The stock option knowledge deficit
Most startup employees don't understand the most important component of their pay
If you've been following the blog for any amount of time, you know I love to talk about stock options. It might seem like a weird fascination, but as an economist and a capitalist, I think incentive stock options are one of the most effective tools for aligning employee action with company goals. As an employee, I can unequivocally say that stock options are the best way to build wealth in a normal 9-5 job. Stock options helped me to fund my portfolio and paid for basically all of my condo.
They certainly aren't perfect: in some cases executive pay can balloon out of control due to options, and in some cases employees may "rest and vest" if they can find a way to slack off from their job while still remaining employed. I don't think you would be able to find many people who would argue either of those negatives even come close to outweighing the enormous positives.
But, there's a big problem in the world of stock options. The vast majority of the employees who receive them know ALMOST NOTHING about them. In the past six months alone, I've spoken with over 20 colleagues about our equity compensation, and nearly all of them had major, life-changing misconceptions about how they work and what they will deliver.
It's not just my company either. I've spoken with dozens of San Franciscans in my time here, and I've been hard pressed to find anyone who truly understands how stock options work, how they can take advantage of them, and how they can avoid punitive taxes on them. In my mind, this lack of knowledge represents a massive failure on the part of the companies who employ these people. They fail to give advice because they don't want to expose themselves to liability, but in the long run they are depriving their employees of billions of dollars in lost compensation.
Today, I've pulled together a list of vital knowledge around incentive stock options. Based on my conversations on the subject, I would estimate that at least 50% of startup employees are oblivious to one or all of these tidbits of information. If you have friends who work at a startup, please share.
1. To take advantage of the tax benefits of stock options it’s important to (buy) shares at least 1 year before selling them
Incentive Stock Options are tax advantaged to an enormous degree. If you exercise your shares at least a year before you sell them, then you only pay capital gains tax on the difference between the share price at exercise and the share price at sale. That difference can be quite dramatic.
For instance, if I were granted 100 shares in company XYZ at $1 dollar per share on 1/1/2018, and I exercised on 2/1/2019 at $2 per share, then sold on 3/1/2020 at $10 per share, I would only pay 15% long term capital gains tax on the difference between the exercise and sale price, which amounts of $120 ($10-$2=$8*.15=$1.2 per share in taxes * 100 = $120 in capital gains tax at sale). If I waited to exercise until the date I sold, I would pay income taxes of ($10-$1=$9*.3333=$3 per share in taxes * 100 = $300 in income tax at sale).
Long story short, you could easily save 20-80% on your taxes by exercising early. This is one of the biggest advantages of stock options.
Note: The one time you do NOT want to exercise shares is when you expect the value of the company to go down. In that case, waiting to sell would obviously be a bad thing… that’s why it’s important to consult a professional about these things.
2. You may owe AMT when you exercise!
Whether your company is public or not, when you exercise your options you may owe Alternative Minimum Tax. Quite simply, the difference between the price at exercise and the strike price is taxed as income under the AMT when you exercise your stock. In the example above, that would correlate to the difference between the $2 per share price on 2/1/2019 and the $1 strike price, so $1 per share total. That amount is counted towards AMT income, and may result in a HEFTY tax bill if you exercise enough stock. I cannot emphasize enough the need to understand and research this kind of thing.
3. You need to know the price per share to even get close to understanding the value of your options
I see it all the time: new employees are so awe struck with their new job offer that they forget to ask the most important question about their stock options: HOW MUCH ARE THEY WORTH. SOME companies divulge this information automatically (my employer being one of them), but many just tell employees they received xx,xxx options... and that's it. Of course, thousands of stock options sounds like a LOT, but it could be a tiny amount or it could be the motherlode of all options deals. If you don't know the price per share, you don't know anything.
Contrary to popular belief, you can absolutely ask for this information, and any reputable company will give it to you gladly.
Hopefully, this post is helpful to someone. If so, please share it with the people you care about who are working at startups and other companies that award stock options. Also, keep in mind that I am not a CPA or tax attorney, and everyone should consult their own counsel when making important decisions about their money. Don't consider this advice... but more of a heads up to what you should be asking questions about.