Stock Options Flashcards
Granting incentive stock options (ISOs) to >10% holders: What do I need to know?
If an individual owns stock that is over 10% of the total voting power of the company’s voting stock (or is treated as owning >10%, as in the case of officers and directors), no stock options granted to that individual can qualify as incentive stock options unless the price is 110% or more of the fair market value (FMV) and the options an expiration date of no more than five years after the initial grant date. To compare ISOs granted to holders with <10% holders can be granted with a strike price equal to 100% of the FMV, with an expiration date of up to ten years.
Secondary Sales 101
A “secondary sale” is a sale of private company stock, usually by a founder or other key early employee, to other current investors or new investors. Secondary sales can be an important mechanism to give liquidity to critical contributors who have been at the company for a long time, and who have likely taken a significant salary pay cut in order to work on the startup. Secondary sales are also helpful in the case of a “life event” such as purchasing a house, paying for a wedding, or paying for family medical expenses. In general, the goal should be to address the secondary seller’s financial needs without giving them such a large payday that they are disincentivized from continuing to work for the company for years to come.
Another common instance of secondary sales is a limited employee sale leading up to an initial public offering (IPO), for employees who want early liquidity prior to the IPO and without having to wait for the end of the standard 180-day “lockup” period.
Unless facilitated by the company, secondary sales can be complicated and expensive. Because a company may not want new equity holders investors on its cap table, it may prevent employees from selling equity to outsiders, or at all (stock almost always comes with “blanket transfer restrictions,” which restrict the sale or transfer of stock without company approval).
A “secondary sale” is a sale of private company stock, usually by a founder or other key early employee, to other current investors or new investors. Secondary sales can be an important mechanism to give liquidity to critical contributors who have been at the company for a long time, and who have likely taken a significant salary pay cut in order to work on the startup. Secondary sales are also helpful in the case of a “life event” such as purchasing a house, paying for a wedding, or paying for family medical expenses. In general, the goal should be to address the secondary seller’s financial needs without giving them such a large payday that they are disincentivized from continuing to work for the company for years to come.
Another common instance of secondary sales is a limited employee sale leading up to an initial public offering (IPO), for employees who want early liquidity prior to the IPO and without having to wait for the end of the standard 180-day “lockup” period.
Unless facilitated by the company, secondary sales can be complicated and expensive. Because a company may not want new equity holders investors on its cap table, it may prevent employees from selling equity to outsiders, or at all (stock almost always comes with “blanket transfer restrictions,” which restrict the sale or transfer of stock without company approval).
Here are some considerations for employee stockholders/option holders looking to sell their stock:
Timing
The most common times for successful secondary sales are in conjunction with late-stage financings (Series B+) or before an IPO
In the case of company-organized secondary sales, they are often in conjunction with financing rounds.
If a company chooses to stay private for longer, it may periodically organize standalone secondary sales to other investors (or buybacks) in order to create liquidity opportunities for its employees.
Momentum
Please consult with your tax/financial advisor before assessing your company’s stock price trajectory and determining the right time to sell.
Typically the highest momentum moment will be in conjunction with fundraising.
Valuation (price per share)
Private company valuations are notoriously opaque, and therefore the employees’ personal valuation of their equity may differ greatly from what investors may be willing to pay.
Discounts of 20 - 60% compared to the most recent valuation are not uncommon.
Amount sold
For ongoing contributors (e.g., CEO), a secondary sale should be large enough to meet the current financial need but not so large that the seller is disincentivized from continuing to work for the company for years to come.
Corporate approvals are required (if the secondary sale isn’t coordinated by the company)
If the secondary sale is not coordinated by the company, the seller will likely need board approval of the company
In addition, the company may have the right (outlined either in the bylaws or the option award agreement itself) to purchase shares that a stockholder proposes to sell to a third party.
How and when can I sell my equity?
There are only a few ways that employees can sell their equity:
M&A: All stock may be purchased by an acquirer in exchange for cash and/or equity in the acquirer.
IPO: After the company goes public via initial public offering (IPO), stockholders may sell freely on the public markets (generally after a 180-day post-IPO “lock-up” period where employees cannot sell, which helps keep the stock price stable).
