Your Simplified Guide To Equity Compensation At Start-Ups

Your Simplified Guide To Equity Compensation At Start-Ups

15.0 MIN READ

.Congrats! You’re working at a start-up and you’ve been granted equity compensation so you can participate in the future growth of the company. Do you feel more invested in the company? I hope so.  

But what does this equity compensation mean to you? How does this impact your financial life? What are the risks? What are the tax ramifications?

Receiving equity is not nearly as simple as receiving a base salary and bonus. There are different types of equity, unique decisions for each type, tax ramifications, financial planning considerations, etc. that you need to fully understand.

You can think of equity compensation like wine. Wine is great (obviously!), but there are different types of wine that go with certain foods, seasons, etc. A Cabernet and Sauvignon Blanc are both wine, but they are completely different. Each has its own unique taste, food pairings and seasons that make you want to drink it. The same applies with equity compensation. There are many different types of equity compensation with its own unique decisions.

The decisions for equity compensation you receive from company A will likely differ from the decisions for equity compensation from company B. While there may be common terminology, each company is unique and therefore, there is no uniform decision on what to do with equity compensation. 

With equity compensation, you first want to get educated on what you have and then carefully understand the tax and financial planning implications of how different decisions can impact you. If handled properly, your equity compensation can be life changing. If handled poorly, your equity compensation can set you back financially and produce a massive surprise tax bill.

Equity Compensation Terminology

Before we dive into the details about private company equity compensation, we need to review some basic terminology that will be used throughout this blog post.

Private company/start-up: A company that is not traded on a public stock exchange and therefore has no readily available market where you can sell your shares quickly.

Stock agreement: An agreement that outlines the details of the shares. This is likely a long, confusing document with many legal terms.

Shares granted: The total number of shares that you received from a company.

Vesting: When the stock actually becomes yours. Your equity will likely be subject to some type of vesting schedule which outlines the specific dates when your equity vests. A very common vesting schedule is a 1-year cliff (you receive 25% of a grant after 1 year) and then monthly or quarterly vesting for the next 3 years.

Restricted Stock: Shares that are granted outright to you, but don’t become yours until certain conditions are met (ex – a vesting period, liquidation event, etc.). Upon vesting, you owe ordinary income tax based upon the fair market value of the stock at vesting, unless an 83(b) election has been previously elected (discussed more later).

Incentive Stock Options (ISOs): Stock options that give you the option to buy stock at a pre-specified exercise price and carry potential favorable tax treatment. You don’t owe any ordinary income tax upon exercising, but you may owe alternative minimum tax (discussed more later).

Non-Qualified Stock Options (NSOs): Just like ISOs, stock options that give you the option to buy a stock at a pre-specified exercise price, but don’t have the preferential tax treatment of ISOs. You owe ordinary income tax based upon the difference of the fair market value and exercise price upon exercising.

Restricted Stock Units (RSUs): Similar to Restricted Stock (confusing AF right?), except the company provides a promise to grant you shares upon certain conditions being met (ex – a vesting period, liquidation event, etc.). Upon vesting, you owe ordinary income tax based upon the fair market value of the stock at vesting. You can’t make the 83(b) election on these shares.

409(a) valuation: An independent appraisal of what the company stock is worth. These are typically done annually by the company, or when specific events occur like new fundraising. This will set the new fair market value of the stock.

Funding round: The number of rounds that your company has received outside financing. The earliest rounds are referred to “seed funding” and then subsequent rounds are classified by “series funding”. Series funding are classified by letters – Series A is the earliest and it can continue all the way to Series E in some cases. Most companies strive for some type of liquidation event (IPO or acquisition) after Series C.

Initial Public Offering (IPO): This occurs when the company lists itself on a stock exchange where shares can typically be freely bought and sold, subject to company trading restriction for employees. This allows investors, employees and founders to “cash out” – you’ll typically start seeing your employees rolling up to work in nicer cars after an IPO occurs. The stock market sets the stock price of the company which changes daily.  

Company Acquisition: Similar to an IPO, but instead of a company listing itself on a stock exchange, it is acquired by another company. The acquisition price is set based upon the purchase agreement and payments are typically made via cash and sometimes additional stock in the new company. You’ll also likely see employees rolling up to work in nicer cars after a company acquisition.   

