Joining a startup? Get your stock options right! Here's what to know about grant sizes, vesting, cliffs, exercise price, and the ISO v. NSO dichotomy, plus advanced asks around accelerated vesting, cashless exercise, future retention grants, extended post-termination exercise rights, and the possible pros and cons of restricted stock awards versus stock options.
Executive Summary
Not a Substitute for Cash. Unless you are rich, stock options should only supplement and not replace cash compensation. Most stock options turn to dust, so be sure to be paid fairly.
Option Grant Sizes/Ranges. At the risk of stating the obvious, when it comes to equity grants, bigger is better. So ask for equity grants at the higher end of the range for your position. It may seem difficult to get good information on what that range is, but well-managed startups follow roughly consistent equity granting practices, so a few questions and clever negotiation can help guide your equity grant to an appropriate level.
Restricted Stock Award Alternative. When joining a very recently formed startup, a grant of restricted stock may have advantages over stock options. The word “restricted” simply means the stock cannot be sold, except in compliance with certain rules and restrictions. But unlike options, the holder of restricted stock is an actual stockholder. As discussed below, IRS Section 1202 eliminates up to $10M of capital gains tax on startup stock held for 5 years before being sold/cashed out. But restricted stock grants can create substantial tax risk, especially when issued recklessly by companies with valuable stock but deficient legal or tax expertise. Among other concerns, restricted stock grants are taxed as income as they vest based on their value at the time. Sadly, many have received whopping tax bills after receiving illiquid restricted stock.
Follow-On Grants/Retention Equity. Ask whether the company issues additional future equity grants, also called “retention equity,” and see if they are willing to commit to future grants to reward performance. If you received 150,000 stock options up front, you might try to negotiate additional annual tranches of 40,000 options for superior job performance, or about 20% to 25% of the original grant per year.
Vesting and Cliffs. Many companies consistently impose four-year vesting with a one-year “cliff.” If you leave within year one, a one-year cliff means none of your options will vest. It may be easier to shorten or entirely negotiate away a cliff than to shorten your vesting period, but two and three-year vesting may be possible for in-demand job candidates.
Acceleration on COC. Consider asking for “acceleration of vesting upon a change of control.” This is a request to have all of your options or restricted stock vest upon a change of control (“COC”) involving more than 70% of the company’s stock or assets.
ISOs versus NSOs. Options come in two types, – incentive stock options (“ISOs”) and non-statutory options (“NSOs”). You should read this article from Cooley to understand their different tax consequences - "ISOs v. NSOs: What’s the Difference?" The primary advantage of ISOs is that, unlike NSOs, they do not trigger income tax when exercised. When negotiating an option grant, you should request that it be an ISO, but the company might have a policy of only issuing NSOs, since they allow the company to take certain tax deductions, while ISOs do not.
Exercise Price and Cashless Exercise. The tax code requires stock option exercise prices to be at fair market value at the time of grant, so don’t waste effort trying to negotiate a lower exercise price. But you can request “cashless exercise,” also called “net exercise,” meaning the company commits to letting you exercise your options for no money out of pocket, but rather allowing you to net your total exercise consideration against the number of shares you receive.
Post-Termination Exercise This is aggressive, but consider requesting the right to elect to convert your ISO to an NSO if you depart the company other than for termination for cause, and request a right of post-termination exercise for two or more years. Otherwise, ISOs must be exercised within 90 days of leaving the company or they expire. For many, leaving a job can strain finances and you might need your available cash for purposes other than exercising options. Getting a two-year or greater extension on your exercise period can be a big win, even if some tax advantages are lost in converting from ISO to NSO options. If you know your options will be NSOs, definitely consider asking for one or two years to exercise after termination of employment. Any meaningful post-termination exercise extension can mean the difference between enjoying a lucrative cashless/net exercise in a big M&A exit or completely missing out on the deal.
Timing of Option Exercises. Whether and when to exercise options is a highly fact-dependent question, but one that is worth studying carefully and then seeking professional advice to make a clear plan of action to minimize potentially significant tax consequences.
