How to make the most out of your startup equity from a tax perspective
Disclaimer: I am not a certified tax accountant by any means, so please treat this as a source of information rather than formal legal advice.
With many startups nowadays sitting on a comfortable cushion of funding, joining a startup has become a competitive alternative for job seekers who enjoy the roller-coaster of a startup life without having to compromise on salary & other financial perks. Nonetheless, the major part why people seek to join a startup from a compensation point of view is still the equity component associated with joining.
Now, the overall package seems straight-forward: salary & equity. However, depending on how the equity is handed out, there are different scenarios that should be considered, and most of the consideration is based on the current valuation of the startup. To facilitate the discussion of the different options, let’s introduce some basic financial terminology first:
- Grant date: the date the ISO was granted
- Strike price: the cost to purchase a share of stock
- Exercise date: the date on which the option was exercised and shares purchased
- 409a Valuation: The Internal Revenue Service (IRS) requires a valuation of the fair market of a company whenever it gives out stock options. This valuation is conducted according to certain methodologies that are governed by IRS Section 409a (hence the name).
- Fair Market Value (FMV): The valuation mentioned above is often associated with the Fair Market Value (FMV) of a company, which is equivalent to the price per share. This valuation is often a lower bound on the preferred stock valuation, which is the valuation investors would attribute to the company (can range from 1:2 to 1:10)
- Early Exercise: For share options, you can choose to purchase them upfront, i.e. you obtain the actual shares, even before they vest. Usually, companies retain a repurchase right for these shares in case you leave prior to having them vested. Early exercising is not an automatic right, so you should make sure that companies offer the option to early exercise if that is important to you.
- 83b Election: Filing for this election no more than 30 days after your early exercising of options allows you to pay taxes at time of the grant of the option instead of the time of vesting.
- Long-Term Capital Gain (LTCG): Any income that qualifies as LTCG is subject to a maximum of 20% taxation depending on the overall income of the individual. In contrast, short-term capital gain (STCG) is subject to taxation equivalent to the ordinary income tax which goes up to 37% (check here for current brackets for both LTCG and STCG).
- Alternate Minimum Tax (AMT): The Alternate Minimum Tax is calculated by taking all the income of the current year plus potential deductions that would not be subject to normal taxation usually, such as standard deduction and health care. The tax is 26% for income below $191,500 and 28% for income above. If the AMT for the current tax year is higher than the income tax calculated in the conventional way, the individual has to pay the difference on top of the original income tax.
- Exercise date: the date on which the option was exercised and shares purchased
So why do we care about all of this in in the first place? The answer is obviously money, but how much are we really talking? First, let’s look at the four most common types of shares that are issued in a startup environment. Secondly, we investigate how the current valuation and your personal investment preferences influence the more appropriate type of share you should opt for.
Restricted Stock Award (RSA)
These are shares given to you by the company according to a fixed vesting schedule (e.g. vesting over 4 years with a 1-year cliff). Usually, RSAs are given out a strike price of $0 / unit, but it can practically be any value between $0 and FMV. What this implies is that the IRS will treat the entire difference between the current FMV and your strike price ($0) as income on which you be taxed at the time of vesting. However, you can file an 83b election to pay tax at time of grant rather than at time of vesting.
You legally own the entire amount of stock issued to you at time of granting; vesting in this case only implies that the company can repurchase any non-vested stock from you in case you were to leave early. You cannot early exercise RSAs because you already own them fully at time of grant. Because you fully own the stock from the date of grant, this type of stock is usually not given out for startups that are already beyond certain funding rounds, because they basically give you partial ownership “for free”.
Restricted Stock Unit (RSU)
From a practical standpoint, this type of stock is the same as a Restricted Stock Award talked about in the previous section. The main difference to RSAs is that you do not legally own the stock until you vest it. Also, in contrast to RSAs, RSUs cannot be used for filing an election 83b. The company does not have the right to repurchase any non-vested stock because you have never legally owned that chunk of non-vested stock in the first place. Practically, RSUs are a weaker version of RSAs from an employee’s point of view.
Incentive Stock Option (ISO)
These options give you the right to purchase the granted number of shares at any given point in time for the strike price set at date of grant, again according to a set vesting schedule. For example, you might be offered 10,000 shares at a strike price of $0.10, and from now on you have the choice of purchasing actual stock worth of whatever percentage of your 10,000 shares you have already vested. Note that your potential employer is legally obliged to give out ISOs at a strike place at least equivalent to their current FMV, so it is futile trying to negotiate that price down.
