How We Can Fix Startup Stock Options
I’ve worked at a good number of startups in my career (eight of them by last count). And every single time that I go and join a startup, I spend countless hours trying to learn more about what kind of information I need to get to understand my stock options grant.
Startup fundraising and how stock works at a startup can be a challenging game to win since none of the participants are willing to share any information that might weaken their position. But yet, the whole draw of going to a startup in the first place is that you’re going to strike it rich…right? As I’ve written before, there are too many ways a startup can go sideways before you have a chance to cash in your shares.
In my last post - I talked about why it may be challenging to leave a startup, especially if your shares do have value. When you buy them, you’ll have to pay some taxes on the “gain” even if you can’t sell them yet.
Take, for example, the recent news of Docker selling off parts of their business and restructuring Docker with a new investment. While I have no details about this deal, given the amount of money Docker raised, its HIGHLY unlikely that any of the common shareholders got paid out. And for those employees that left, bought their shares, and paid their taxes (at a much higher valuation), they could be sitting on total losses.
We Can Fix This
There is a way to ensure your protection in advance of joining a startup as well as getting the benefit of the tax-advantaged status of long term capital gains. We want to early exercise our stock options as soon as we join the company. Typically, you need to have money available to pay for them, but who wants to have to cut a check for thousands of dollars on their first day on the job?
What if, instead, you negotiate a signing bonus - that is equal to the cost to early exercise plus the taxes on the bonus itself. This way - you have minimal (if any) financial risk or tax risk if the value grows and you end up leaving the company.
Let’s play this scenario out with an example:
You get an offer from a growing Series A funded startup. You follow the excellent advice of Justin Lintz and ask all kinds of questions about the equity portion of the offer. They come back to you with a pretty standard looking stock option plan.
- 20,000 Shares - four-year vesting
- 25% at the one year cliff, and monthly after that.
- The strike price is $0.20.
- Assuming this grant is fully vested, you’ll have the option to buy these shares for $4,000.
To avoid the tax implications that I talked about in my last post, we are going to negotiate with the company for both a signing bonus as well as the ability to early exercise the entire stock option grant. In our scenario above, you want the company to give you a bonus equal to the cost of the options PLUS the taxes on the bonus itself. So in our case, we’d want to get a signing bonus of at LEAST $6500 to cover a potential 40% tax withholding. You would net about $4000 from this bonus - which is what you need to exercise your shares early.
Now - there is one VERY IMPORTANT thing you must do within 30 days of this transaction. File an 83(b) election with the IRS.
What is an 83(b)?
Section 83 of the Internal Revenue Code states that you do not have to recognize income from owning equity in a company until that stock vests. It seems simple enough. Section 83(b) refers to a special election you can make with the IRS to let them know that, despite the fact you have not yet vested your stock, you still want to recognize the income associated with ownership immediately. If you file the 83(b) election before your stock has appreciated from its strike price, there will be no income and, therefore, no tax owed.
The implication of this can be dramatic as a company grows in the future. As Wealthfront says in their post:
The ability to exercise early allows you to change the gain on all your options from ordinary income to a long-term capital gain, which is taxed at a much lower rate.
But most importantly - this frees you from the burden of “I can’t afford the taxes if I buy my stock options when I quit”.
Assuming (for simplicity sake), you leave the company after four years - the entire grant has vested, you own those shares FREE AND CLEAR.
From Wealthfront again:
The 83(b) election resolves this issue, elegantly and simply. It’s a form that you send to the IRS that declares, explicitly, that even though you have not vested your stock yet, you wish to be treated as if you have full ownership as of the exercise date. (This is why, by the way, you only need to file the 83(b) when you exercise stock options that you have not vested yet.) Thus, if you exercise your stock options when the fair market value equals the exercise price, the 83(b) leaves you with no tax liability until you actually sell your shares.
Early exercising is a relatively simple solution to the problem that can plague many employees of startups. But this only works if you make an effort and negotiate it as part of your compensation package. The company will very likely not offer this up as an option. The job market is still incredibly hot right now; you hold a lot more power to affect change than you think.
- Get a signing bonus that is enough to cover taxes PLUS the cost of your options
- Make sure the company will allow you to early exercise your stock options.
- FILE YOUR 83(b) ELECTION WITH THE IRS WITHIN 30 DAYS.
- Seriously DO NOT forget about filing the 83(b) election. There is no form on the IRS website, but your company has copies they can provide you.
The best time to protect yourself and set up yourself for success is BEFORE you sign your offer letter. Take the time, do the research, ask for help, and push the company to include this in your employment offer. The stress you save if you ever decide is more than worth the short term pains of negotiating this.
Also - I am not a financial expert or an accountant. You should definitely make sure you speak with one to better understand your tax implications of doing this.