gives the employee the flexibility to carry the options unexercised but exercisable for a period going well beyond the 90-day period currently defining expiration of such options, the employee can leave employment, hold the options, and wait for such extended period (e.g., the 7 years discussed in the article here) before deciding whether to take the tax risk of exercising and holding illiquid shares. And, if, in the interim, the company does have a liquidation event, then the employee's dilemma vanishes and he can exercise and sell right away in order to make the profit and pay the associated taxes.
8. The net result of the startup's agreeing to eliminate the 90-day provision is that employees need no longer feel trapped in their employment once their options have vested when the stock price becomes high. They can leave and still keep the option of cashing in on their hard-earned options.
9. So why don't most companies agree to such modifications? Their lawyers will tell you that the law requires the 90-day rule and this is true but misleading because that requirement can be violated in a lawful way that simply changes the character of the options. Thus, if the parties can live with the change, why not do it routinely? Well, I leave it to everyone to draw his own conclusions. Perhaps startups want to keep their employees trapped. Perhaps they are just listening to lawyers who insist on following the rules. Or perhaps a board of directors does not feel it consistent with fiduciary duties to give employees something that appears to be a gratuitous modification that does not benefit the company. Whatever the reason, it remains true that most startups choose to leave their employees trapped in this dilemma without even giving them a good explanation beyond the fact they agreed to the condition and that the the tax laws "require" it.
In any case, kudos to Pinterest for doing the decent thing here. It is indeed all too rare to see something like this and they are to be congratulated for it.
"Phantom stock grants and vesting agreements align employees' motives with owners' motives, i.e. increasing stock prices, while avoiding both taxable compensation and the need to give recipients voting or other rights typically associated with shares."
AMT helps the government get paid sooner than later for fast-growing companies. This mechanism doesn't have to affect non-C-level execs to be effective.
For non UK residents the first $16k of CGT in a year is not taxed.
Of course, it's very early stage companies that you really want options in...
This movement only makes me appreciate the management and culture of Pinterest; quite the opposite of the Zynga fiasco 
But the vast bulk of it was clearly exploit prevention "code". You can quite clearly work out what the scam was that caused each of the overly specific rules. This makes it somewhat irreducibly complicated.
Basically, you have the option of $250k annual liquid compensation from GoogFaceSoft and a low stress & time working environment. Vs. random startup that if it hits it big, you would make more than that amount and have more fun doing it.
Now you starting hearing stories that equity compensation isn't so great:
1. Companies take far longer to get to IPO now. You might not be able to liquidate your stock until 7+ years later. They also don't like it when you try to sell in between.
2. Companies play take back games with dilution, zynga style threats, or even just pure stock buyback options at the original / FMV strike price like Skype.
3. VCs play take back games with liquidation preferences & more.
4. There is this AMT headache that can be double or more than your strike price cost. Founders have 0 AMT, 0 strike price cost, and long term capital gains tax rates!
5. You soon realize it's %70 investors, %15 1 or 2 founders and %15 all employees on a power law! If your facebook then maybe %20 founders, %20 employees. Why become an early start up employee who works just as hard with %0.5-%0.01 when you can be a founder? Thus the 'glut' of start ups with angel rounds.
You have overpriced mortgages & rent to pay in the bay area, so money is important.
I would turn the point around and start from here. GoogFaceSoft is great comp low stress environment only close to headquarters.
In most other places GoogFaceSoft engs are the guy the headquarter outsourced to, and that is a dramatic shift in stress/job satisfaction.
Bottom line, talent is everywhere, if the product is solid investors will find you; if the startup is focused on angels/exit instead of great products then, well, that's why people want no part in it.
* asking an employee to give up a certain number of options
* firing the employee, making further option vesting impossible
By not firing immediately and by not requesting 100% of options be cancelled out, Zynga was actually playing nice. If you were among people affected by that offer, the writing as far as future career prospects at Zynga was on the wall.
If someone had $1M in unvested options, and you ask them to renegotiate for $200k and keep them there as an employee, that's really tone deaf. Do you really think that employee is going to give their best efforts after you just cheated them out of $800k?
From strictly rational perspective, choosing between two messages - "you're costing the company too much, therefore we're reducing your package" and "you're costing the company too much, you're fired, Jonathan will walk you from the building" - is a no-brainer for employees.
Is it really a negotiation mistake, rather than a result of growing valuation?
The point of stock options is to grant and receive them early at a low price. There's a good chance that they won't amount to much, but there's also a hope that they will be worth a lot. That's the entire point of accepting stock options over salary as an early employee.
But if stock options are likely to be cancelled if they appreciate in value, then their expected value quickly falls to zero, and it would make more sense to just offer yearly cash bonuses instead.
Probably not. But you've just saved enough for ~3->5 person years of work. Hire new employees!
I wouldn't work for such a company unless the alternative were starvation.
That's not why Zynga did it. They weren't playing nice, they wanted people to stay on with a reduced compensation.