DISCLAIMER:
NOT LEGAL, TAX, OR FINANCIAL ADVICE
ALWAYS CONSULT PROFESSIONAL ADVISORS
REGARDING YOUR SPECIFIC FACTS AND CIRCUMSTANCES
Overview
To stretch tight budgets and inspire employee performance, startups usually sweeten compensation packages with stock options, restricted stock, or restricted stock units – what we call “equity compensation,” or “equity incentive compensation.”
After you successfully interview with a startup, they might send you an Offer Letter Agreement that says something like, “In addition to your salary, we will recommend to the Board that you receive a grant of 50,000 stock options that will vest over four years, subject to a one-year cliff, and an exercise price at the fair market value per share (“FMV”) at the time of grant.”
This article will help you understand that language and, more broadly, how to think about, negotiate, and manage equity compensation.
Corporation versus Limited Liability Company Equity Interests
Most high-growth, venture capital-funded tech startups are corporations – i.e., companies with “Inc.,” “Corporation,” or “Corp” at the end of their names.
But many other high-growth companies are formed and structured as limited liability companies, or “LLCs.” An LLC’s official “legal name” will end with either “LLC” or “Limited Liability Company.” You may have to probe a bit to identify LLCs, as they often seem to omit the LLC designation in their branding and even in their consumer and employee-facing documentation.
LLCs are quite different from corporations. They are hybrid entities that have some attributes of corporations, but they borrow more from partnership law and contract law.
Equity interests in corporations are fairly commonly understood, relatively transparent, and fairly linear/mathematical in how their value is calculated. These are primarily stock (both common and preferred) and other instruments based on stock, like stock options, restricted stock, and phantom stock.
LLCs, on the other hand, issue partnership-like interests called Membership Units and complex incentive compensation equity grants of various types that might be called phantom units, revenue participation interests, or something even more exotic. No LLC ever issued a stock option, at least not legitimately.
The ultimate value of an LLC equity incentive grant is almost always harder to calculate and they are also subject to more severe risks of forfeiture than a typical corporate equity grant. Usually, for example, if you leave an LLC, you leave all equity on the table.
This is generally not the case with stock options or restricted stock awards, which have more reasonable vesting periods in which the rights of the employee become more fixed. Vested stock options can usually be exercised at any time, including for up to 90 days after leaving a job in most cases.
In general, equity grants in corporations are better for employees than equity grants in LLCs. Without going into too many boring details, an equity grant in a corporation is generally a lot easier to evaluate and understand, less susceptible to being gamed against the employee’s interests, and less likely to be forfeited back to the company at termination of employment.
For those reasons, and because LLC equity compensation is simply too complex for the intended purpose of this article, this article focuses solely on equity in corporations.
Equity is a Supplement to Compensation, Not a Replacement
Perhaps the most important advice is to keep equity compensation in perspective.
If you are willing to work at a startup for less pay because of the training and learning experiences offered, that is a legitimate exchange of value, especially if your resume is on the light side and you will be learning and growing on the job.
But, unless you are already independently wealthy, do not accept a substantially below-market wage or salary in exchange for an equity grant.
This is because the vast majority of equity grants never turn into cash.
Reasons Most Equity Grants Turn to Dust
Here are four common reasons most equity grants never produce any cash value:
Failure to achieve a “liquidity event” in which the equity grant is converted to cash, such as an IPO or acquisition. We call this kind of liquidity event an “exit.”
Equity grants that are “out of the money” – i.e., stock options that have a higher exercise price than their cash value in an exit. We discuss exercise price below.
Forfeiture of “unvested” equity grants following termination of employment due to departing employees’ oversight or conscious decisions to not exercise vested options due to cost.
Company debts and senior investor “liquidation preferences” can prevent any cash in an acquisition from going to the holders of common stock, and hence to employees holding equity grants.
The stars need to align just perfectly before an equity grant produces any meaningful cash value:
The grants need to be on reasonably favorable terms, such as a low exercise price for options.
The company needs to be very successful at creating real or perceived value.
That value needs to be unlocked in a cash liquidity event, either in the form of an IPO, an acquisition, or a rare type of financing transaction in which early investors and employees might be partially or wholly cashed out.