Ordinary Income Tax: Any type of income that is earned by an individual and subject to the standard tax rates. These rates start at 12% and increase up to 37% as income increases.

Capital Gain Tax: Any income or loss that is generated from the profit of an investment. These rates are lower than ordinary income tax rates. Capital gains rates start at 0% and increase up to 20% as income increases.

Does your head hurt yet? You’re not alone. This stuff is confusing, but hopefully this is helpful for you to reference.

Now onto a deeper dive into equity compensation. The sequence of equity compensation below corresponds to when equity compensation is typically issued when the company gets older.   

Start-Up Restricted Stock

Restricted Stock is rare to receive – it’s typically granted at the very, very early stages of a company. Why is that?  

Remember – Restricted Stock is taxed as ordinary income based upon the fair market value of shares upon the vesting date. If you have 1,000 Restricted Stock that vests at a $15 market value, you owe ordinary income tax on 1,000 * $15 = $15,000.

The issue though is that the Restricted Stock likely has no market to sell. This means you just paid tax on $15,000 of stock that you can’t do anything with!

Therefore, Restricted Stock is most commonly granted to employees when the stock value is $0 or very close to $0. If a company is incentivized to keep you around, Restricted Stock is a good way to do this, especially since the tax impact to you would be very minimal when the stock is essentially worthless.

83(b) Election for Restricted Stock

Restricted Stock is also eligible for a special tax election called 83(b). 83(b) allows you to elect full taxation upon receipt of the shares, even if the vesting doesn’t occur for future years. After the 83(b) election is made, any subsequent gain is treated as a capital gain, instead of ordinary income, which has lower tax rates when the shares are held for >1 year.

But why would you elect to be taxed on something before you own it? Well, if the current value of the Restricted Stock is $0, then you are electing to be taxed on something that is worthless and therefore, you don’t owe any tax upon election of 83(b). You also just converted any future gain from ordinary income to capital gain which will lower your future tax bill. It’s a win-win.

Now, if the value of the Restricted Stock >$0, then it’s riskier to make the 83(b) election since you would owe a tax upon making the 83(b) election. In addition, if you make the 83(b) election and then leave before all of the stock is vested, there is no way to get back the tax you paid on shares that you don’t yet own!

The 83(b) election must be made with 30 days of receipt of Restricted Stock, so it is a very timely election that you need to make. The company likely has a blank 83(b) form for you to complete and submit to the IRS on your behalf.

Once you have Restricted Stock, there is not much you can do until some type of liquidation event happens in the future, so be sure to keep good records of the stock receipt and 83(b) election because you may need to dig that up down the road.

Start-Up Incentive Stock Options (ISOs) + Non-Qualified Stock Options (NSOs)

Incentive Stock Options (ISOs) and Non-Qualified Stock options (NSOs) are the most common types of equity compensation you’ll receive at a start-up. ISOs are only granted by corporations (not LLCs or partnerships) and only employees (not advisors, consultants, etc.) can receive up to $100,000 of exercisable ISOs in a calendar year.

Unlike ISOs, NSOs can be granted to anyone (consultants, advisors, banks, etc.) in addition to employees. Due to the $100,000 ISO annual limit to employees, you may receive a mix of ISOs and NSOs if you are receiving a high amount of equity compensation from your employer.

Companies typically begin offering ISOs and NSOs around Series A funding. At this point, the company has convinced some outside investors that the company has a bright future and therefore, the stock begins to have value.

You will likely receive an initial grant of ISOs and NSOs upon starting with the company and then may be eligible to receive additional grants in future years. Your grant details will include:

  • The number of shares granted
  • The exercise price
  • The vesting period

The most common vesting period is a 1-year cliff where you received 25% of shares after you hit your 1 year of employment and then a monthly or quarterly vesting afterwards.

Upon grant of ISOs and NSOs, the exercise price is the current fair market value (or 409A valuation) of the company. Especially at early funding stages, it’s common to see this exercise price be very low (<$1/share). If you wanted to exercise any options, the cost to exercise would be the amount of shares multiplied by the exercise price. For example, if you have 50,000 ISOs at $0.35 exercise price, you need to pay 50,000 * $0.35 = $17,500 to own the shares.

Why Should You Exercise Private Company ISOs?