Secondary Sale: If the company approves a sale to a purchaser willing to buy the employee’s equity, typically at a discount to account for the equity’s illiquidity. Secondary sales can be difficult to execute, subject to unpalatable discounts, and not approved by the company.
Tender Offer / Buyback: The company may offer to buy back a certain amount of shares at a certain price, which stockholders may accept or not.
In the case of stock options, the option holder must first exercise their options and then sell, unless the options are “net exercisable.” We recommend seeking the counsel of experienced tax & financial advisors prior to selling equity.
Is there a time limit to exercise my stock options?
By law, incentive stock options (ISOs) expire ten years after they are granted. If the ISO holder owns at least 10% of the company’s fully-diluted stock, the expiration period is five years. While non-qualified stock options (NSOs) do not have an expiration date prescribed by statute, companies often include a contractual 10-year expiration period. Upon expiration, the underlying stock is returned to the company’s option pool.
If the employee leaves the company, typically they have 90 days to exercise their options.
When should I exercise my (private company) options?
See “What are tax optimization strategies for stock options?” for a discussion of the pros and cons of exercising your (private company) options at different stages (e.g. early exercise and full or partial exercise one year prior to sale).
What are “early exercisable” options?
If the options are specifically granted as “early exercisable,” an option holder could exercise some or all of their options even before they vest.
After an early exercise, the stock will be on the same vesting schedule as the options. If, for instance, 60% of the holder’s options are vested before exercise, then 40% of their stock after exercise would be unvested. The option holder is responsible for filing a Section 83(b) tax election with respect to the remaining 40%, which are now shares of common stock vesting over time.
A key advantage of early exercisable options is starting the clock early on the long-term capital gains holding period (one year), and also possibly benefiting from the Qualified Small Business Stock (QSBS) exclusion, which requires a holding period of five years. Furthermore, if the options are non-qualified stock options (NSOs), and are exercised soon after they are issued, the taxable amount–the spread between fair market value (FMV) and the exercise price–is likely very low, or zero, as compared with exercising the options later, when the FMV is higher and the NSO exercise results in a larger immediate tax liability.
However, early exercise carries risk in the event that the FMV decreases after exercise but before the stock is sold. Stockholders are usually subject to transfer restrictions, face market illiquidity, and have little control over when private company stock can be sold. Early exercise usually makes the most sense in cases where the exercise price is very low and/or the option holder has very high confidence that the stock will increase in value prior to liquidity and wants to benefit from the long-term capital gains treatment and potentially QSBS.
The decision to early exercise stock options can be complicated and fact-dependent, and we recommend consulting an experienced financial and/or tax advisor.
What are “net exercisable” options?
Net exercisable options allow option holders to avoid paying cash to exercise their options by allowing them to pay the exercise price with other vested options, surrendering those options to the company. This is useful when an option holder does not have enough cash to pay the exercise price. From the company’s perspective, net exercise means that options are returning to the stock option pool upon exercise, and can be granted to future optionees, which can be beneficial in slowing down dilution.
Number of shares received = [(fair market value per share - strike price) * (number of options exercised)] / (fair market value)
So if an employee net exercises 100 options with an exercise price of $0.75 and a fair market value of $1.00 at the time of exercise, the employee will receive [($1.00 - $0.75) * 100] / ($1.00) = 25 shares worth $1.00 each ($25).
Why does my VC Term Sheet require such a large option pool?
There are three reasons investors want the stock option pool to be large:
Hire great talent. Investors want to ensure that the company has plenty of equity set aside to hire and compensate future employees.
Avoid future dilution. New investors are not diluted by increases to the pool in the current financing, only future increases. So a Series A investor is highly incentivized to negotiate a significant pool increase at the time of the Series A, such that the company does not need to make large pool increases at the Series B and Series C.
The “option pool shuffle.” Any reserved but unissued equity at the time of liquidity (e.g., M&A) benefits all equity holders pro rata, which is an extra benefit to investors. Consider the following: A company is sold for $100,000,000. At the time of sale, three founders own 10% each (30%), investors hold 50%, and there is 20% in the option pool, 10% of which has been granted and 10% of which is reserved but unissued. In this case, the $100,000,000 price is divided among the equityholders, but the 10% in the pool that has not been issued does not receive a payout. Therefore the investors receive $55,555,555, rather than $50,000,000, because their distribution calculation takes into account the unissued 10%: $100,000,000 * 50% / (100% - 10%).