The employee needs to retain the equity grant against risks of expiration or forfeiture until the liquidity event, usually by remaining employed by the company.
The amount of value created in the liquidity event needs to be greater than the sum total of the company’s debts, transaction costs, and obligations to preferred stockholders called liquidation preferences.
That final hurdle relates to what is known as the payout “waterfall” in a sale exit. In a sale of a company for $120 million for example, the company might have $40 million of senior indebtedness and $80 million of preferred stock liquidation preferences. These are amounts that are paid out before any holders of common stock see any of the sale proceeds.
In this scenario of a $120 million sale and $120 million in senior obligations, holders of common stock and stock options for common stock would receive zero dollars unless the holders of the preferred stock agree to forgo some of their liquidation preferences. Fortunately, it is relatively common for holders of preferred stock to agree during a sale exit to set aside some cash for the holders of common stock, including "optionees." They do this for noble reasons and also to reduce their risk of being sued by aggrieved common stockholders.
Key Terms of Equity Grants and What is Negotiable and What is Not
Determining whether an equity grant has good economic terms is tricky for most job candidates. While a CFO candidate may have the leverage to obtain detailed financial statements and capitalization tables, most prospective employees have no such leverage. This makes it difficult or impossible to meaningfully assess the true future value of an equity grant the way one can more easily evaluate the prospects of a publicly traded stock.
And equity grants are often made on a “take-it-or-leave-it” basis, so efforts to negotiate terms can be met with resistance. But that does not mean it is not worth trying.
Stock Options versus Restricted Stock Awards
Stock Options. A stock option is a board-approved contract between a company and employee (or other “service provider,” like an independent contractor or board member) that gives the employee the right to purchase a certain number of shares of stock at a specific price (the “exercise price”) for a certain period of time (the “life of the option,” usually ten years from grant date). To convert a stock option into actual stock, the holder must “exercise” the option by submitting a Notice to Exercise to the company and paying the exercise price.
Virtually all stock options “vest” (become exercisable) over time. The most common stock option vesting formula is vesting in equal monthly amounts over a four-year/forty-eight month period, subject to a cliff. Cliffs are often one year, but six months is also common. Stock options have no tax consequences to the holder until they are exercised. And the holder of ISOs can avoid taxation at exercise under certain circumstances.
Restricted Stock. A restricted stock award is a grant of a certain number of shares of stock that are subject to what we call “reverse vesting.” We say reverse vesting because the holder often owns all of the shares up front, but they are subject to a “risk of forfeiture” back to the company on a schedule that often mirrors a typical option vesting schedule.
The vast majority of startup equity grants are stock options, but a job applicant should know when to consider requesting an award of restricted stock instead.
In general, unless you pay the full value for a grant or award of restricted stock, it will be taxable to you as income. If it is fully vested at grant (unlikely), it will be taxable as income at that time. If it vests over time, each tranche will be taxable as it vests. This is one reason to prefer stock options, which are never taxed until the option holder decides to exercise.
In my view, the very best time to get an award of restricted stock is at or near the time a company is formed, when the stock has no value or very little value.
On the other hand, it is risky to receive an award of restricted stock that has substantial value at the time of the award. There are slightly complex ways to delay any tax consequences (i.e., double-trigger vesting, with the final vesting occurring only at the time of a substantial liquidity event) until a liquidity event, but even then, you can experience tax pain if the shares of stock are not immediately cashed out in the liquidity event.
I once received restricted stock that vested in an IPO, but I was an insider and hence unable to sell them until they lost most of their value. I paid more in taxes than the current value of the shares. Perversely, those who quit the company just before the IPO and sold everything at the earliest opportunity made the most money – not those of us who stayed on to ensure the success of the company’s transition to public status.
Despite that rough experience, I always opt for restricted stock awards in companies that I help form and I make sure those awards are made within weeks of formation, when their verifiable value is zero dollars.