ISOs are eligible for filing an 83b election if your employer provides the option to do so. However, be aware of the fact hat ISOs can fall under a disqualifying disposition (you sold your exercised ISOs less than 2 years after grant & less than 1 year after exercise), resulting in the loss of LTCG treatment. So now you would end up paying full income tax on all profits made through selling.
Non-Qualified Stock Option (NSO)
Practically, this type of stock option is the same as an Incentive Stock Options talked about in the previous section. The key difference to an ISO is that when exercising, the difference in strike price and current FMV will be taxed as normal income, while the difference in strike price and FMV for ISOs is subject to the so-called Alternate Minimum Tax (AMT). Also, early exercising NSO does not lead to loss of LTCG treatment in case of a disqualifying disposition because NSOs simply cannot fall under a disqualifying disposition from a legal standpoint. This implies that once you (early) exercise your NSOs, you will be guaranteed to receive LTCG treatment after 2 years of grant & after 1 year of exercise.
So, what’s the deal now?
Let’s consider different stages of the startup you’re about to join and go from there. Generally, the optimization problem for all scenarios is the following:
How much money are you willing to pay upfront vs. how much money to you want to save for potential profits later, and how much less RSAs would you get if you asked for it instead of NSOs (usually, companies give more options than restricted stock out since the strike price for restricted stock is usually $0, and no one really likes to give away stock for free). However, in most cases the company is already set on giving you either options or restricted stock, so let’s talk about what to do when you’re presented either options (ISO/NSO) or stock (RSA/RSA) in your written offer:
Scenario 1: The first employee
Company Size: 1–10, FMV: <$0.10 / unit, Total Equity $ Value in FMV: $0-$5,000
If you’re among the first people to join a startup, the company is probably still at a stage where they’re mostly living from some type of seed money, and the 409a valuation is still low.
1. If you’re given RSAs, file an 83b election within 30 days of date of grant if you can bear paying the extra income tax on the Total Equity $ Value (which in this scenario would amount to standard income taxation on the total equity value, so a couple of thousand dollars)
2. If you’re given RSUs, I would double-check the contract since this is the worst type of stock you could get in this scenario since you will end up paying huge amount of taxes in case the valuation goes up in the future and there’s not much you can do besides forfeiting your stocks or pay out of your own pocket for illiquid stocks.
3. If you’re given ISOs, early exercise as many options as you have money on the side that you feel comfortable investing. File an 83b election within 30 days of grant. Ask for the options you want to exercise early to be converted to NSOs, leaving the remaining ones as ISOs if possible so they cannot fall under a disqualifying disposition.
Just to make sure we know why we want to exercise early: Let’s say, 6 years from now, your equity will be worth $5 million, you’d pay full 37% income tax on every cent you make in this sell ($1.85 million), while you’d only pay 20% LTCG tax ($1 million) if you had early exercised all your options at date of grant. You overall ended up saving $850k in this scenario. But again: The company might also just fail, which would leave you with worthless stock. So only invest the money that you can afford losing in the worst-case scenario.
4. If you’re given NSOs, early exercise and file an 83b election within 30 days of grant if you have enough money on the side to pay the Total Equity $ Value at time of grant. Ask to convert the non-exercised ones to ISO (Essentially, this is the same scenario as above, with the slight difference that the company gave you NSOs in the first place, which is rather unorthodox).
In this scenario, if you were given the same number of shares in RSA and in ISO, the first one would be a better offer because you can file an 83b election only having to pay income tax on the spread between strike price and FMV, whereas for the option-based offer you’d have to pay the Total Equity $ Value upfront, which is of course more expensive than paying a percentage worth of tax on the same amount of money.
Bottom line: Go for RSA if you can. If they offered you more ISOs than RSAs, you need to personally decide whether it’s worth it to spend more money upfront to get more stocks. And yes, in this scenario you should always try to early exercise as much as possible.
Scenario 2: The late joiner
Company Size: 50–200, FMV: >$1.00 / unit, Total Equity $ Value in FMV: >$100,000
At this point, the company might have just raised their Series C or D. Depending on your offer, you might be presented with a huge chunk of shares in $ value. While the FMV of the company is undoubtedly high, you would still expect it to get higher in the future.
