TL;DR Joining a startup as an early employee can be a great career hack if done correctly. Beating the odds and winning the startup game begins with understanding the compensation outlined in your offer letter. There are several key components—the type of stock options granted (NSOs, ISOs, RSUs, or RSAs), 409a valuation, preferred price, and the total number of fully diluted shares—that all have major financial and tax implications. Don’t be afraid to ask the founder or hiring manager for the information you need to fully understand your offer and to negotiate if you're not satisfied.
Editor's Note: Bolded terms are defined in the Definitions section below
The cleanest path to financial freedom is to join an established company, perform well, invest wisely, and coast to retirement. Breakout startups propose a hack—an alternative career accelerated through learning, wealth, and reputation. Most startups fail, though, and provide no financial return. (Even if a startup fails, it can be great fun and provide a tremendous opportunity for rapid growth.) Picking the right company is hugely important; you will want to scrutinize every aspect of this decision to the best of your ability.
One of the least commonly understood aspects of startups is compensation. Compensation is made up of several factors: salary, benefits, bonuses, and equity. Equity will be your largest driver of compensation at a startup. Thus, it is critical that you understand how your equity functions.
This guide explains how startup equity works, the basic tax implications, and how to evaluate startup offers.
DISCLAIMER: This material has been prepared for informational purposes only. Please read the disclaimer and consult your tax, legal, and accounting advisors before making any decision.
Early-stage companies often grant stock options as part of your compensation package.
A stock option gives you the right to purchase a fixed number of shares of your company’s stock at a predetermined price. Purchasing your shares is known as exercising the option and the predetermined price is referred to as the strike price or exercise price. You earn the ability to exercise your options over a period of time. This process, called vesting, follows the vesting schedule outlined in your stock option agreement. (A standard vesting schedule is four years, with a 25% one-year cliff.)
The pre-tax value of your stock options is simply the difference between the company’s share price and your strike price. For example, if the shares are valued at $10 and your strike price is $2, your option is worth $8. That difference, known as the bargain element, increases proportionally with the company's valuation growth. Importantly, you are only able to realize this value following an event like an Initial Public Offering (IPO), acquisition, or if your company facilitates a liquidity event. If your company goes to zero, so does the value of your stock options.
The two most common forms of stock options for early-stage startup employees are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). RSUs are also becoming more common for private companies. (We dive more into RSUs here in RSU 101.) RSAs are also a less common grant of company stock.
NSOs are common and the bargain element (spread between the company’s 409A and your strike price) is taxed at the same tax rate as your ordinary paycheck. Whether the company is public or private, you have to pay the taxes when you exercise the shares or have a same-day liquidity event. Your cost basis for the shares is then increased to the company's current 409A.
Only employees can receive ISOs, whereas NSOs may be granted to employees, directors, consultants, and advisors. Exercising an ISO does not create regular income, but may trigger something called the Alternative Minimum Tax (AMT). AMT is a parallel tax calculation that may apply when taxpayers have additional AMT income. Factors for calculating AMT may include ISO exercise income, QSBS AMT adjustments (other than 100% QSBS), and several other less common adjustments. (Read more on AMT here. We will also cover AMT in more depth in a future piece.)
Regardless, you may owe taxes at the time of your exercise, so you should do this analysis carefully before exercising your options.
You may sell any of your shares received as options following the lock-up period in an IPO, direct listing, or via a private market prior to a public listing if your company allows it.
For NSOs, you're taxed on the delta of FMV when you exercise (your cost basis) and the current FMV when you sell (your proceeds). For ISOs, you’re taxed on the delta between your cost basis and proceeds, but AMT may also apply as previously mentioned. For AMT, you’re taxed on the delta of FMV at exercise and sale price. The exact AMT calculation is based on your specific circumstances and based on this complexity, we recommend you consult with your tax advisor.
The length of time between the exercise of your options and sale of the stock you received determines whether you are taxed at the ordinary income tax rate (i.e. the short-term capital gains rate) or the more favorable long-term capital gains tax rate.
QSBS is another factor you might want to consider. Check out our Guide to QSBS here.
The Guide to Equity Compensation explains many of the other relevant federal, state and local (i.e. NYC) taxes, including the Ordinary Income Tax, Alternative Minimum Tax, Net Investment Income Tax, Social Security Tax, Medicare Tax, and Capital Gains Tax. Consult with your tax advisor to determine an optimal strategy for your particular situation.
Once you accept your offer, you should begin thinking about how to manage your equity. Many people are put in difficult situations when their equity becomes valuable or liquid.
The most important question you will eventually need to answer revolves around when you should exercise your options.
If you are very optimistic about the long-term value of your equity, you should consider exercising your options as early as possible to reduce tax exposure and maximize your optionality. Due to how taxation is handled on options, and the extended timeline under which companies are taking to go public, an increasing number of companies are allowing employees to purchase all of their unvested stock options up-front. This is known as early exercising. If you exercise early enough, your bargain element will be close to zero and you may not owe any immediate taxes.
The longer you wait to exercise, the more information you can accumulate about the likelihood and magnitude of a potential exit opportunity. This is valuable—startups are prone to failure and success is hard to predict. At the same time, waiting to exercise may increase your exposure to AMT and the likelihood of a disqualifying disposition if your options are ISOs. Additional external factors, such as dilution and liquidation preferences, may also impact your decision.
Unfortunately, you can’t delay the exercise decision indefinitely as US tax rules mandate that employee stock options expire 10 years from the date of grant. Traditionally, option agreements typically specify that you have a 90-day window to purchase any of your vested options if your employment ceases. (Anything that expires will be returned to the company.) The reason is that by law all ISOs will automatically become NSOs within 90 days of termination of employment. With this short of a window, you will have just three months to figure out how and if you should exercise your options. Exercising can be costly not just in paying the exercise price, but also in the resulting tax obligations. More recently, some companies have adopted a longer post-employment exercise window up to 10 years, but you should be aware that your ISOs will convert to NSOs after 90 days regardless once you leave the company.
Again, consult with your tax advisor to determine an optimal strategy for your particular situation.
Your offer will specify details about your position such as your role, title, and level of seniority. It will also outline your total compensation package including your annual cash salary, any bonus incentives, and your equity compensation.
The details of your equity in the offer letter can often be confusing. Startups rarely provide all of the information you need to make an informed decision.
While it can be intimidating, you should not be afraid to ask clarifying questions of your future employer to fully understand it. You are a coveted asset—by the time a company has made you an offer, it has likely invested thousands of dollars in your recruitment—it is your right to get this information.
Here are some of the key terms you’ll want to understand:
Some companies may be unwilling to provide you with this type of data. This is generally a red flag and you should carefully consider their offer and the viability of the company. Another approach can be to ask them to walk you through how much money you would make if the company were to exit for [$100m, $500m] (including liquidation preferences).
Here are some additional questions you may ask to get key information:
In analyzing the company, you may also want to consider:
As a reminder, every piece of your offer letter is negotiable. These are some excellent resources that detail the art of negotiation:
Thank you very much for providing the offer letter! I remain very excited, but have a few questions to help me fully understand the offer.
Startups are a long-term game and there are surer ways to get rich. Remember—no one besides you knows what is really best for your particular situation. Do your own research before making any final decision. But if you do choose to go the startup route, winning starts with understanding the offer in front of you. Good luck and enjoy the ride!
DISCLAIMER: This material has been prepared for informational purposes only and is not intended to provide or be relied on for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before making any decision. The information contained herein is general in nature and based on authorities that are subject to change. Compound Financial, Inc. assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.