Conventional wisdom says that startup equity is worthless. While most startups fail, there’s a chance your equity will become a life-changing pot of money. This guide explains how to make the most of your equity.
Suppose you join a Series A startup as the fifteenth employee. A few months in, and you’re feeling incredibly optimistic. Customer demand is skyrocketing; you can’t seem to build quickly enough to meet their needs. The startup has added six new employees since you joined and is frantically recruiting more—you’re already a “senior employee!”
You’ve been offered the opportunity to “early exercise” all of the stock options you’ve been granted. This will cost you $40,000.
It sounds expensive (and it is!) but say that, two years from now, your company reaches a billion dollar valuation—it’ll then cost you upwards of $400,000 to exercise this same tranche of stock options and cover all of the tax obligations.
Silicon Valley is full of stories where startup employees miss out on material tax savings, on the order of hundreds of thousands, sometimes millions of dollars, because they ignored their equity compensation until it was too late. This guide helps you strategically maximize your upside as an early startup employee at a fast-growing company.
Your stock options represent the right to purchase shares of your company at a fixed price, known as the exercise price. You earn the right to exercise your options over time through a process called vesting, the timeframe of which is stipulated by a vesting schedule. There are two types—ISOs and NSOs—and early-stage companies will typically issue a mix of both to their employees.
For each tranche of options that you’ve been issued, be aware of three key numbers:
On a high level, here is the difference between ISOs and NSOs:
Upon exercising your ISOs, you will likely qualify for the Alternative Minimum Tax, or AMT. Back in 1969, 155 individuals with incomes over $200,000 managed to pay zero federal income taxes, triggering popular outrage. The AMT was introduced to prevent this from happening again.
The AMT is calculated based on the bargain element: the (409A value - exercise price). You owe AMT if:
You will have to pay AMT when you file your tax return for the year that you exercise your ISOs (it is not withheld at the time you exercise), so make sure to plan accordingly.
Upon exercising your ISOs, you pay AMT. Then, when you sell those shares, you’re taxed again on your capital gains. To lessen the blow of thus being taxed twice on ISOs, Congress introduced AMT credits.
Suppose you paid $5000 in AMT in 2019. In any subsequent year where you don't owe AMT (say, 2020), you might be able to get back some or all of that $5000. There are a few conditions for getting this tax credit:
There are many other caveats that may warrant speaking with a financial advisor. But the bottom line is: you may want to try to strategically maximize the amount of AMT credit that you can claim later. Or, you can limit the number of ISOs that you exercise and stay below the AMT exemption amount (thus avoiding the AMT altogether).
RSUs turn into shares of your company’s stock when they vest. They’re typically issued by companies valued at over $1 billion.
RSUs are subject to either single- or double-trigger vesting. Single-trigger RSUs can vest before IPO. This means you’ll owe taxes on them as they vest (because you’re coming into ownership of new shares of stock). However, if the company is still private, you won’t be able to sell those shares to make money to pay the taxes you owe on them.
That’s why many companies instead offer double-trigger RSUs, which only vest after the IPO. That way, you’ll only owe taxes once the company is public and you can actually sell those shares. So, for the year that your company IPOs, be prepared to pay taxes on any double-trigger RSUs that you vest. Your RSUs may vest either on IPO day or after the lockup period, depending on the company.
When your RSUs vest (whether before or after IPO), you’ll owe ordinary income tax on the 409A value of your newly issued shares as of that day. As a reminder, the 409A value after IPO is equivalent to the company’s public stock price. Then, when you sell those shares, your profit (i.e. [sale price - 409A value as of the day the shares vested]) will be taxed as capital gains. Again, these qualify for long-term capital gains tax treatment if you hold onto the shares for over a year.
You can actually exempt your stock from all the federal taxes we’ve discussed above, if it counts as qualified small business stock (QSBS). Your stock might qualify as QSBS if:
Exercising your stock options represents a high-risk, potentially high-reward investment in your company. At a high level, here are the pros and cons of making such an investment:
With the 409A rising, you’re incentivized to exercise sooner rather than later. Furthermore, your options do expire eventually, so you can’t put off exercising them indefinitely. This will kickstart the long-term capital gains clock and break your golden handcuffs. The term golden handcuffs refers to compensation incentives that discourage you from leaving your company. While your equity may pose a large reward, if you cannot afford to exercise it, you’re monetarily encouraged to stay at your company until at least the IPO.
Investing capital into stock directly tied to your single source of income greatly increases your overall concentration in a risky, illiquid asset.
To answer the question of whether or not you should exercise, consider the following:
Your liquidity constraints will limit the number of options that you are able to exercise. To determine these constraints, audit your personal finances. Consider metrics such as your current liquidity, movable assets, near-term liabilities, and financial goals.
Cash flow timing plays an important role, as startups often take 5-10 years to exit (if ever). Investing in your startup therefore comes with a significant opportunity cost: you could deploy this same capital into other opportunities (e.g., public stocks or real estate) that could generate steady, dependable returns over the course of those 5-10 years. You’re really looking to come up with a projected, probabilistic return on investment for exercising your stock options (and compare that to your broader financial picture).
In deciding how much of stock to purchase, you are essentially quantifying your level of optimism in your company. While you’re unlikely to have access to every line-item on your company’s income statement, you do likely have access to key figures (e.g., revenue trends) to inform your analysis. In the end, you need to form your personal investment thesis—Why will your company win? What will prevent you from succeeding? What’s the best case scenario?
At the same time, keep in mind that even startups with the most seemingly promising trajectories can stumble. WeWork is an obvious example: in early 2019, it was valued at $47 billion and was filing for an IPO. By the end of the year, its valuation had dropped to $8 billion. Pebble went from a $740 million valuation in 2015 to $40 million by 2016. Juul went from $38 billion in 2018 to $12 billion in 2020. Employees who exercised their options at the higher valuations fell out of the money (and overpaid in taxes).
To quantify this decision, let’s explore another example.
Here are the various strategies you can try:
The table below estimates the hypothetical costs of exercising now, in 3 years, and in 5 years.
Importantly, these projections assume a successful outcome for your company and don’t account for relevant factors such as dilution, timing, and liquidation preferences. Early exercising performs worse than doing nothing in the event your startup fails. Exercising your stock options is making an investment in your company. You are betting on its future performance and if it fails, you will lose your principal investment. Consult your financial and tax advisers to make the right decision.
Deciding when to exercise is also a matter of timing. How soon do you need liquidity? It’s often possible to sell some of your equity before your company goes public (or gets acquired).
From time to time, your company may hold what’s called a tender offer. In a tender offer, some cohort of shareholders are given the opportunity to sell their shares for a set price per share. Most companies irregularly hold tender offers (once every couple of years), and generally restrict them to current employees who’ve reached some level of tenure. Deciding whether or not to opt-in the tender offer has trade-offs—every share you sell is potentially worth more (or less) in the future.
A number of secondary markets make it possible to sell shares to independent investors. There are also funds and brokerages designed to help you get financing to exercise your options. It’s not guaranteed that you’ll be able to participate in either of these vehicles; it depends on factors such as transfer restrictions, timing, and demand from investors.
No matter what, early-stage startups are inherently risky. You could end up with a life-changing pot of money in five years, or your equity could end up being worthless. Furthermore, along the way, funding rounds and 409A re-evaluations can occur and change your financial situation at any time without warning. In light of this risk and uncertainty, it’s crucial that you take an active role in managing your equity strategically from the start.