When should the company create a stock option pool?
Companies often create an option pool around the time of the first significant financing (>$500,000), because setting up a stock option pool usually requires several thousand dollars per year of legal and compliance costs (e.g., 409A valuation), and simply grant common stock to early contributors until that time. The creation or enlargement of a stock option pool is a key negotiated item in equity venture financings (Series Seed, Series A, etc.).
What is a stock option pool, stock plan, equity compensation plan, employee stock option plan (ESOP), etc.?
These are all various terms for the same thing: A number of shares that the company sets aside to be issued at a later date, typically to employees in the form of stock options (which can later be exercised so the employee owns the underlying shares). In addition to employees, other service providers like independent contractors and outside advisors may also receive equity from the pool.
A stock option pool is typically set up in connection with a company’s first financing round, and is increased or “refreshed” in future financing rounds. It provides the company with an equity “budget” to be spent compensating contributors in addition to cash, and is one of the key reasons that startups are able to lure employees with high salaries away from their current jobs.
These are all various terms for the same thing: A number of shares that the company sets aside to be issued at a later date, typically to employees in the form of stock options (which can later be exercised so the employee owns the underlying shares). In addition to employees, other service providers like independent contractors and outside advisors may also receive equity from the pool.
A stock option pool is typically set up in connection with a company’s first financing round, and is increased or “refreshed” in future financing rounds. It provides the company with an equity “budget” to be spent compensating contributors in addition to cash, and is one of the key reasons that startups are able to lure employees with high salaries away from their current jobs.
Creating a stock option pool, or increasing its size, requires majority approval of the board of directors and the stockholders.
When should we grant NSOs vs. ISOs?
While NSOs are usually issued to rank & file employees, consultants, contractors, and advisors, ISOs are often reserved for the founders and key employees. The tax benefits of ISOs serve as an added perk for the leadership’s services, while regular employees enjoy the relatively straightforward exercise process of NSOs. Usually, rank & file employees may not have the financial flexibility to exercise to hold illiquid stock prior to an initial public offering (IPO) or M&A event, so the benefit of ISOs might be moot.
What are incentive stock options (ISOs)?
Incentive stock options (ISOs) are one of two common types of stock option (along with non-qualified stock options or NSOs).
ISOs are not taxed at the time of grant. And, unlike NSOs, there is no income tax when an ISO is exercised (however, it is worth noting that the difference between the exercise price and the fair market value at the time of exercise is subject to the alternative minimum tax, which may apply to the grantee). This means that ISOs are more commonly exercised prior to a liquidity event in order to receive the preferential (lower) long-term capital gains tax rate, which only begins when an option holder exercises an option to purchase the underlying stock and comes into effect once that stock has been held for at least a year prior to sale.
The best case scenario is for an option holder to receive options with a low exercise price, to exercise those options, hold for at least one year, and then sell at a per-share price much higher than the exercise price, paying long-term capital gains tax on the sale.
Incentive stock options (ISOs) are one of two common types of stock option (along with non-qualified stock options or NSOs).
ISOs are not taxed at the time of grant. And, unlike NSOs, there is no income tax when an ISO is exercised (however, it is worth noting that the difference between the exercise price and the fair market value at the time of exercise is subject to the alternative minimum tax, which may apply to the grantee). This means that ISOs are more commonly exercised prior to a liquidity event in order to receive the preferential (lower) long-term capital gains tax rate, which only begins when an option holder exercises an option to purchase the underlying stock and comes into effect once that stock has been held for at least a year prior to sale.
The best case scenario is for an option holder to receive options with a low exercise price, to exercise those options, hold for at least one year, and then sell at a per-share price much higher than the exercise price, paying long-term capital gains tax on the sale.
ISOs are subject to certain additional important requirements (not required for NSOs), including, but not limited to:
Only employees may receive ISOs (this excludes contractors, advisors, board members, etc.)
No more than $100,000 of shares can become exercisable each year.
