Guide to Understanding Your Job Offer with Stock Options. congratulation! You have just landed your dream job. However, you may have a bigger puzzle to solve. Your compensation package includes a combination of basic pay and stock options. The news is exciting but also a bit confusing. What does owning stock options mean for your finances and career prospects?
The rules for stock options can be quite complex. Early decisions can affect your future earnings and tax burden to a great extent.
In this article, I try to understand some important points you should consider before accepting a job offer with stock options.
What are employee stock options?
Employee stock options are a type of equity compensation. Many employers and startups, especially in the tech and biotech spaces, use stock options to reward and retain talented employees in a competitive recruitment environment.
Options give you the right to buy shares of a company at a specific exercise price during your employment period. By exercising your stock options, you will become a shareholder of your company and participate in the future success.
Being a shareholder of a successful company can be a guarantee of your future financial prosperity. However, owning stock options and company shares will require a lot of tax and financial planning.
What type of stock options – NSO or ISO?
There are two main types of employee stock options — incentive stock options and non-qualified stock options. I have written two articles explaining each type.
- Click for Incentive Stock Options Here.
- For non-qualified stock options, click Here.
Comparing the two types, ISOs generally have better preferential tax treatment over NSOs. Using an ISO does not create taxable income, but depending on your total annual income, you may have to pay an alternate minimum tax. The IRS allows you to treat your total received gains as long-term capital gains as long as you hold your shares for 2 years after the grant date and 1 year after exercise.
For comparison, the NSO exercise will automatically trigger a taxable event. You will have to pay income tax immediately on the difference between the fair market value and the exercise value.
Another important difference between the two types is that ISOs can only be awarded to employees. Conversely, companies can provide NSOs to both employees, vendors, and other third parties.
What is your share in equity?
Your job offer will include a unique number Once you have exercised your stock options, you can have as many shares as you can. As high as this number may look, knowing your percentage share is much more important. You need to ask your prospective employer what the total number of outstanding shares of the company is. Your number of shares divided by the total number of shares in the company will give your stake in the company. Also, keep in mind that your employer may issue new shares to outside investors and VCs in the future, which may be vulnerable to your ownership stake.
This information is important, especially if you are joining an early stage startup where the number of shares may initially be very liquid.
Receiving an option grant does not immediately make you a shareholder. You can exercise your stock options only once when they are vested. Vesting represents a transfer of ownership from your company to you. Your employer will give you a vesting schedule with a range of dates. On each date or anniversary of employment, you will receive ownership of a specific lot or percentage of stock options.
keep in mind that you must exercise Your stock options for owning the company’s shares. Non-exercise options can potentially expire, and you will lose your ability to be a shareholder.
The strike price or exercise price is the price at which you can buy shares of a company after exercising your stock options. You will be responsible for buying the shares. Fortunately, most startups set the strike price near the $1 range. And most likely, the total cost will be deducted directly from your paycheck. The strike price is important because it will set the stage for your tax payable based on the type of stock option you have.
fair market value
Fair market value (FMV) is the price at which your company’s shares are valued at any given time. Your employer must provide you with the fair market value at the time of stock option exercise.
The FMV of a publicly traded company is straightforward. This is usually the market price at the end of the day on the stock exchange.
However, obtaining the FMV of a private company can be difficult. You won’t have a publicly available value. For this reason, startups will employ third-party experts to calculate FMV based on recent rounds of funding, comparable company analysis, discounted cash flow and expected revenue growth projections.
When evaluating your job offer, you can ask whether your employer will allow early exercise of your stock options. Under IRC 83(b) election, you can exercise your stock grants early and recognize them as compensation. This choice can potentially save you taxes in the long run. Early practice is especially beneficial for employees and founders of early-stage startups. By choosing the early exercise, you just pay income tax at the lower fair market value. No income tax will be payable at the time of vesting. When you sell your shares, you must pay capital gains tax on the difference between the sale price and the opening exercise price.
Liquidity and exit strategy
If your prospective employer is a public corporation, you can easily sell your shares when you exercise. Selling shares can help you pay taxes on your earnings and diversify your investments.
The liquidity challenge arises when you are working for a private company. There will be no public market for the stock. You should plan to hold your shares for a long period of time. In addition, exercising stock options can trigger something taxable, which you must cover with your personal savings.
Vesting if the company is acquired.
Often startups are acquired before they go public. Before accepting a job offer, you’ll want to know what will happen to your outstanding shares and stock options upon acquisition of your company. In the most likely outcome, the acquiring company will liquidate all of your shares and options. It is also possible that the acquiring company will exchange your employee shares and stock options for itself.
What happens to my stock options if I decide to leave the company? Typically, you will have 90 days from your departure to exercise your vested stock options. Unfortunately, you will lose any uninvested stock options. It will be up to you to keep or sell any outstanding shares of the company.
Finally, let’s talk about taxes. You will be responsible for all taxes resulting from exercising your stock options and selling your shares. Depending on the exact option type, you may be liable to pay ordinary income tax, short-term, long-term capital gains tax or alternate minimum tax.
In some cases, when exercising an NSO, your employer will automatically sell the shares to cover all federal and state income taxes. In other cases, especially in the case of private companies, you will have to pay taxes directly from your bank account.
Stock option taxes can be complicated. You may face several scenarios depending on the success of your company. I strongly encourage you to stay proactive and work with an experienced CPA or financial advisor who can guide you through the tax planning process.
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