Because these restricted stock awards are subject to vesting over three or four years, it is very important to file a tax form called a Form 83(b). By filing this form, you “elect” to pay all employment taxes due on the shares, even though you might lose most of them to forfeiture back to the company if you leave while they are still reverse-vesting. In these situations, I’m effectively telling the IRS, “please include in this current tax year $0.00 of income for me for these shares, the tax on which is $0.00.”
A Form 83(b) must be filed within 30 days of receiving an award of restricted stock that is subject to risk of forfeiture. Failure to do so can be catastrophic, as both you and the company will have tax obligations to calculate and remit with each monthly, quarterly, or annual reverse vesting milestone, as applicable to the specific grant.
These tax complexities and risks are part of why most equity grants are stock options. Another big reason favors companies – that’s the simple fact that most options expire unexercised. As mentioned earlier, ISOs must, by IRS rule, be exercised within 90 days of an employee’s termination of employment. Many employees simply choose not to pay thousands of dollars to exercise options if they are uncertain about if or when their company will be sold for big bucks, go public, or go bust.
When options expire unvested or unexercised, they go back into the stock option pool to be granted to another employee. The holder of restricted stock, however, generally, gets to keep all vested shares at the time of their departure from the company.
Number of Options/Shares of Restricted Stock
The next big question is how many options or shares of restricted stock should you try to get from a company?
As mentioned in the executive summary, the short answer is “as many as you can.”
But every well-run company has internal guidelines or established practices, written or unwritten, dictating ranges for option grant sizes by position. And often, but not always, these option grant ranges are calibrated to a somewhat standardized capitalization structure based on the company having 10,000,000 total “authorized shares.” This means the company’s initial Certificate of Incorporation will state the following:
“This corporation is authorized to issue only one class of stock, to be designated Common Stock. The total number of shares of Common Stock presently authorized is 10,000,000, each having a par value of $0.0001.”
As validation for this point, it is worth noting that 10,000,000 authorized shares is the default number in CooleyGo’s “Delaware Incorporation Package,” found at www.cooleygo.com.
Out of this total of 10,000,000 authorized shares of common stock, a company that plans to issue equity compensation is likely to “reserve,” or set aside, by action of the board and the shareholders, between 1,000,000 and 2,000,000 shares of common stock under the equity incentive compensation plan.
The company’s board might then establish ranges for option grants to future hires along these lines, based on authorized shares of 10,000,000:
Position/Role Option Grant Range/Shares
Non-founder CEO 800,000 - 1,000,000
CFO 500,000 - 800,000
CTO, GC, Senior VPs 200,000 - 500,000
Director Level Employees 150,000 – 250,000
Manager Level Employees 80,000 – 150,000
Individual Contributors 40,000 - 80,000
Administrative/Support 20,000 – 40,000
Regarding the above table, most startups do not hire a CEO, as one of the founders is likely to serve as CEO for at least the first five to ten years. But most startups do hire a CFO once they have raised a substantial “Series A” or “Series B” VC-backed financing.
In general, it is often safe to assume that a promising startup or emerging growth company that has been properly formed is administering its option plan somewhat along these lines. So if you are offered a job as a director-level employee and your offer letter mentions an option grant to purchase 250,000 shares of stock, you might be pretty close to the top of their usual range for your position. If the option grant is for 10,000 shares of stock, you should start asking questions. For me, it would go along these lines:
“Thanks Beth. The option grant seems very low for the position. Can you tell me how many authorized shares the company has in its current certificate of incorporation, how many shares are reserved under the option plan, and what the usual option grant range is for similar positions in the company?”
Beth might be a bit taken aback by these questions, but they show you understand some things about cap tables and option grants, which she might appreciate.
There are many good articles online about typical option grant levels, many of which discuss grant levels in terms of percentages of the total number of shares outstanding.
The better denominator for calculating and analyzing equity grant percentages is what is called the total number of “fully diluted” shares, or “total outstanding shares on a fully-diluted basis.” That means all shares of common stock already issued and outstanding, plus all outstanding equity grants, plus the remaining pool of shares “reserved for issuance” under the company’s equity incentive compensation plan.
