- Stock Option: a contract which gives the buyer the right (not the obligation) to buy or sell shares of stocks.
- Strike price: the price the buyer pays to exercise the option (buy or sell the shares).
- 409a valuation: fair market value of a stock determined by a “reasonable application of a reasonable valuation method.” Important for determining the strike price of an option.
- Bargain element: BE = $(fair market value – strike price) * number of shares.
- ISO: Incentive stock options provide favorable tax treatment compared to non qualified options. ISO’s are the most common type of startup stock option for this reason.
- AMT: Alternative minimum tax, America’s other tax code. Usually reserved for the top 1% or earners, AMT also kicks in when exercising ISO’s.
This is the first in a series of posts on stock options and how they relate to early startup employees. This post covers the basics and introduces the concepts and terms related to startup stock options.
First – what is an option?
Wikipedia defines an option as such:
- An option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date.
Put another way an option is a bet without a significant downside. The other party is obligated to sell you the underlying security at the pre-agreed upon price but only if you choose to buy.
The strike price is the price the buyer pays the seller for each unit of stock, should she choose to exercise the option. For example, if you have 10 options with a strike price of $10 you’ll have to pay $100 to purchase those shares. The idea is that by the time you exercise the option the underlying security has increased in value far and beyond the strike price. For instance if the market value of the option is not $100 but $1,000 then you have a paper gain of $900!
So why doesn’t your startup employer just grant options with a strike price of $0, thereby maximizing your profit? Simple – taxes. More specifically Internal Revenue Code Section 409a.
409A was created in 2004 to reign in perceived abuses of deferred compensation plans, including stock options, in the wake of the Enron scandal. The code stipulates that should a company grant a stock option that is “in-the-money” (ie, strike price below fair market value) the recipient will have derived financial value from the exchange. This value exchange represents a taxable event in the eyes of the IRS and will be taxed accordingly.
To avoid this taxable event startup employees must be granted options with a strike price set to the fair market value of the stock. To determine the fair market value of a privately held startup the company undergoes a 409a valuation. It’s carried out by a bank (such as SVB), an accounting firm, or another qualified professional. It is not the same valuation figure you read about in TechCrunch (‘Company X raised $10MM on a $30MM pre money valuation’). Instead it is a figure determined by a tax professional based on current cash flows and slew of other factors.
Now that we have a fair market value of the company and a set strike price, what happens when you exercise the option? The bargain element is the profit you pocket from this transaction (before fees and taxes), i.e the fair market value minus the strike price. Remember this term it becomes important when it’s time to pay the tax man.
In startup land there are two flavors of options – non qualified stock options (NQO) and incentive stock options (ISO’s). ISO’s are far more common and don’t require the holder to pay ordinary tax on the bargain element. Instead you are taxed under the alternate minimum tax.
What is the alternate minimum tax? The US actually has two tax systems – regular income tax and AMT. In the US all taxpayers must calculate their regular tax and their AMT and pay whichever figure is higher. AMT usually kicks in for high income earners with incomes in the $100k to $500k range. However, when you exercise an ISO you’re responsible to pay AMT on the bargain element ([FMV - strike price] * num shares).
This has been an introduction to stock options, specifically those relating to early startup employees. In the next post in this series we’ll take a look at strategies early employees can use to maximize their potential profit and keep taxes to a minimum.
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