Exercising ISOs early can often be a good idea if you feel confident about the company’s future and you can afford the risk of never seeing the cash you used to exercise again. Remember, there is no readily available market for this private company stock, so there is certainly a risk that the shares could turn out worthless.

As the market value of the stock goes up in the future, it can be more costly for you to exercise the options from a tax perspective, as opposed to when the market value of the stock is close to/at the exercise price.

When you exercise ISOs, any future gain on the stock will qualify for preferential capital gain tax if you hold the stock for both a) two years from grant and b) 1 year from exercise. If the company has a liquidation event in the future, this could result a large tax savings compared to not exercising the shares and having any future gain taxed as ordinary income.

If you exercise ISOs and don’t meet the holding period requirements before a liquidation event, the entire gain is taxed as ordinary income (just like NSOs).

However, before exercising ISOs, you want to pay very close attention to a scary tax called Alternative Minimum Tax (AMT).

Beware of AMT Before Exercising ISOs

As if the tax code wasn’t complicated enough, there is a separate tax calculation called “Alternative Minimum Tax” (AMT). This tax was designed to ensure that people (often those who are very wealthy) pay their fair share of tax given the various tax loopholes.

If the tax calculated under AMT exceeds that of the regular income tax, then you would owe the extra amount of AMT vs. regular income tax on your current tax return. For example, if the AMT tax calculation was $75,000 and your ordinary income tax calculation was $65,000, you would owe an additional $10,000 of AMT.

When you exercise ISOs, the “bargain” element is included in the AMT calculation, but not the regular income tax calculation. The bargain element is the difference between the 409a valuation of the exercise date and the exercise price multiplied by the number of shares.

As the company’s progresses in its funding rounds, you will very likely see the exercise price continue to increase (and sometimes quite rapidly!). Therefore, it’s critical to understand how much AMT exposure you may have when exercising ISOs. The last thing you want to have happen is be hit with a huge tax bill as a result of exercising ISOs and have no readily available market to sell your shares in order to pay the tax!

With the help of a financial planner and a good CPA, you will be able to understand your “AMT cushion” – the number of ISOs that you could exercise without triggering AMT. A common strategy is to exercise enough ISOs in certain years up to the “AMT cushion” where the AMT tax calculation is equal, or close, to the regular income tax calculation.

If you do end up owing AMT as a result of an ISO exercise, you want to ensure that you have clear documentation of your AMT on IRS form 8801 because you will receive an “AMT credit” that can be used to offset future tax for any AMT tax that you pay. This is a very commonly lost form, especially if you are preparing your own taxes and/or switch tax preparers.

Why Should You Exercise NSOs?

When you exercise NSOs, the difference between the fair market value (409a valuation) and the exercise price is taxed as ordinary income upon exercise. This means, unlike ISOs, you need to come up with cash to not only pay the exercise price, but also the tax due!

Therefore, if you do want to exercise NSOs, it’s typically better to exercise the NSOs when the spread between the fair market value and exercise price is low so you can reduce the tax you would owe. After exercise of NSOs, any future gain would be taxed as long-term capital gain instead of ordinary income if held >1 year, so if the company has a liquidation event in the future, you could pay a lot less tax compared to holding onto your NSOs and not exercising.

The risk is that your NSOs may turn out to be worthless. This means you could find yourself paying a) the exercise cost and b) ordinary income tax on something that you could never receive any benefit from! With ISOs, at least you avoid the ordinary income tax (and hopefully AMT with proper planning), so exercising ISOs costs less than exercising NSOs.

If you have a mix of ISOs and NSOs, then I’d recommend exploring the option of exercising your ISOs first. If you only have NSOs and decide to exercise, then you are really taking a bet that the company have a large payout since you are paying a guaranteed tax now upon exercise, in exchange for a hopeful lower tax rate in the future if the company has a liquidation event.

Start-Up Restricted Stock Units (RSUs)

As companies progress in their funding rounds, it’s common to start receiving Restricted Stock Units (RSUs) instead of stock options. As the value of a company increases during funding rounds, it becomes more expensive to exercise shares due to the 409(a) valuation increasing. In addition, it’s less likely that a company will experience the same level of increases in valuation that they had in earlier funding rounds.

Upon receipt of RSUs, you owe ordinary income based upon the fair market value of the stock at vesting multiplied by the number of shares vesting. Just like with NSOs, the issue here is that you could be taxed on shares that have no readily available market to sell!