Going in, a startup employee gets some stock (upside) in exchange for risk (downside). Zygna used their relative power to reneged on that agreement to capture the employee's upside. "You can give us your money or we can take it AND fire you. Hey, but its your choice."
They were in no way being nice.
Not that you were, but that episode always seems to be painted as though Pincus were yanking options away from sub-$100k/yr employees in the trenches.
disclaimer: I'm not defending Zynga in general, nor am I trying to take the shine off of Pinterest's policy.
Zygna isn't the only one that did this. Didn't Facebook also do this?
(So in a startup, you can be screwed with options in three ways. If the startup fails, your equity is worth zero. If there's a low-value buyout, the common shareholders can get nothing. If the startup is wildly successful, the company will claw back your unvested options. Why join a startup for equity if you're going to get cheated when you hit the 100x home run?)
Zygna got what they deserved. With changes to the way Facebook promotes their feeds and the switch to mobile, they lost most of their market.
What would be even better is if smaller companies / start-ups just did 83(b) elections up-front (say on day one or year one upon cliff). Another (for larger companies) option is to just offer RSUs.
The bottom line is that opportunities via tax law complexity are not particularly motivating to the majority of employees (i.e. ICs), and yet ICs are the most likely to suffer near-bankruptcy due to unexpected income tax. This is a nice step in the direction of transferring deserved wealth from 'the top' to ICs, but there's still plenty of progress to be had.
Let's say you join a startup that the IRS can claim is worth $20M (based on e.g. money raising valuation), and get 1% in RSUs worth $200K - depending on your other income that year, the tax bill can easily be close to $100K (if you made $100K in salary and live in NYC) for doing an 83(b), and it is still likely to be worth zero being a startup.
And before you say "the fact it raised $2M on $20M makes preferred reflect that value, not common which is still worth zero" - that is a common position, and the IRS almost never challenges 83(b) election valuations - but are you willing to risk that they won't start challenging them? I gave up more than one offer because I wasn't.
The bottom line is that the US tax system's taxing of virtual, unrealized, unrealizable profit is insane - I am not aware of any other western country that does that.
Agree that the taxes on unrealized gains are insane, but they were intended to protect the government's income source from different problems. Tech compensation and VC has evolved dramatically since AMT was introduced.
And I think sanity should not be judged by intention, but rather by action - especially when we've had more than 40 years to evaluate.
edit: added link; thanks, choppaface
The value of startup equity, given all the risk factors and historical outcome data, is extremely low. It's usually easy to show that an entire startup is worth less than $1K. Using 83(b) to pay tax on the equity FMV when awarded rather than when vested/exercised/etc can make a big, big difference. If you win the equity lottery, that is.
I was giving the choice and I elected 1/2 RSUs and 1/2 stock.
The advantage is seeing how well the stock performs, then performing the exercise. If the company has gone public, then no real money needs to be put up by the employee; Exercise and sale can occur in one fell swoop.
You lose the reduced taxes of long term capital gains if you wait, for whatever reason, to exercise and sell the same day. You have to hold the shares for 1 year + 1 day from the day you exercise for the subsequent sale to be taxed as long term capital gains. For even the top tax bracket, the difference is 20% in taxes.
To add insult to injury, many got nailed by AMT at the point of exercise. By the time they figured this out, the entire grant would not cover the bill to the Feds.
Disclaimer: I'm with EquityZen. EquityZen helps employees get liquidity for some of their options/shares before the company exits, so not only can they afford the exercise, but also finance life events.
As has been discussed before it's not the mechanics that matter here, but rather the psychology of founders.
More often than not, there is the belief that even if you've been an employee for 2+ years, if you're not "in it for the long haul" then you don't deserve to hold on to your equity without paying for it in cash (or taking the tax hit).
Not to mention there's very little incentive to amend these policies outside of generating general goodwill.
There is now an incentive for other companies to follow suit since savvy employees will value offers from Pinterest and other companies with this policy much more highly.
It's rare that a company like Pinterest breaks ranks on things like this. I hope they get a lot of goodwill from employees and applicants as a result.
If he exercises now, he only gets the raw value (current price - strike).
If he waits to exercise, he get the time-value of money and implied leverage (he doesn't have to cough up the strike until he exercises), and the optionality part (if Netflix goes below the strike, he can decline to exercise).
He also can hedge by short-selling (and lock in a sure profit no matter what), but you'd need a big-value account at a brokerage to hedge on favorable terms.
It's interesting, because I thought about this. When I worked for the company I wasn't allowed to hedge, because you can't buy shorts in the company you work for.
Now that I'm out I can, but the problem is, the company gave me such good options there is no way I can buy an opposite option for the hedge. For example, there is no retail short for more than two years, but my options still have between 6 and 9 years left.
Also, don't write covered calls, that gives up too much upside. Instead, sell outright.
