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Understanding Startup Offers

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. 

Stock Options 101

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.

Taxes 101

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.

Taxes at Exercise of Options

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. 

Taxes at Sale of Stock

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.

The Tax Treatment for ISOs: 

  • If >1 year since exercise date and >2 years since grant date, the bargain element is considered long-term capital gains
  • If <1 year since exercise date, the sale is a disqualified disposition and the bargain element is re-classed as ordinary income
  • There is no withholding on ISOs. You’ll also never owe FICA taxes on ISOs.

The Tax Treatment for NSOs: 

  • If >1 year since exercise date, the bargain element is considered long-term capital gains
  • If <1 year since exercise date, the bargain element is considered short-term capital gains. 

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. 

Managing Your Equity

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.

Early Exercising

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.  

Stock Option Expirations

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. 

Evaluating Your Offer

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. 

Key Details

Here are some of the key terms you’ll want to understand: 

  • The type (ISOs, NSOs, RSUs), quantity, vesting terms, and strike price of your options.
  • The latest 409a valuation, preferred price, and the total number of fully diluted shares
  • The exercise window and if you are able to early exercise your shares.

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).

Asking for More Information

Here are some additional questions you may ask to get key information:

  • What percentage of the company do my shares represent in proportion to the number of fully diluted shares outstanding?
  • What was the latest 409a valuation and when is the next one expected?
  • Have you raised capital with greater than a 1x liquidation preferences?
  • Do you allow for early exercise? 
  • What is the exercise window for employees?
  • Is there a double trigger clause? (If not, then the founder can restart your vesting after an acquisition.)
  • Can I sell my exercised stock on the secondary market? (Some companies don’t allow this.)

In analyzing the company, you may also want to consider: 

  • Is the company currently generating revenue? If not, when is revenue expected? How much? 
  • How much runway does the company have? 
  • Are there any founders who have left the company? 

As a reminder, every piece of your offer letter is negotiable. These are some excellent resources that detail the art of negotiation:

Email Template 

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.

  • What percentage of the company do my shares represent in proportion to the number of fully diluted shares outstanding?
  • What was the latest 409a valuation and when is the next one expected?
  • Have you raised capital with greater than a 1x liquidation preferences?
  • Do you allow for early exercise? 
  • What is the exercise window for employees?
  • Is there a double trigger clause?
  • Can I sell my exercised stock on the secondary market?

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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!

Definitions

  • Company Stock: There are generally two classes of private company stock: common and preferred. As an employee, your option grants you the ability to purchase shares of common stock. The price of the common stock is known as the Fair Market Value. 
  • Tax Exposure: You may owe taxes when exercising or selling your stock options. Tax exposure increases as the valuation of the company rises.
  • Early Exercise: Some companies allow you to purchase your unvested stock options. This is known as early exercising. Early exercising takes advantage of a low bargain element. If you exercise early enough, your bargain element will be close to zero and you will not owe any immediate taxes.
  • AMT Exposure: AMT is a parallel tax calculation that gets triggered when taxpayers have higher minimum tax than regular tax. When you exercise ISOs, you may trigger the AMT. 
  • Dilution: Dilution refers to a reduction in your ownership in the company as new shares are issued. When your company raises money from investors or issues stock options to hire new employees, you will be diluted. Dilution is not always bad — additional capital may be critical to fueling growth. 
  • Liquidation Preferences: The liquidation preference is a clause that refers to the ordering and amount of payment investors will receive during a liquidation event. It is expressed as a multiple (a 2x liquidation preference means the investor has the right to 2x her original investment before any founders or employees receive a cent). The multiple is generally 1 or 2x. 
  • '409a valuation explanation': The 409a valuation is an independent appraisal process mandated by the IRS. The Fair Market Value is determined by something called a 409a valuation. 
  • ‘Latest equity financing valuation’: The latest equity financing valuation is the valuation of the entire company. 
  • Exercise window: The exercise window, specified in your option agreement, tells you how many days to purchase any of your vested options if your employment ceases. Typically, companies either have 90-day or 10-year exercise windows but you should confirm in your contract.

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.

Disclosure
This material presented on Compound’s Manual is for informational purposes only and should not be construed as legal, tax, accounting or investment advice. Under no circumstances should any material on this Manual be used for or considered as an offer to sell or a solicitation of any offer to buy an interest in any securities or investment fund. The material on this website does not constitute, and may not be used in connection with, an offer or solicitation by anyone in any jurisdiction in which such offer or solicitation is not permitted by law or in which the person making such offer or solicitation is not qualified to do so or to any person to whom it is unlawful to make such offer or solicitation.Any analysis or discussion of financial planning matters, investments, sectors or the market generally are based on current information, including from public sources, that we consider reliable, but we do not represent that any research or the information provided is accurate or complete, and it should not be relied on as such. Our views and opinions expressed on this Manual or in any post content are current at the time of publication and are subject to change.