Therefore, most RSUs at private companies are subject to “double trigger” vesting. This means that two events need to occur before your shares vest (and thus, you owe tax) –

  • Service requirement (aka working there for a certain period of time), and
  • A liquidation event

By having this requirement in place, it eliminates the scenario of you being taxed on shares upon service vesting, but not having a market to sell any shares to cover the tax.

The good news for you is that RSUs are pretty simple – you can’t do anything until some type of liquidation event occurs, so it’s a wait-and-see approach. In addition, you can’t make the 83(b) election for RSUs, unlike Restricted Stock.

The bad news is that you may feel handcuffed to the company until a liquidation event occurs, even if you’ve met the service requirement. With double trigger vesting, you need to meet both requirements in order to own the shares, so leaving the company may be a difficult decision for you if there is a hope for a liquidation event is on the horizon since you’d likely be leaving the shares behind.

Financial Planning Considerations for Your Private Company Equity Compensation

Phew! That was a lot… you may want to go back and read those sections again. Equity compensation is complex with many rules and requirements that are unique to the type of equity compensation you receive.

When joining a start-up, it’s crucial for you to understand how your equity compensation could impact the various other aspects of your financial life. The upside of private company equity compensation can be huge, but the risk of never monetizing the options is also equally as large. If you do end up exercising options in private companies, you should do it with the mindset that you’ll never see the money again. Is that a risk you can afford? It depends on many factors.

Here is a helpful question to ask yourself – how will your life be different if you pay to exercise your options and you never receive a payout? How will your life be different if you pay to exercise your options and there is a future payout?

If exercising options would dramatically impact other financial planning goals like travel, buying a home, starting a business, etc. then I’d likely lean towards not exercising the options. If exercising options would essentially have no impact on other financial planning goals and you have sufficient cash on hand to do it, then you may want to consider exercising the options.

We help educate clients about their equity compensation, carefully plan for any tax ramifications, and advise them how their equity compensation folds into other areas of their financial life. At the end of the day, you will know most about the company and its prospects for growth in the future. The best you can do is make a well-informed decision with your equity compensation knowing that you can’t control what happens in the future, but you also eliminate a surprise tax bill now.  

Key Takeaways

  • Take inventory of your equity compensation – what type of equity compensation do you have? What are the vesting requirements? If you have options, what is the exercise price? Read through the grant documents that the company provides you.
  • Ask your company about the funding round, 409(a) valuation and whether it meets the criteria for Qualified Small Business Stock (QSBS). QSBS permits you to exclude 100% of any future gain if you meet the holding period criteria.
  • If you are granted Restricted Stock, consider making an 83(b) election upon grant if the stock has $0 value so that any future gain is considered capital gain instead of ordinary income. If the Restricted Stock does have value, then carefully weigh the risks of paying an “early” tax on something you may not receive in the future.
  • If you have a mix of ISOs and NSOs, you likely want to consider exercising your ISOs first since it may cost you less if there is a difference between the 409(a) valuation and exercise price.
  • Carefully consider any tax ramifications before exercising ISOs or NSOs. For ISOs, you primarily need to be aware of any AMT upon exercise. For NSOs, you need to plan for any ordinary income tax to be due upon exercise. The last thing you want to do is to exercise options, be hit with a surprise tax bill and not have the cash to pay the tax!
  • When exercising stock options, have the mindset that you’ll never see the money again. This is a private equity investment with a high risk and high potential return. It’s better to be pleasantly surprised when a payout occurs than to be disappointed when it doesn’t.
  • How will your life be different if you pay to exercise your options and you never receive a payout? How will your life be different if you pay to exercise your options and there is a future payout? With any financial planning decisions, you need to put your life first, so then your money can follow.

JakeNorthrupAbout the Author
Jake is the Founder of Experience Your Wealth, LLC, a fee-only financial planning firm helping travel-loving young families with >$200k household income find the responsible balance between paying down debt, investing for the future, but also experiencing life now during their journey to financial independence. His firm specializes in helping clients that have a) equity compensation, b) >$100k of student loan debt and/or c) are a current or aspiring business owner.

 

Did you know XYPN advisors provide virtual services? They can work with clients in any state! View Jake's Find an Advisor profile.

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