Understanding Your Company Stock Options

David Barta, CFP®, CFA®
24 Jun

When it comes to dealing with your employer stock options, you’ve got options. Let’s unpack what stock options are and a few general suggestions to make the most of them. We are not CPA’s therefore for specific guidance on your situation we highly recommend speaking with a tax professional. 

What are my Employer Options?

While employer options may come in a few different forms the most common is formally known as “Incentive Stock Options” (ISOs). These are given to you as a benefit by your employer to ideally participate in the future growth of the company. These options typically vest (vesting is when the shares officially become yours) over a number of years. When vested, you have the option to buy equity in the company at a discounted rate (the strike price). Then when you sell the equity (after an IPO, in a private equity market like EquityZen or SharePost, or back to your company) your profit will receive tax-beneficial treatment (if you meet a few requirements). 

A standard 4 year vesting schedule with 1-year cliff for 10,000 shares would look like this:

This shows you that for the first year of service you own zero options. Then, on your first anniversary, you will receive 25% of the shares you were granted and then incrementally more over the coming months until you reach 4 years. If you leave your company at any point before the 4 years, you lose any unvested shares. 

How do I determine how much my options are worth? 

It’s important to note that in order to exercise you have to purchase the shares. Yes, this means that depending on how many options you have you may be required to invest tens of thousands of dollars. For some, this just isn’t feasible when you first receive shares so you will need to exercise over time as you save up. 

Additionally, when you purchase those shares it is possible you won’t get that money back. When you invest in the company by exercising your options you are hoping that the value of the company, and therefore their stock, will appreciate in value. If you are being granted shares early on in a company’s life the strike price is quite low, however, as the company ages that strike price should get higher. It is possible that a company goes public and/or is acquired for a price below the strike price especially if you were granted those shares close to an IPO or acquisition. Your strike price will not change, however, if your company continues to grant you new shares, those new shares will be at the latest strike price.

At times, when someone leaves a pre-IPO company, they will decide not to exercise because they don’t feel the company is heading in the right direction. This decision is up to you but just like any investment, you have the ability to make money or lose money. 

When we talk about the “current value” of the stock it may make sense where to get that value when the company is already publicly traded. But what about pre-IPO companies? If the company has not gone public, the price is likely based on the latest 409A appraisal. You will see a new valuation occur around each round of fundraising and it’s important to pay attention to the new value. The 409A appraisal, like a stock value on the public exchange, will tell you the current value of your equity, per share. 409A appraisals are done by an independent party and are presumed to be a ‘reasonable’ valuation of the equity by the IRS. If your company gets acquired, however, the price per share will be negotiated into the deal and you likely won’t have any advance warning about what that price might be. 

If I have vested shares when should I exercise?

When to exercise is based on a number of factors, part of which are out of your control. Before we go through a few scenarios it’s important to note that employee shares are usually restricted from being sold in the first 6 months after an IPO. Typically when this lockup ends, there are more sellers than buyers (employees offloading their shares) which may drive the price down. It’s usually about 3 months from the time a company files with the SEC to go public and when the shares trade publicly. 

In almost ALL scenarios it’s important to work with a tax professional in the year you exercise. Everyone's tax situation is unique and that impacts how much you may ultimately owe. If you don't use a professional you may not account for all areas of tax and end up with a large tax bill you can’t afford. More on taxes later in the article. 

Now, let’s go through some of the scenarios you could run into with your options. 

If your company is public and you still have unexercised options, be careful of having too much of your assets in this one stock. You may want to begin exercising incrementally so you can begin to diversify your portfolio by selling existing shares. 

If your company is about to go public we would probably recommend exercising around the date your company files with the SEC (if you can cover the AMT payment next April with your current assets, more on this below), or waiting til the following January (to be able to use future proceeds to cover your AMT). 

If your company is not about to go public, but there is a private equity market for the shares (EquityZen or SharePost), you have the choice of starting to offload some shares, or just waiting for an IPO. 

If your company is not about to go public and there isn’t a private equity market for the shares, you can wait and preserve the optionality of your option or purchase your shares incrementally to keep the cost down.

If your company is brand new and you’re an initial employee, it might only cost a few thousand dollars to early exercise using an 83(b) election (more on this below), that could be worth it. 

How complicated are the taxes on ISOs?

We’re not going to lie, they’re a little complicated because we have to delve into the AMT (Alternative Minimum Tax) code. The best piece of advice for those of you who don’t care to understand the tax intricacies is to get a CPA involved the year you want to exercise your options. They can advise you on how this will impact you from a tax perspective. You will need to provide them with the exercise price, the number of vested shared (or unvested if you are allowed to early exercise) and the latest stock valuation. 