Here are a few good articles on option grant levels:
Exercise Price
As mentioned in the executive summary, options must be issued at “fair market value,” or FMV, per strict requirements under the U.S. Internal Revenue Code. In fact, most companies need to regularly pay outside firms to create valuation reports called “Rule 409A valuation reports,” which provide a detailed analysis showing the exact FMV per share.
Again, as with restricted stock grants, it is generally better to get stock options early in a company’s life than later, as that is when the exercise price for the company’s options is likely to be the lowest, hopefully just pennies per share.
After a company has done one or more VC-backed financings, its FMV for stock option issuances is likely to go up substantially, ranging perhaps from $.25 per share to $1.80 per share or higher.
Options with higher exercise prices will provide their holders with less value, if any, in a sale or IPO. If, for example, the total cash consideration in a deal is calculated at $1.25 per share, holders of options with an exercise price of $1.80 per share are out of luck, as their options are “out of the money.”
And then there is the problem of the payout “waterfall” in exits, discussed earlier – in a sale of a company for $120 million for example, the company might have $40 million of senior indebtedness and $80 million of preferred stock liquidation preferences, leaving zero dollars for holders of common stock or holders options for common stock.
Given these consequences of exercise prices and payout waterfalls, it is worth asking about a company’s current stock option FMV, its fully diluted share count, its total amount of debt and the amount of VC funding it has received (which will generally equal its total liquidation preferences), and about its prospects for a suitably lucrative exit.
Stock options with a significant exercise price from a company with substantial debts and liquidation preferences will never be worth anything if the company is not tracking toward a meaningful sale or IPO, no matter how many of them you have.
A final point on exercise price. Very few people think to ask for this, and it’s probably rare for companies to put this into an offer letter agreement, but a contractual agreement allowing for “cashless exercise” would be a fantastic win.
This means that the option holder can just have the company withhold some shares instead of the option holder paying cash to exercise. Most companies end up allowing for cashless exercise in M&A deals and IPOs, but it’s rare to have that right outside of a transaction, as it’s in the company’s interest to limit exercises by requiring cash.
Vesting Periods and Cliffs
Vesting periods and cliffs can be tough to negotiate, but it’s generally worth trying. Perhaps the easiest concession to get is acceleration of vesting in connection with a sale. In your offer letter agreement, you would simply ask to include something like, “All of Employee’s unvested options shall be deemed fully vested in the event of a merger or sale involving at least 70% of the company’s stock or assets.”
If the company’s typical stock option awards vest in 4 years with a one-year cliff, you might also succeed at negotiating the one-year cliff to six months. And if you are a particularly desirable candidate, you should also consider requesting two or three years vesting. With two-year vesting, each month you will vest into twice as many shares as you would have with four-year vesting.
Not a One-Time Deal
As mentioned in the executive summary, it might be worth starting a conversation about additional grants by asking if the company has a policy or practice of issuing retention grants as part of its annual compensation review cycles. As noted in some of the articles listed earlier, it is a common practice.
Whether the answer is yes or no, this might provide an opportunity to ask something like, “Assuming my performance is strong, what is the possibility that I might be awarded additional option grants in the future?” If the answer seems favorable, that might create an opportunity to follow up with, “Would the company consider putting something about future equity grants in my offer letter agreement?”
Repurchase Rights, Forfeiture Provisions, and Other Clawbacks
Repurchase rights and clawbacks are commonly found in restricted stock awards, as those are the mechanisms that implement reverse vesting – i.e., those awards are subject to either repurchase or outright forfeiture in the event of a departure before fully vesting.
But stock options and/or shares issued upon the exercise of options can be subject to more arbitrary risks of forfeiture or repurchase, depriving
grantees of all value represented by the options. This happened when Microsoft bought Skype. The following is an excerpt from my book, Startup Law and Fundraising:
Leading up to Microsoft’s acquisition of Skype in May 2011, Skype employees with vested stock were likely looking forward to their big payday. But for some, the big payday never happened. That’s because Skype fired some of its executives just before the $8.5 billion acquisition – ostensibly for performance reasons.
