An Engineer’s guide to Stock Options

1. The value of options is inextricably linked to tax and you need to understand the tax basics in evaluating the economic risks and benefits of holding and exercising any kind of option. With NQOs, you are taxed on the spread as ordinary income on the date of exercise (meaning, on the difference between what the stock is worth and what you pay to exercise). With ISOs, the value of the spread becomes subject to AMT and you can wind up paying large taxes that way in spite of the supposed tax benefits of ISOs. The way to avoid having a large spread subjecting you to such tax risks is to exercise as early as possible before the company value goes up much but you then need to take the economic risk associated with having to pay hard cash for stock whose long-term value is highly uncertain. Moreover, early exercise is not possible if your options haven't vested unless you specifically get an early exercise privilege as part of your grant. With an early exercise privilege, and particularly if the grant is made for a bargain price, you can early-exercise, file an 83(b), and (as long as you hold the stock for at least 2 years) get the equivalent of a restricted stock grant by which you pay no further tax until you eventually sell the stock at a liquidation event. In that case, you are also taxed at the lower long-term capital gains rates. Of course, in the early-exercise scenario, you do not get to bypass vesting and your shares remain subject to their original vesting requirements and can thus be forfeited in whole or in part if those requirements are not met. But early exercise does provide an elegant solution to most of the tax risks associated with options provided you are willing to assume the economic risks of paying for the stock up front.

2. Other than the early-exercise scenario, 83(b) elections are not required for option grants. Under 83(a) of the Internal Revenue Code, any service provider who gets property in exchange for services is taxed at ordinary income rates on the value of the property received. For example, if you do work for a startup and are paid in stock when you complete the deliverable, you are taxed on the value of the stock received. You are taxed on the value of that stock as it exists as of the date you receive it in payment for such services. So, if you do development work tied to a milestone, and you meet that milestone, and you get 100,000 shares for the work, you would be taxed on, say, the $1.00/sh that the stock is worth on the day six months or a year (or whatever) out when the milestone is met, and not on the $.01/sh that it was worth when the contract terms began. In contrast to this performance-based form of incentive, let us say that you get a time-based incentive by which you buy the stock up front for a nominal price but you must earn it out over time. With such a time-based performance incentive, which is what is called "restricted stock", you own the stock up front and you pay no tax at the time of purchase in the normal case where the amount you pay for it equals its fair value on the date of the grant. Because the stock must be earned out as part of a continuing service relationship, and is hence subject to a "substantial risk of forfeiture", there is a very important technical question under section 83(a) on what the date is on which you are deemed to have received the stock in exchange for your services. Well, the default rule under 83(a) is that you receive it on the date it is no longer subject to a substantial risk of forfeiture and that then becomes the relevant date on which the value of the stock is measured for purpose of computing the taxable service income on which you must pay tax. So, if you get your 100,000 share grant at $.01/sh, and you pay $.01 share, you pay no tax at inception. But, as that grant vests at, say, a monthly ratable rate over four years, the IRS treats you as having received 48 separate grants (one each month) over the four-year period. Thus, at each vesting point, you are treated as having received property in exchange for services under 83(a) and you pay tax on the difference between the value of the property received and what you paid for it. If you paid $.01 per share, and if the stock is worth $1.00 at a given vesting point, you realize $.99 worth of taxable income per share. In a venture whose value is rising quickly, in the absence of any saving mechanism, you might have as many as 48 separate tax hits (basically, having to pay tax on the difference between what you paid for your grant and the 409A valuation price placed on the common) just for the privilege of holding a piece of paper that may or may not ever have an ultimate cash value of any type. It is in this type of scenario, and only here, that 83(b) comes into play by providing that, in lieu of having to suffer under the default rule of 83(a), you can elect to pay all taxes up front on the grant and not be subjected to the often onerous workings of the default rule. This means that, for an 83(b) election even to be relevant, you must first own your stock (or other property) and that stock or property must be subject to a substantial risk of forfeiture. If you hold only an unexercised option, you do not yet own the stock and it is not subject to forfeiture (hence, 83(b) is not relevant). If you do an early exercise, though, and get stock under terms where it must still vest out and can be forfeited, then 83(b) does apply. But that is the only case normally where it becomes relevant at all to options.

3. Options really shine when they wind up on a level playing field with the preferred stock and they tend to dim commensurately to the extent they do not. Optimum case is IPO when all stock is (typically) forced to convert to common prior to the public offering and, thus, all shares participate equally in the benefits. This can happen too in big-scale M&A exits but a drop-off occurs on lesser ones in at least two ways: (a) where the total acquisition price is largely gobbled up by the liquidation preferences and/or management incentive plans; (b) where an acqui-hire occurs in which a few founders get a disproportionate share of the total value through employment arrangements made on the other side of the deal.

4. Given all of the above, and given that IPOs remain at far below the old bubble levels in frequency, it can be risky to lay out any excessive cash to exercise at any time before a liquidity event. Too many things can happen by which a seeming "sure thing" winds up evaporating before your very eyes, leaving you with no more than a pretty lousy capital loss that you get the privilege of deducting at the rate of no more than $3,000 per year unless you can find other capital gains to offset it against.

5. The 90-day tail for exercise upon termination of a service relationship applies only to ISOs and not to NQOs but, of course, ISOs have other advantages and they are what is typically offered in VC-backed ventures. In other types of ventures, where the company value is already somewhat high at the time of grant, I have seen executives bargain for and get NQOs with long exercise periods following termination just to have the flexibility to leave the venture if needed without being forced to forfeit the options.

6. In light of all of the above, having to pay an angel backer 25 or 30% of your gains to provide you with a risk-free exercise in an otherwise high-risk situation may be worth it even though the cost seems high on its face. It is a matter of preserving some decent part of your potential upside while giving up the rest to make the upside potential even a possibility for you given the tax risks involved. If IPOs come back strong some day, then you may be giving up too much at such a cost because they are the great leveler when it comes to weighing the value of options against other forms of equity holdings. Until that day comes, however, options remain a valuable but relatively high-risk way of deriving value from a startup if you need to part with any significant cash (either for the purchase or for the associate tax) for the privilege of hoping to profit from a startup. Again, for those who need to weigh their choices, this piece provides great insights and stands head and shoulders above the typical discussion of such issues. Great work by the author in making an otherwise dry and even formidable subject pretty accessible.