For those who want to dive into the meat of the taxes let’s walk through an example. 

For this example, the difference from $2 to $10 is known as the ‘bargain element’. If you exercise your 3,600 options on Jan 15th 2020, you will need to write a check to your company for $7,200 (to pay for the strike price). 

To get the optimal tax treatment, you want to hold your equity for at least one year before selling (and 2 years from your grant date which is July 15, 2019 in this example). This is shown in the 5th scenario below (selling after July 16th, 2021). For completeness (and fun!) we’ve listed the 4 other scenarios as well

Scenario 1: Go nuts, exercise and sell your equity on the same day (bad idea, you’ll pay the higher ordinary income tax rates).

Scenario 2: Go nuts more slowly, exercise and sell equity in the same year (usually a bad idea, same reason as above, but can be useful if your stock price is tanking).

Scenario 3: Exercise and sell equity in different years, but hold the equity <1 full year (never any reason to not just wait the full year, especially if you exercise in January).

Scenario 4: Exercise and sell the equity after holding for more than 1 year but less than 2 years from when your options grant was given to you.

Scenario 5: Exercise and sell the equity after holding for more than 1 year and more than 2 years from when your option grant was given to you (This is the best tax option. Pay the lower long-term capital gains rates).

What is AMT?

AMT is an alternate way to calculate taxes. If it’s higher than your ‘regular tax’ calculation, you must pay the difference. AMT calculations are super-duper complex, and can be as high as 28% (not to mention state-level AMT). You should definitely consult a tax professional to determine how much AMT you might owe. For the sake of this example let’s assume 28% for AMT rate. If you don’t sell your equity in the same year you exercise (Scenario no. 2 from above), you could owe AMT on the bargain element, even though you may not have sold the equity yet. This sneaks up on people. Using Scenario no. 3, we could owe 28% on the bargain element in AMT which is 28% of $8 x 3600 shares. This is ~8k in AMT in 2020. When we do sell the equity on January 5th, 2021, we will owe ordinary income tax on both the bargain element and the gains on our 2021 taxes filed in April 2022, of ~16k ($15-$2 = $13 x 3600. Tax at 33.3% ordinary income tax) Your total out of pocket by 2021 is ~24k

Now hold on a second, we paid AMT on the bargain element ($2 to $10 per share) in 2020, and now we’re paying ordinary income taxes on the bargain element and gains ($2 to $15 per share) in 2021, aren’t we paying double-taxes on the bargain element!? Yes, we are. This is accounted for with a tax credit. When you pay AMT from exercising ISOs you get a tax credit that can be used in the future to offset gains. Most of this will probably be used when you sell the shares in 2021. So the AMT paid in 2020 was roughly a prepayment of part of the future ordinary income taxes we would pay when we sold. So in this scenario we pay ~8k in 2020, and ~8k in 2021 (paying 16k on combined bargain element and gains, but you get back the 8k AMT credit). At the end of the day, we’ve paid ~16k, just like Scenario no. 2. 

In Scenario no. 5 we also must prepay AMT, but it should net against future long-term capital gains taxes versus ordinary income tax when we eventually do sell the equity. In that scenario, we should pay less in taxes overall.

What’s an 83(b) election?

As we stated above, when you exercise options you will owe AMT on the bargain element (if you don’t sell the shares in the same year). What if the bargain element was 0? You wouldn’t owe any AMT. When you first get your options, there is a good chance that your strike price equals the fair market value (bargain element is 0). Unfortunately, usually none will vest until you’ve been there at least a year, so you can’t exercise for at least a year, and the fair market value could rise (so now the bargain element is >0). 

However, if your company lets you exercise unvested shares, and you do so within a certain timeframe (like 30 days from starting work), you can file an 83(b) election (in those same first 30 days). You’ll have to pay the strike price to your company, but you won’t owe any taxes or AMT. Then if you hold for 1 year and 2 years from the grant (so likely 2 years from starting work) before selling, you’ll just owe long-term capital gains tax on the gains (amount above the strike price). This could be a good way to avoid having to pay AMT on exercise. If you leave your employer before some options vest, your employer will buy them back at the strike price. The decision to do an 83(b) election centers around tax benefits and how much money you want to risk immediately to buy your company’s shares. 

Is there anything else I should know?

There are other specific rules, such as the $100k rule, which says that only $100k of ISO options (by strike price) can vest each year. Any excess are treated as NSOs. So if you have $500k in options (by strike price) vesting over 4 years, $25k/year will be NSOs, not ISOs. 

Generally speaking, everyone’s situation is different. We’ve provided a high level overview of this topic, but consulting a specific tax advisor would be worthwhile. Your Origin Planner can help make this introduction for you.