Trying to decide when to exercise my equity options

by nord2rocks. Posted on Sep 11, 2020    1    8


I work at a small-medium sized startup, we are looking to raise Series B soon.

I just hit the first date for a portion of my options being vested, and I'm trying to decide when to exercise these. I've done some reading online, but am having a hard time figuring out the tax implications if I exercise and hold my available shares. I've asked for the 409a valuation, but finance hasn't told me. Right now my strike price is $0.10/share.

I should mention that we didn't have a traditional Series A, rather came out of an incubator-like setting. So I expect as we raise our different series, and as I progress with my role/status in the company I'll also be awarded additional equity.

How do you all approach this when at a startup and what do you suggest your employees do?


Comments

tengable 2

IDK to be frank, exercising shares is complex af. And I am not an expert.

But something to keep in mind, is that you probably have common stock, as apposed to preferred, which investors get.

That means you will be last in line to get paid in the event of your company selling. Even behind the people who invest in a series B. You might be riding high now, but keep in mind that you will probably only get paid if there is a great exit. A meh exit will not result in a big pay day. And if you buy the stock now, it could mean losing money.

See https://news.ycombinator.com/item?id=24198228

  nord2rocks 2

Thanks for this. Yeah definitely hav common stock... But based on our incubator's/VC's track record (we're biotech), most of the companies in the portfolio go to IPO - some are big, some mediocre

fuglybear 2

If you believe in the company and have cash to spare, exercising before a Series B creates a valuation event can be long term beneficial from a tax perspective:

In the year in which you exercise, the IRS treats the difference between the FMV (aka "your company's 409(a) valuation) and your strike prices as income for purposes of computing your Alternative Minimum Tax (AMT). It recently became easier to avoid AMT, but exercising stock options is probably the most common way tech workers get hit with AMT

For example, your base salary is $100k and your pre-SeriesB 409(a) valuation is 15¢. If you exercise 10,000 options, you "add" 10,000 * (15¢ FMV - 10¢ strike) = $500 of income to your 2020 income statement. Probably no big deal. It makes your taxes a little harder cuz you gotta show you tried computing normal taxes and AMT now, but you almost certainly won't move in to an AMT payment situation because of $500

Now if you wait around and your series B comes in at like $20, then exercising those 10,000 shares adds 10,000 * ($20 - 10¢) = $199,000 to your income and that will sting you. You'd own your marginal income tax rate on that amount come 4/15/2021

Disclaimer: IANAL, get advice from a professional, yada yada

  nord2rocks 1

Thank you for the info. I had a general idea about the tax benefits, now they're more clear. I am going to try an get the FMV of our shares from the CEO or head of finance.


I assume this tactic is generally the same as you go through various rounds of funding? It's dependent upon strike and FMV?

fuglybear 2

\> I assume this tactic is generally the same as you go through various rounds of funding? It's dependent upon strike and FMV?

Yes, exactly. The tax implications usually get more dramatic between later rounds because FMV in a Series A might be $2, Series B might be $10, Series C might be $20 so if you're considering what to do with a large number of penny options and you're sitting in a post-Series-C $20 valuation you can really hurt yourself by exercising.

Here's like "the best possible scenario", followed by "the worst possible scenario":

​

the best:

1/1/2019: company is incorporated, you are granted 100k options, strike price 1¢. 409(a) valuation 1¢

1/1/2019: you early exercise* all those options for $1,000 and pay 0 taxes on them because (FMV - strike price = $0)

1/1/2021: company acquired at $25 and because you've held the shares for more than 1 year, they are "qualifying" shares and you pay long term capital gains (\~20%) on your windfall instead of your marginal tax rat (\~40%). So the windfall is $2.5m, and you owe $500k in taxes but saved $500k in taxes

* = early exercise is a thing you can do, depending on your grant paperwork; you gotta register the fact you did it with the IRS within 1 month of doing so or you can lose the benefits

​

the wurst:

1/1/2019: company is incorporated, you are granted 100k options, strike price 1¢

1/1/2020: company gets a 409(a) valuation at $25

1/2/2020: you exercise all your options (you write a $1,000 check) and the IRS thinks you just earned $2,499,000

4/15/2021: you gotta come up with about $1m to pay taxes

4/16/2021: your company goes bankrupt

  nord2rocks 1

This makes a heck of a lot more sense, thank you! One last question though:

So Finance just got back to me and said that they're updating the 409(a) and it will be available at the end of the month. They also just mentioned that the options are Incentive Stock Options (ISO) and that there is no tax applied on the purchase of those. Is that correct/do the ISOs change anything?

just tried digesting this Investopedia entry https://www.investopedia.com/articles/stocks/12/introduction-incentive-stock-options.asp


and this https://www.thebalance.com/incentive-stock-options-3192970


My general consensus is that as long as I hold the exercised shares for more than 2 years and exercise them within 3 months there are no real tax disadvantages.

fuglybear 2

> hey also just mentioned that the options are Incentive Stock Options (ISO) and that there is no tax applied on the purchase of those. Is that correct/do the ISOs change anything?

That's not 100% accurate. When you do your taxes every year, you're supposed to do them 2 different ways and pay the larger of the 2. The "first way" is probably the only way you've ever done your taxes and it's the standard IRS 1040 form, minus deductions, etc. Exercising options has no impact on the "first way"

The "second way" is the "alternative minimum tax" which was setup to stop a bunch of really rich people from using loopholes to get out of paying their fair share. When you exercise options, the difference between your strike price and the FMV counts as income in that calendar year when you tally up your AMT income. Now, just because you exercise ISOs doesn't automatically mean you need to pay the AMT amount -- the amount of money you need to earn needs to exceed a threshold, but it's easy to exceed that if you're talking about tens of thousands of options and a high 409(a) valuation.

So if your finance department said "there is no tax applied" they are either (a) assuming you're not going to get hit with AMT (b) that you will be exercising when your strike price == FMV (in which case income is $0) or (c) they don't know what they're talking about

The whole "hold 2 years" thing comes in to play when you go to sell your shares; to qualify for long term capital gains rate (20%) you need to have exercised your options and held on to them for a while (google "qualiified" vs "non-qualified" ISOs)

  nord2rocks 2

Ah I see I see, thank you very much for the insight it has been extremely useful. I'm very new to this with it being my first full-time job post college and grad school.