Navigating Startup Equity: How and When to Exercise Your SharesWhen you sign on with a startup, your compensation package may include some sort of equity in the company – either stock options or stock grants. You’ll need to review your equity package (and understand its tax treatment) or you’ll find yourself facing a really hefty tax bill. We’ll break down the financial ins and outs of exercising, whether you’ve just started your job and want to plan ahead or you’re about to leave and are deciding when and how to exercise. Warning: This article assumes you know basic startup equity terminology, like fair market value, strike price, and exercise price. If those terms are unfamiliar, or you’d like a refresher, check out Startup Equity Basics: What to Ask About Your Stock Before You Accept. Here, we’ll cover how to think about exercising if:
No matter your scenario, though, it’s worth knowing the overall tax and financial implications of startup equity for the next time you sign on with a company in exchange for stock.
You’re just starting a new jobWhen stock grants or options are part of your compensation package, you’ll face a major financial decision right away. Within 30 days of your grant date (usually date of hire), you’ll have to decide whether to file a Section 83(b) election. What’s an 83(b) election? Glad you asked. Typically, your stock vests over time, and stock grants are taxed as they vest. However, in many cases, you’ll have the option to have all your stock taxed immediately by filing a Section 83(b) election with the IRS. If you make an 83(b) election, you agree to pay ordinary income and payroll tax on the stock’s value at the grant date (i.e. your date of hire) rather than pay as you vest. And we’ll say it again: you must file your 83(b) within 30 days of the grant or you’ll default to being taxed as you go – no exceptions.
Who can make an 83(b) election?If your compensation package includes restricted stock grants, you’re usually eligible for an 83(b). If you’re getting stock options, it’s a bit more complicated. Your company may allow for early exercise. This means that you can buy all of your options immediately at the stated exercise price, but if you leave before you’re fully vested, the company will buy back your options at the exercise price. For example, if your compensation package offers you 10,000 shares at $1 per share and you exercise early, you’ll pay $10,000 to get all 10,000 shares (and get taxed on those shares). If you leave the company when you’re only ¾ vested, the company will pay you $2,500 to buy back the unvested options, leaving you with 7,500 shares. If your company allows an early exercise, you’re eligible to file an 83(b). If not, you can’t file an 83(b) – but we’d still recommend you read the section on how to exercise while you’re still an employee.
When does an 83(b) make sense?Now that you know what an 83(b) is, and who can make it, let’s talk about whether or not you should actually file. On its surface, the idea of being taxed on stocks that haven’t even vested yet seems counterproductive. However, it can save you thousands, if not tens of thousands, when used right. The decision to make an 83(b) election comes down to two factors:
- Can you afford it?
- Do you think the startup will succeed?
In a nutshell, filing an 83(b) is a great idea if you think your startup will do well (if you don’t, you may want to consider finding a more promising job). If the company does poorly, you’re out of luck.
Your shares are already vestingOnce you’ve signed on with your new company and are past the 30-day Section 83(b) election period, your main concern will be whether you should exercise as you vest, or all at once (typically this happens when you leave your job). If you’re getting stock grants, you can skip this section – you’ll be getting your stock free and clear. If you’re getting options, however, you’ll have a few decisions to make. Generally speaking, if your startup does well, it’s better to exercise your options as they vest. We’ll go into the two main reasons why – tax treatment and cash flow – but the quick-and-dirty answer is that if you trust your startup to grow, you’re better off exercising your stock options as soon as you can.
Tax treatmentWhen you exercise your options, the difference between the current valuation and the strike price is taxed as ordinary income. However, when you actually sell the stock, the difference between the sale price and the valuation at exercise is taxed long-term capital gains (as long as you’ve held the stock for at least one year after exercise and two years after they’re granted). This means you should try to minimize the difference between the strike price and exercise price – at a successful startup, this equates to exercising ASAP. Let’s say you’re offered 10,000 shares at a strike price of $5 (for simplicity, assume that 50% of your stock vests after Year 1 and 50% after Year 2). The startup is valued at $10 at Year 1, $30 at Year 2, and $50 at Year 3. Now, say you decide to leave the company at Year 3, and that like most startups, your company requires departing employees to exercise their options within 90 days. Here’s a comparison of your taxable income from your options if you exercise as you vest, compared to all at once:
|As you vest||All at once|
= 5,000 shares * ($10 FMV – $5 strike)
|Year 2||$150,000 =5,000 shares * ($30 FMV – $5 strike)||$0|
|Year 3||$0||$450,000 10,000 * ($50 FMV – $5 strike)|
Cash flowReason number two: Take a look at the taxable income in Year 3. $450,000 at a 32.2% ordinary income tax rate is, again, a tax bill of $144,900 – nearly double the average American household income. Moreover, that’s a tax on money you don’t really have, since you haven’t sold the shares yet. Combine that with the possibility of a lower salary when you leave your job, and you may not have enough cash on hand to pay your tax bill.