Some of them had very confusing and unfavorable clawback provisions, apparently giving the company the right to repurchase their shares and cutting them out of the larger payout from the then-imminent sale. These shares were acquired back by Skype at the original purchase price, completely erasing any upside value.
The following is the opaque paragraph that permitted these clawbacks:
“If, in connection with the termination of a Participant’s Employment, the Ordinary Shares issued to such Participant pursuant to the exercise of the Option or issuable to such Participant pursuant to any portion of the Option that is then vested are to be repurchased, the Participant shall be required to exercise his or her vested Option and any Ordinary Shares issued in connection with such exercise shall be subject to the repurchase and other provisions in the Management Partnership agreement.”
Presumably, the Management Partnership Agreement contains language confirming the right to claw back the shares at the original purchase price.
In a letter to impacted employees, Skype’s then Associate General Counsel detailed the operation of the above language and the related Management Partnership Agreement, stating matter-of-factly:
“As explained in greater detail below, we are writing to inform you that you will not receive any value from the Options regardless of whether the Options were vested.”
Skype and the private equity firm that had control over it took heat in the press at the time, with one former worker quoted as saying, “Seriously, how greedy do you have to be to make $5 billion and still try to screw the people who made that value possible?”
You would certainly want to be alert for any provision in an option agreement or other documentation that allowed an employer to do this to you, as it is highly unorthodox and quite unethical.
Understanding, Signing, and Keeping Track of Your Equity Documents
As difficult as it might seem, it is important to carefully read, understand, timely sign your equity grant documents, and then know where to find them for future reference.
Stock Options. For stock options, this means the company’s Equity Incentive Compensation Plan, your Equity Grant Notice(s), and your Stock Option Agreement. You should receive all three documents in connection with any option grant, and you will likely be required to sign both your Grant Notice and your Stock Option Agreement.
One of the most important things to do is confirm that the Option Grant Notice and the Option Agreement correctly reflect the key details of your promised grant, including the number of underlying shares, whether ISO or NSO, your agreed-upon vesting period, any agreed-upon acceleration of vesting in a change of control, and any extension of your post-termination exercise period. You will be stuck with any errors or omitted terms, so fix anything that is incorrect or missing.
Failing to sign your docs (and to receive copies signed by the company) could render your grants invalid – especially the absence of a Stock Option Agreement signed by you and an officer of the company.
If you think you have stock options but you haven’t signed any of these documents, you likely do not have enforceable stock options.
These days, you are likely to receive your stock option documents electronically via a cap table platform like Carta, Shareworks, Pulley, or AngelList. It is important to timely follow whatever steps the cap table platform requires. Initially, this usually means responding to an email, establishing an account, and electronically signing your documents. Don’t just do the bare minimum. Among other things, make sure that the platform has all of your contact information, including a permanent email address, phone number and physical address. Bookmark the sign-in page to the platform and revisit it at least annually.
Restricted Stock Awards
A restricted stock award will likely consist of a document that might be called a restricted stock purchase agreement or something similar. It will have one or more attachments, possibly a spousal consent, maybe a form of assignment to facilitate any forfeitures under the agreement, and maybe also an acknowledgement that the recipient must timely file a Form 83(b).
Be sure to check and understand the reverse vesting provisions – likely repurchase or forfeiture language. When in doubt, ask questions before signing.
And again, immediately file your Form 83(b) with the IRS or you could be hit with many thousands of dollars in unnecessary income taxes.
To Exercise or Not To Exercise – Income Tax and Capital Gains Tax Considerations
Whether and when to exercise options are questions that are slightly more interesting than you might think. The five-year holding period under IRS Section 1202, for example, largely goes undiscussed. As noted above, Section 1202 can exempt up to $10 million from capital gains tax, so getting that clock started could be extremely valuable, and it does not start running until an option is exercised and converted to actual stock.
Apart from Section 1202, the difference between short and long-term capital gains taxes can be material. If an Exit transaction sneaks up on an option holder before they can exercise the options and hold actual stock for a year or longer, the tax consequences could be significant.
Short-term capital gains on assets held less than one year are taxed according to ordinary income tax brackets, ranging from 10% to 37%. Long-term capital gains are taxed at 0%, 15%, or 20%, with most taxpayers generally paying at the 15% level, according to the IRS.
