When is a stock option a golden ticket, when is it of no consequence, and when is it a losing proposition?
These are important questions for people in the startup world, where stock and stock options are a key part of most compensation packages. Startup companies like using stock because it costs little at a time when money is scarce. Instead of cash, employees get the promise of future ownership.
With stories of Apple and Microsoft millionaires fresh in their heads, however, many employees don’t take the time to do effective planning for their options or other stock compensation. That leaves them ill-equipped for the numerous decisions that they must make as they exercise their options, sell their stock, and figure out their tax strategy. Many get burned.
Incentive stock options are the most common form of stock compensation at startups. They give an employee the right to buy company stock at a set price based on the value when the options were issued. Options typically vest over a four-year period and are valid for 10 years.
So when do you act? That depends on lots of variables, ranging from the outlook for the company and the value of the stock to the remaining life of the options and the possibility of triggering the alternative minimum tax.
Sometimes people wait too long, exercising their options only after their company announces that it is being purchased. Since the new owner will buy those shares, the employee can’t hold them for the required year-and-a-day to qualify for long-term capital-gains tax treatment upon their sale. Instead of being taxed at the capital gains rate—which is a maximum of 20 percent—any gains would be considered ordinary income and taxed at rates of up to 39.6 percent.
Then, too, some people exercise too quickly. That can make it hard to find a buyer for the stock. Moreover, stock-option exercise is an alternative-minimum-tax preference item, which can leave the employee open to significant taxes well before actually selling the stock. There’s also the possibility that the stock’s early gains will evaporate between the exercise and eventually sale. That would leave the employee paying big taxes but getting no upside benefit.
To avoid these pitfalls, option holders need to begin planning early. A financial professional can help here, running projections that explore the possible problems and benefits inherent in each strategy. Understanding the total cost involved can make decision-making easier.
Cash flow is a critical part of any such planning. Option holders need to come up with the funds to exercise their options and buy their stock. That can add up to hundreds of thousands of dollars. Those who decide to exercise and hold in order to qualify for long-term capital gains treatment must also cover any alternative minimum tax liability triggered by exercising their options.
Some brokerage firms offer special arrangements that allow a holder to exercise and then immediately sell the newly purchased shares, with the broker taking a set portion of the proceeds. This approach, however, means any gains will be treated as ordinary income.
An exercise-and-sell strategy can be helpful for employees who are concerned that their portfolio will become over-weighted with company stock. Alternatively, they may want to make use of various hedging strategies, such as puts and collars. Good professional advice is critical here, as well.
Restricted stock is another common form of startup stock compensation typically reserved for upper-level management. Here the concerns are different, since the employee actually owns the stock—as opposed to owning an option which simply locks in the right to buy at a set price. Restricted stock typically vests over a period of four years.
With restricted stock, the critical decision is about tax treatment. The shareholder has 30 days from issuance to decide whether to make an 83b election, which would include the value of the stock on his or her annual W-2 form. This election makes the value of the stock taxable income in the year it is issued.
If the stock isn’t worth much or if it has a lot of upside potential, the 83b election makes sense. But if the stock is hot and already highly valued, it may be better to wait. Taking the 83b election in this case would dramatically boost both income and taxes. Moreover, it would leave you vulnerable if the shares suddenly lost value.
In the fast changing world of startups, the value of stock options and restricted stock are difficult to manage. But as their company’s fortunes rise and fall, employees would be wise to regularly review their strategy for this critical part of their workplace compensation.