For many employees in the US, especially those at startups, stock options are a part of their compensation packages. While the right to buy stock in a company at a set price is an attractive form of compensation, stock options have more complex tax implications than straight cash.
Understanding NSOs and ISOs
The two basic stock options are Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs).
Both NSOs and ISOs may be subject to a vesting schedule during which employees can buy a certain number of shares each year over a period of several years. Regardless of the vesting schedule duration, the employee is generally locked into the grant price at which options were granted to him/her. This means that even if the value of the company skyrockets, the employee will still be able to buy stock options at the pre-determined grant price.
Employees are more likely to receive NSOs – an option that lets you buy shares of the company’s stock at a predetermined price (aka grant price) within a specific time frame. If the value of the stock goes up, the employee will be able to sell it for a profit.
On the other hand, an ISO is a corporate benefit that gives an employee the right to buy shares of company stock at a discounted price with the added benefit of possible tax breaks on the profit. The profit on qualified incentive stock options is usually taxed at the capital gains rate and not the higher rate for ordinary income. ISO exercises qualify for special tax treatment only if the employee meets certain requirements. The tax scheme depends on when the employee decides to exercise and sell the stock options granted to him/her.
Should I Exercise My Stock Options?
Exercising NSOs or ISOs might open new opportunities for you to multiply your personal wealth. Yes, you might have to pay some tax upfront, but exercising stock options certainly improves the cash inflow curve.
There are certain risks involved, however. If the startup fails, you will lose the money that you would have used to exercise ESOPs.
But is taking such a risk worth it? Would you need to burn your savings or tone down your travel plans? Or maybe, stop investing in other alternatives?
All things considered, if exercising stop options feels right, go for it. After all, it’s a gut call.
When should I exercise?
If you are confident that your company will scale and grow, exercise your options right after they vest. But, if you think that the 409A valuation of your company might go down, you might want to postpone exercising your options. In all other cases, exercise your options right before the 409A valuation update. This is because the higher the 409A valuation, the more you will pay to exercise your options.
Note that 409A re-valuations happen at least every year. And, it also happens at the time of events such as a new investment round, a huge sales deal, or considerable partnerships. When such events are underway, your company will typically prevent you from exercising and most likely will do a tax valuation update. You can always take this up with the leadership team to anticipate 409A updates and exercise accordingly.
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