She’s been working at an exciting 3-year-old tech startup for about six months now.
When she was first hired, she noticed her employment agreement said something about “equity options,”
along with salary and benefits. She didn’t really understand what that meant at the time, but the word “equity”
sounded good and it was exciting to be getting some company stock, right? So, she signed her employment agreement
enthusiastically and joined the team.
At a recent all-hands company meeting, Cris finds out the company is working on an initial public offering (IPO) for
a NASDAQ listing in one year. “Wow, how exciting!” Cris thinks. She’s part of a successful company with unicorn potential,
and her shares are going to be a gold mine!
Slow down, Cris.
In fact, she doesn’t own any company stock. At least not yet. First, she needs to take action and “exercise,” or buy her stock options.
Doing so gives her actual equity, or ownership, of her shares, along with potential tax benefits down the road. But how are you supposed to
exercise your stock options before an IPO? Cris is beginning to realize she needs to come up with the cash to buy her shares. Now what?
If this sounds a little like you, then you’re in the right place. Here’s what you need to know about employee stock options,
and why it’s better to exercise them sooner versus later.
Two types of employee stock options
Before you find yourself in the same situation as Cris, it helps to understand what stock options you have, and how to maximize your tax savings.
When you joined your company, you likely received a bunch of paperwork about benefits.
Most people tend to save these for later and forget about them until they’re needed.
However, if you were given stock options, it’s important to carefully review these documents.
First, find out how many shares you’ve been given. You’ll probably have to log-in to a separate
financial or brokerage platform to find out their quantity and current market value.
You’ll also need to know what type of options you have.
The Internal Revenue Service classifies stock options in two ways—incentive stock options (ISOs) and
non-qualified stock options (NSOs). Let’s take a look at both.
Incentive stock options
An incentive stock option allows you to purchase a stock at a discounted or set price only after
you’ve worked at the company for a specific time (called a vesting period). After you’ve purchased
your stock, you may then also be required to hold it for a certain period of time (called a holding period).
ISOs are popular incentives typically given to managers or key employees, with common vesting
periods of a few years and holding periods of one year or more.
How the IRS treats ISOs
Because you are generally required to hold ISOs for more than one year after you exercise,
the IRS treats any profits from selling the stock as capital gains (rather than income).
However, if your income is high enough, you might trigger alternative minimum tax (AMT) rates
of 26% or 28% when you exercise your options.
If you exercise an option and don’t sell it in the same year, you’ll need to report the difference
between the amount you paid to exercise the option and the stock’s fair market value (FMV) when you sell it.
If you’re subject to it, you would be subject to AMT on that difference.
If you sell your stock later on, then you may be able to claim this as a capital gain, but only if you meet
the criteria for a “qualifying disposition. In order to meet the criteria and sell your stock in a way that
gets you better tax treatment, you must meet the following requirements:
Sell your stock no earlier than one year after you exercise your option.
Sell your stock no earlier than two years after the ISO was granted.
Non-qualifying stock options
A non-qualifying stock option is a stock option that doesn’t qualify for
preferential tax treatment like ISOs do.
How the IRS treats NSOs
If you have an NSO, then you pay income taxes on the difference between the
price you paid (the grant price) and the price at which you exercised your option.
You will pay taxes on NSOs when the shares are sold (assuming there was a gain in value).
Similar to other investments, if you hold the shares longer than one year, then you’re taxed
at the capital gains rate for any gains you made over the market value of the shares when you
purchased it. On the other hand, if you sell it before you’ve held it for at least one year,
any gains from the fair market value will be taxed as income.
Our friends at Carta have shared a great visual of this conundrum –
This is why people use Quid to exercise their stock options early. Those that exercise get to become an owner in their company,
take advantage of the better tax rate, and enjoy the fruits of their labor when a liquidity event comes around. If you have any
questions on how this might be applicable to you, reach out to us at [email protected].
How to exercise your equity options early: Use a non-recourse financing solution.
Remember Cris? How did she fare?
Cris wasn’t scheduled to be fully vested until after the IPO. Turns out, she didn’t have the money
to exercise her options early, so she decided to wait. Pre-IPO, a share was worth $30, but her option agreement
would have allowed her to exercise at $10 per share.
Fast forward to one year later, and the company is now public. It seems investors were just as excited about
the startup’s potential because the value of its shares jumped 139%.
Now, post-IPO, she had to exercise her options and pay ordinary income tax on the spread between
her $10 exercise price and the IPO price of $41.7.
How a pre-IPO financing solution can help you save money on your equity options.
Luckily, for Cris, a time machine takes her back to her pre-IPO moment and a solution to her problems
appears—a smart financing source that will allow her to exercise her options early.
Like many of her coworkers, Cris didn’t know this source existed, nor did her employer share this
information with her. With funding from Quid, Cris is able to buy her 100,000 shares at $10 per share,
enabling her to receive capital gains tax treatment and earn $3.8 million from the IPO (as opposed to $3.3 million with a post-IPO exercise).
Aside from the time machine that helps Cris avoid a costly mistake, her scenario isn’t unique.
For many who work at younger companies offering equity options, it may be difficult to decide
when is best to exercise them. This checklist can help.