1. If you’re given RSAs, file an 83b election within 30 days of date of grant if you can bear paying the extra income tax on the Total Equity $ Value. At this point, the income tax makes up a huge amount of $, so you better be aware of that. In principle, the same thought process holds as before, it’s just now you have to pay much more money for less potential reward. Also, be aware of the fact that you pay income tax every time you vest stock, so in the case where the company is pre-IPO and you cannot sell stocks immediately, you might end up having to pay a ton of tax out of your own pocket for stock which you cannot directly sell. Here, you should consider asking for options instead of restricted stock (see point 3 further down.).
2. If you’re given RSUs, you still pay tax when you vest, so that’s bad. Again, RSU are worse than RSA, and in this scenario, both are a bad deal taxwise.
3. If you’re given ISOs, early exercise as many options as you have money on the side that you can potentially afford to lose. File an 83b election within 30 days of grant. Ask for the options you want to exercise early to be converted to NSOs, leaving the remaining ones as ISOs if possible. Why do we like ISOs here? We like them because you don’t have to pay tax until you exercise, so in this scenario we do not want to early exercise because it costs a truck load of money, and we defer paying taxes until we exercise which we can do once we find a seller! So, we never have to pay taxes for an illiquid asset as was the case with restricted stock. However, if you do not sell the stock in the same year you exercised it, you might pay AMT.
4. If you’re given NSO, early exercise and file an 83b election 30 days of grant if you have enough money on the side to pay the Total Equity $ Value at time of grant. Ask to convert the non-exercised ones to ISO. (in essence, this is the same scenario as above just that the company gave you NSOs which is unorthodox). However, if you do not sell the stock in the same year you exercised it, you definitely pay more income tax, instead of only potentially paying for AMT in the case with ISO. The message here is to go with ISOs if you do not early exercise for the reason of potential savings due to AMT.
In this scenario, you want to go with options if you don’t want to pay massive tax every year.
Bottom line: Go for ISOs, except if you have enough money to spend on the taxes that’d be withheld when you were to file an 83b election on your RSAs, and you’re willing to put that money on the line.
Scenario 3: Joining mid-way
Company Size: 10–50, FMV: $0.10 — $1.00 / unit, Total Equity $ Value in FMV: $5,000 — $100,000
At this point, the company might have just raised their Series A or B. Depending on your offer, you might be presented with a huge chunk of shares in $ value. While the FMV of the company is quite high already, you would still expect it to get much higher in the future.
The optimal tactic here is right in the middle of the first two scenarios, so it might either be viable to prefer restricted stock or options, depending on how high the FMV is. Generally, if you can bear the extra income tax for the current year of the Total Equity $ Value, RSAs with an 83b election are always a good way to go about it. Once this tax burden becomes too high, however, you should go for options and early exercise as many as you feel comfortable with, leaving the remaining ISOs to be exercised whenever you feel comfortable to do so.
A company issues you 50,000 shares at a FMV of $0.50 per unit. This amount to an overall value of $25,000. Congrats, that’s a great chunk of equity! If it’s RSA, and you can take the hit of roughly $10,000 extra tax for this year to be withheld from you when filing an 83b election, go for it. The safe option, however, would be to get ISOs (and in this case, you can play it smartly and ask for more ISOs than they gave you RSAs). Then, early exercise as many ISOs as you feel comfortable (possibly converting them to NSO prior and leaving the remaining ones as ISO). As a side note: If you early exercise more options worth of money than the income tax would have been for the RSA, then you logically should’ve just stuck with RSA and paid the income tax.
At this stage, however, most companies won’t even offer you RSA in the first place, because of legal considerations & legal implications, so it will be most likely ISOs what’s mentioned in your contract. And that’s fine. Just ask that they provide the option to early exercise, and early exercise as many options you feel comfortable exercising — it’s practically equivalent to investing in normal stocks on the stock market, except it’s slightly different because your investment by early exercising here acts as a 17% lever (% tax less for LTCG vs regular income tax) on all potential profits that you might ever make when selling those early exercised options once they qualify as LTCG.
There is a lot of different aspects to consider regarding the type of stock or option you are presented and depending on the situation you are in and at what current stage the startup is, different types are more useful than others. Nonetheless, even if you don’t want to think too much about it, at least make sure you understand the specific type of option you are receiving, and how you can make the most of it (especially regarding early exercise and the 83b election). At the very least make sure that your employer offers the option to early exercise if you are granted stock options.
I hope that this article will help you to navigate through the ragged landscape of startup equity taxation; it certainly took me quite some time to wrap my head around it.