To cover the difference, you may need to sell some of your shares immediately. Because you held the shares for less than a year, you’ll pay short-term capital gains (the same rate as ordinary income). Not only do you potentially miss out on further share price increases, but you’ll send more money to the IRS. Once again, if you think your startup is on the rise, it’s probably a good idea to exercise as you go.
You’re about to leave your jobFinally, we’ll talk about what to do if you’re on your way out and need to decide what to do with your unexercised stock. If you only have stock grants, you don’t have to do anything since you’re given the stock outright. However, if you have vested stock options you haven’t exercised, you’ll likely have to exercise within 90 days of leaving the job – or forfeit the options. There are three steps to deciding what to do:
- Decide if you think the stock’s value will increase
- Determine the total cost of exercising
- Find the money to exercise
Decide if you think the stock’s value will increaseFirst, you’ll have to decide whether you think the stock is on the rise. If your startup is failing, exercising your options will be a waste of money. If it’s doing well, you’ll want to exercise as much of your stock as you can (or as much as you’re comfortable with), according to how much you can afford. Which brings us to the next step…
Determine the total cost of exercisingIf you’ve made an early exercise and filed a Section 83(b) election (see the section on starting a new job), you’ll already have paid the company and the IRS to exercise your stock, and you won’t have to worry about additional costs. Assuming you haven’t filed an 83(b) election, the total cost of exercising your stock will be: Strike price * number of shares + tax rate * (fair market value – strike price) * number of shares = total cost of exercise Since you’ll be taxed on the difference between the FMV and strike price at ordinary income rates, you’ll probably be paying upwards of 28%. For now, we’ll assume the 32.2% rate that a Californian making $100,000 a year would pay in state and federal taxes (note that the $100,000 figure includes both salary and the FMV-strike price difference). For example, if you have 10,000 unexercised shares with a strike price of $5 and an FMV of $7, your total cost will be $5*10,000 + ($7-$5) * 10,000 = $ 56,440. That’s a lot of money – especially if you’re leaving a high-paying job to raise a family, go to grad school, or otherwise take a lower salary. If you can afford the total cost of exercising and believe that your shares will be worth much more down the line, go for it. If you can’t, we’ll break down your options.
Find the money to exerciseIf you have the cash to exercise and pay taxes on your options, you’re in the clear. Otherwise, you’ll have three main options: Loans Your first option is the most obvious: Take out a loan to cover the excess cost. Such loans can come from the company itself (in the form of a promissory note, often with the stock for collateral), specialized lenders, or more traditional institutions like banks, online loan marketplaces or credit cards (though this last comes with prohibitively high interest rates and is almost never a good idea). The main benefits of borrowing are that you retain the upside if the company’s stock grows in value, and you can avoid paying short-term capital gains tax by holding your stock for at least a year after exercise (and two years after grant). The downside, though, is pretty significant. If your stock ends up being worthless, you’re still on the hook for the loan, which can be a significant financial burden. The folks at Fenwick and West call it playing with fire, and they’re not entirely wrong. It’s a risky proposition, to say the least. Net exercise If you want to avoid the risk of taking out a loan or promissory note, you can make a net exercise – basically, selling some stock back to the company to cover the cost of your options. When it comes time to exercise, your startup will determine the current FMV of your options, then reduces the number of shares issued to you by the cost of exercise (which includes tax withholdings, if you have non-qualified stock options). Here’s an example. Let’s say you have 5,000 shares, with a strike price of $1, a FMV of $5, and a tax rate of 30%. If you were to exercise all your shares, you’d have to pay $11,000 including taxes. If you wanted to make the transaction without paying anything, you could do a net exercise. In that case, you’ll exercise 3,225 shares at a cost of $7,095 (including taxes). Your employer will keep 1,775 shares, which are worth $7,100 after deducting the strike price. Your 3,225 shares will be yours free and clear, and your taxes will already be taken care of. Quick note: If you have incentive stock options rather than non-qualified stock options, your employer won’t automatically withhold taxes on your exercised options, so you’ll have to make sure you have enough set aside to pay the IRS (or sell additional shares back to the company). Cashless exercise The third option is only available to some startup employees, and usually should only be used if a net exercise isn’t possible. Cashless exercises are more common with public companies, but can be done with private companies with a secondary market for their shares – usually, this translates to large, highly sought-after startups. To make a cashless exercise, you’ll need a broker who can sell your stock for you. In a cashless exercise, your broker will:
- Exercise all of your vested options
- Calculate the shortfall between your cash on hand and the cost of exercise
- Immediately sell off enough stock to cover the shortfall
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