If the grantee holds more than 10% of the company’s stock on a fully-diluted basis (founders), the exercise price must be ≥ 110% of fair market value.
What are non-qualified stock options (NSOs)?
What are non-qualified stock options (NSOs)?
Non-qualified stock options (NSOs) one of two common types of stock option (along with incentive stock options or ISOs). NSOs can be received by the company’s employees as well as non-employee affiliates such as advisors, consultants, and independent board members.
NSOs are not taxed at the time of grant.The grantee is taxed when the option is exercised. The grantee is taxed at the ordinary income tax rate, and the taxable amount is the difference between the stock’s fair market value at the time of exercise minus the exercise price.
Non-qualified stock options (NSOs) one of two common types of stock option (along with incentive stock options or ISOs). NSOs can be received by the company’s employees as well as non-employee affiliates such as advisors, consultants, and independent board members.
NSOs are not taxed at the time of grant.The grantee is taxed when the option is exercised. The grantee is taxed at the ordinary income tax rate, and the taxable amount is the difference between the stock’s fair market value at the time of exercise minus the exercise price.
Since the tax is due immediately, NSOs can be disadvantageous in certain circumstances. At the time of exercise, the grantee must pay the exercise price as well as any taxes, and, in the case of a private startup company, the stock is usually illiquid, so the option holder may not be able to sell a portion of the stock to cover the costs. In the worst case scenario, the company could fail, so the option holder would have paid the exercise price and taxes on valuable stock, and then end up with worthless stock.
As a result, an NSO option holder usually waits until a liquidity event (like an initial public offering (IPO)) in order to exercise and sell NSOs.
What are stock options? How do they work?
A stock option grants the right, but not the obligation, to buy a certain number of company shares at an agreed-upon price and date. If the value of the company’s stock rises after receipt of the option, the option holder can exercise their options and sell stock, making money on the difference between the purchase (exercise) price of the option, which remains stable, and the actual price of the stock, which is variable (and hopefully increasing). Stock options typically expire after 10 years and must be exercised prior to expiration.
Stock options are not taxed at the time of grant if the exercise price is at least equal to the fair market value of the underlying stock at the time of grant. This price is usually set by a third-party valuation firm to create a statutory safe harbor under Section 409A of the Internal Revenue Code (a “409A valuation”). This allows contributors to receive valuable rights to equity without incurring large tax liability upon grant.
There are two types of stock options with different tax treatment, but here is a basic example for Incentive Stock Options (ISOs): Company X grants an employee an option to purchase 100,000 shares of stock at a price of $1.00 per share. If the following year the value of Company X’s stock rises to $2.50 per share, then the employee could exercise some or all of their options and earn $1.50 per share upon sale.
Types of Equity: Summary Chart
Common Stock
NSOs
ISOs
RSAs
RSUs
Who usually receives it?
Founders
Employees, advisors, consultants, contractors
Founders and key employees
Employees
Employees
When do you actually receive stock?
At the time of grant, in accordance with the applicable vesting schedule.
If vested, at time of exercise; if unvested and *early exercised, then in accordance with the applicable vesting schedule.
If vested, at time of exercise; if unvested and *early exercised, then in accordance with the applicable vesting schedule.
At the time of grant, in accordance with the applicable vesting schedule.
At the time of grant, in accordance with the applicable vesting schedule.
Payment at grant
Par value or nominal value (often a fraction of a penny per share)
Not applicable
Not applicable
Par value or nominal value (often a fraction of a penny per share)
None
Payment at exercise
Not applicable
Exercise price multiplied by the number of options exercised
Exercise price multiplied by the number of options exercised
Not applicable
Not applicable
Tax treatment
Can use 83(b) election to minimize ordinary income tax liability; capital gains owed upon sale; qualified small business stock exclusion may apply.
No tax at time of option grant; difference between strike price and stock value subject to ordinary income tax at time of exercise; capital gains owed upon sale.
No tax at time of option grant; difference between strike price and stock value subject to alternative minimum tax (if applicable) at time of exercise; capital gains owed upon sale.
Can use 83(b) election to minimize ordinary income tax liability; capital gains owed upon sale; qualified small business stock exclusion may apply.
Generally taxable as ordinary income when they vest.
