Option Exercise & Sale
Exercising options and selling stock have complex tax implications. Depending on whether the options are non-qualified (NSO or NQSO) or incentive (ISO), the rules are different as to what is considered income, capital gains or an alternative minimum tax (AMT) adjustment. Then there are the rules with respect to long-term or short-term capital gains. You should always consult with an accountant before making big decisions about how to handle options but the option exercise and sale calculator here can give you a good guess.
A few pointers:
- The calculator won’t show AMT impact on some ISO transactions. Your accountant can help with that. The result depends on too many other variables.
- The fair market value (FMV) of common stock is determined by the board with or without a 409A valuation process. If you don’t know what that number is, ask an exec. Caution: asking for the current FMV is a big telltale sign that you may be thinking about option exercise which is a sign you might be thinking about other things also.
- Make sure to enter the correct income tax and federal/state short- and long-term tax rates.
As you can see if you play with the numbers, the exercise cost can be pretty significant if you join a startup at a high valuation. This can become a problem if you decide to leave or are terminated. Most option plans allow 60-90 days for options exercise. If you don’t exercise your options you lose them.
Here is a story worth repeating. One of my companies wanted to hire an exec from a large private company. He had joined three and a half years earlier, contributed significantly and now wanted to move on to the next thing. His problem was that exercising his options required a little more than $1M, which he didn’t have. Because the company was private and because of transfer restrictions in his option agreement, it was nearly impossible for him to find a way to get liquidity or borrow based on his significant stake. In the end, he chose to stay at the company.
Talk about golden handcuffs, except that he really wasn’t going to get much more equity. He is still there, more than a year later. The company is still private. He can’t move without losing a ton of upside. What surprised me, and this is the reason why I’m sharing the story, is that he hadn’t thought about this issue before he considered leaving nor had it been brought up by his accountant or lawyer over the years.
This is one of the many reasons why joining startups early, when it is cheap to do an 83b election, can make the difference between making a lot of money and having the flexibility to change jobs and making a bit of money or having job flexibility.
Here are some tips:
- Consider the cost of option exercise and the risk of losing that investment when you change jobs, both for the company you are leaving and the one you are thinking about joining.
- Make sure to get an ISO grant. NSO option grants are much worse than ISO option grants because the difference between the fair market value and the strike price of the options is treated as income and is subject to income tax in the year of exercise. Board members and advisors get NSOs. This is one of the reasons why it can be much easier to recruit them early, when the price of the common is very, very low.
- If you have the leverage, negotiate an extension to the period you have to purchase your options. Personally, I would be open to extending the purchase period for someone who’s put in a meaningful amount of time at the company, has proven to be a valuable team member and knows how to leave on friendly terms.
- Make sure you get along with your CEO (or board if you are the CEO). It is very easy for a board, given the right reasons and circumstances, to extend the purchase period or even extend your vesting past the point when you’ve left the company. Or the board can simply do it because the CEO goes to bat for you. (Yup, I’ve seen it happen.) Think carefully about the value you can deliver during a transition period and beyond.
- However, you can’t expect the company to try to help you out if you leave it in a tough spot. Have a succession plan.