But then again, if he exercises in one year and does not sell that year, he gets the tax bill in the exercise year, potentially with no way to cover it.
It's a lot more complicated than it should be.
I probably won't look for something new for a while.
Financially, the move hasn't made a lot of sense. We moved to a cheaper country and we've not been short of rent/food/baby clothes etc, but I have drawn down quite a lot on my capital.
Nonetheless, I am 100% positive I made the right decision. I expect to look back in years to come and be grateful of being able to spend so much time with my newborn.
Everyone has been very supportive of the idea!
> There are some tricky issues around this—for example, the options will automatically convert from ISOs to NSOs 3 months after employment terminates (if applicable) but it’s still far better than just losing the assets.
I've never run the numbers, but my impression is that the AMT level is low enough that AMT will be triggered for any exercise where the number and value of options is meaningful.
>but the possibility of paying no tax is a benefit over NSOs whose gain is taxed as regular income and is subject to tax withholding.
It's not "no tax". It's "deferred tax". But again, in the real world of 6-figure salaries and big mortgage interest deductions in Silicon Valley, the deferral is probably mostly theoretical. Whereas the time limits on ISOs are real and unavoidable.
You might be able to stay out of AMT by splitting ISO exercises across multiple tax years, but that's splitting hairs. You make a good point that this discussion is most interesting in cases where you'd likely be in AMT anyway.
If NSOs are granted with a strike price equal to FMV, there are no taxes due until exercise. If granted at a discount, taxes are due on the difference between grant price and FMV.
Pinterest seems to recognize that if you put in two years at an early stage of the company you deserve to share in future financial success.
I wonder why they made this move now? Specifically, I wonder if it came from the executives, investors, or both?
My impression is that companies rarely sell common stock to investors for that reason (among others). Since investors valued the preferred stock, common stock holders can ignore their massive valuation for tax purposes, and use the 409a.
Does anyone who has found buyers for their private stock without the company's blessing care to post about their experience? Any recommendations for brokers or investment groups that engage in such transactions but aren't predatory? What snags did you run into and how long did the process take?
If you are very early, when the company is worth nothing, then the company can give you a big chunk of stock with no tax consequences. But once the company is worth something, then getting the stock is income, and you have to pay taxes immediately on the market value. It's not as good from the company tax perspective, either.
It's also a problem in that if the stock is already valuable, giving you the stock is the wrong reward structure. Companies are giving you options so that you have an interest in the stock going up. Suppose when you show up the share value is $40 and they give you 1,000 shares. if while you're there the stock goes up to $60, you will have received something worth $60,000, even though you only contributed to creating $20,000 of that. With options, they can give you 3,000 options with a strike price of $40. If the stock goes up to $60, then you still make $60,000 ($20 gain * 3000 options). But if it doesn't go up at all, then your options would be worthless.
That's an interesting way to think about it, but as long as the employee is getting a base salary, the employer couldn't justify granting enough options to achieve this goal of compensation being equal to (theoretical) value added.
If we consider base salary fixed, then options are more leveraged, but a similar reward structure could be achieved by granting the same number of RSUs and reducing base salary by the exercise cost.
Despite that, the US IRS will want you to pay taxes on the current value of that stock in cash this year. The IRS doesn't care that you don't have the cash. And, they don't care that there's a very large chance the stock will turn worthless before you can sell it for cash.
Options however are not taxed until they are exercised. In practice, exercised options are usually converted directly to cash. That makes paying the taxes much easier. And, if the company folds you get nothing, but at least you didn't pay taxes up front on a stock that turned worthless.
So, it's a bit complicated, but options are usually more friendly to employees than direct grants in general. Details in the options like "What happens to my options if I leave the company?" are important. They can also be complicated and possibly employee unfriendly. I'll leave the discussion of that detail to the rest of the crew here.
If Joe Schmoe leaves the company with, say, .05% of the company, and in 7 years those shares would be worth $25m or something, wouldn't the company want to dilute that person out in order to give their current employees value?
I guess I don't really see what the big deal is on this. It would seem to me that the company would aggressively issue more stock to ensure that anyone who left the company 7 years ago couldn't possibly control more stock than current employees.
Makes no sense to me, but is this a real possibility?
It certainly depends on how much risk you're willing to take on though.
The employer benefits from having the options expire because people will be less encouraged to leave with the current standard of expiring options.
Now, consider this policy instead. You'd get a feeling of "I could leave if I really wanted to, nothing is tying me to this place". You get a greater feeling of agency, of personal freedom. That relaxes you, and you feel more comfortable staying with the company.
You don't get stuck with an unmotivated employee who has checked out but can't access his options in liquid form.
This is not an infrequent problem in startups. The folks who "storm the bastions" early on often do not have the skills nor the desire to be a "well-behaved corporate citizen" for IPOs and such.
- people will be less encouraged to leave with the current standard of expiring options.
- people who have checked out mentally will not be forced to stay with the company for financial reasons.