KNOWING YOUR OPTIONS
If you’re a startup founder or an employee, then you need to know not all stock option grants are the same. In fact, you could be paying more than you think, depending on the type of option you hold.
what are options
Before going into the different types of option grants, you should understand that an option grant is not the same as owning stock in a company. Instead, an option grant represents the right for you – the optionee – to buy a certain number of shares of a startup’s common stock at a locked-in value. You must exercise this right and pay the corresponding price to receive all or a portion of your vested shares. You do not have voting rights or oversight as a stockholder in the company’s affairs until you exercise all or a portion of your stock option grant.
Benefits of a stock option grant
Option grants provide employees and contractors access to company equity. An alternative to option grants is restricted common stock, which provides outright ownership in the company and voting rights to the holder. However, these grants are typically priced at the fair market value of the common stock. Acquiring restricted stock early in the company’s lifecycle can be advantageous for a service provider since the valuation of the company is likely to be low. However, as a startup continues to scale and increase in valuation, the fair market value of the shares of common stock will continue to appreciate anywhere from a few cents to dollars per share. Since you must pay these shares, this can result in a hefty lump sum payment to the company as soon as the restricted stock grant is made. Option grants provide the holder discretion to exercise all or a portion of their vested amount at a later point in time, delaying payment in one lump sum or on an installment basis.
TYPES OF OPTION GRANTS
Now that we’ve covered option grants and their significance, let’s dive deeper into different forms of grants. An option grant can have either an ISO (incentive stock option) status or a NSO (non-qualified stock option) status. Aside from eligibility requirements, the primary difference lies in their tax treatment. With NSO grants, the holder is taxed upon exercise of their option grant and upon sale of the issued stock. ISO grants, on the other hand, are only taxed upon sale of the obtained stock.
Let’s assume you were granted an NSO award of 10,000 shares of common stock with an exercise price per share of $0.01 and a four-year vesting schedule. After two years, the company’s market valuation has greatly appreciated, such that the fair market value of the common stock is $1.00 per share. As an employee, you see a clear path to the startups exit relatively soon and decide to exercise your vested shares, which is half of the grant. Upon exercise, you will pay $50.00 in total (5,000 shares of Common Stock * $0.01). This is great! You now own shares that are 100x than what you paid. However, that same tax year, you would recognize the spread between the fair market value per share of Common Stock and the price paid per share. In this case, you would recognize as ordinary income $4,950.
ISOs also get the benefit of a long-term capital gains tax rate upon disposition of the stock. Assuming you meet the holding period requirements noted below and sold your stock issued upon exercise, you’d recognize the spread of the price at which the shares are sold and the exercise price per share as a long-term capital gain. If you fail to meet the holding period requirement and sold your stock, the shares will automatically be treated as NSOs for tax purposes. You would recognize as ordinary income the spread of the fair market value of the shares when you exercised the grant and the exercise price per share and recognize as a capital gain the sales price per share and the fair market value per share upon exercise.
In the above example, let’s assume that you were granted an ISO award instead of an NSO grant, and you sold your shares at $2.00 per share. If you held your shares more than a year after exercise and two years after grant, you would recognize $9,950 as a long-term capital gain (5,000 shares * ($2 per share sales price – $0.01 per share exercise price)). If you held your shares for a shorter amount of time, then your 5,000 shares will be treated as an NSO upon sale. $4,500 will be recognized as ordinary income, and $5,000 will be recognized as a capital gain.
Do I get to choose between an ISO and NSO?
Typically, service providers don’t get a say on whether their stock options will be treated as an ISO vs. NSO as these are tax-regulated and subject to certain eligibility criteria. Only employees are eligible to receive an ISO grant and, even then, only up to $100,000 worth of the shares underlying the grant exercisable in an annual year can retain an ISO status. This $100,000 limit is determined based on the fair market value per share of common stock as of the date of grant. Further, the shares exercised under the grant must be held more than two years after grant and more than one year after exercise to retain ISO tax treatment. Other eligibility requirements will apply depending on whether the number of shares subject to the grant equals 10% or more of the total voting power of the company.
one more layer of complexity
Some stock option plans allow for an early exercise option, where you can exercise all or part of your shares before they vest. Any unvested shares issued upon the exercise will be subject to repurchase from the company at original cost per share. The holder would effectively own restricted stock, begin their capital gains holding period earlier, and make it more likely for the holder to obtain QSBS tax treatment for their shares.
Early exercise, however, can complicate an ISO grant status. Specifically, the $100,000 limit will apply to all shares subject to the grant for that tax year because all shares are exercisable within the first year. This means that less of the shares subject to the grant may be afforded ISO status. Making matters even more complicated, the shares issued upon exercise and still subject to vesting will be subject to tax recognition during the holding period. As the holder, you will recognize as ordinary income the spread of their fair market value at each vesting date and the exercise price per share for each share issued upon exercise and still subject to vesting/repurchase.
Understanding these nuances can help you make more informed decisions about stock options in a startup environment.