Shares issued on exercise of ISOs meeting the requirements detailed below are entitled to long-term capital gains tax. Shares issued on exercise of NSOs held longer than a year are entitled to long-term capital gains tax.
Decisions to exercise are also dictated by income tax considerations. While capital gains taxes hit when actual stock is sold, as in an exit transaction, the mere act of exercising options can also generate taxes.
The following excerpt comes from the article ISOs v. NSOs: What’s the Difference?
“NSOs are generally taxed (for regular federal income tax purposes) upon exercise in an amount equal to the difference between the exercise price and the fair market value (FMV) of the shares on the date of exercise. ISOs, on the other hand, are not taxed (for regular federal income tax purposes) until the optionee sells or otherwise disposes of her shares.”
For employees, this is a significant difference between ISOs and NSOs. There are certain restrictions applicable to ISOs:
ISOs can only be granted to employees, not independent contractors.
ISOs must be held longer than two years after grant and the shares received on exercise must be held longer than one year.
ISOs must be exercised within three months of leaving the company or they expire.
The FVM of ISOs exercisable for the first time in a calendar year cannot exceed $100,000 based on the FMV at the time of grant (any excess will be treated as an NSO). This is one reason for sticking with common vesting terms for large option grants at substantial FMVs/exercise prices.
Only entities taxed as corporations can issue ISOs, not corporations that have elected to be taxed as partnerships (i.e., “S Corps”) and certainly not LLCs.
Another important issue to be aware of is well-described by the following excerpt from “How Your M&A Deal Treats the Payout of Employee Stock Options Can Have Significant Payroll Tax Implications”:
“….Regardless, if the acquisition terms provide that options will be deemed net exercised at closing and paid based on the net number of shares owned, that will cause any ISOs to be treated as NSOs and the proceeds paid will be compensation income subject to all income tax and employment tax withholding.”
This means, in short, that you probably want to go into any M&A deal having already exercised your ISOs, regardless of whether you expect any capital gains tax advantages under Section 1202.
In summary, the decision of when to exercise an ISO versus an NSO is often different, depending on the specific facts and circumstances.
It’s a little less complicated for ISOs, particularly if the exercise price(s) is nominal and affordable – exercise them as they vest or on an every quarter or half-yearly basis. If the options are in a platform like Carta, it is no big deal to go in monthly or quarterly and exercise newly vested options. If you have to sign and process paperwork with your company’s HR or Finance department, monthly might be a bit bothersome for you and them.
For NSOs, it is a mixed bag of issues, as every exercise will be taxable based on the difference between the exercise price and the FMV of the shares on the date of exercise. Each exercise will trigger both Federal income tax and also state, local, and federal payroll taxes. If the exercise price of the NSOs is very low, say $.01 per share, and the FMV at exercise is the same or only slightly higher, say $.09 per share, it may very well make sense to exercise the NSOs promptly and get the Section 1202 clock and the long term capital gains clock running.
But, in general, most people do not exercise NSOs until one of two events: (i) termination of employment and compliance with the NSOs “post-termination exercise period,” usually 90 days under most plans or (ii) a liquidity event/exit.
This is why it is also worth negotiating for “cashless exercise,” also called “net exercise.” In either of the foregoing events – termination of employment or exit – you may not have the cash on hand necessary to exercise, even if your options have substantial value.
As I am not a tax lawyer, feedback from tax experts and equity compensation specialists, including any corrections or supplementations to the above tax-heavy discussion, are welcome and may even result in revisions of the article with appropriate attributions.
Paul Swegle, editor of the StartupGC Blog, serves as in-house chief legal officer/general counsel to numerous tech companies and has advised countless others. He has completed $18+ billion of financings and M&A deals, including growing and selling startups to public companies ING, Capital One, Nortek, and Abbott. Paul teaches entrepreneurship law at Gonzaga Law and Seattle University School of Law and speaks regularly at other top law schools and MBA schools where his popular business law books are widely used in courses focused on entrepreneurship and business law.
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