An Effective Stock Option Strategy for Startup Employees
It’s true that timing is everything.
It’s true that timing is everything. For individuals that receive stock options during a company’s startup or pre-IPO phase, there can be an acceleration of wealth that is unlike any other form of employee compensation. Working at a startup can provide the right mix of entrepreneurial upside with the stable salary and benefits of a competitive full-time job.
Although many people realize benefits of stock options and sometimes layer the proceeds from options into a long-term wealth building strategy, most do not understand the substantial planning opportunities available to minimize taxes around the exercise of options.
A well-timed stock option exercise and hold strategy with a sale at capital gains rates can provide significant tax savings. From a wealth planning standpoint, it can be lightning in a bottle.
Stock Option Basics
A stock option grant is simply the right (or option) to purchase one share of company stock at a set price.
For example, Startup, Inc. could grant Eddy Employee 1,000 stock options at $5/share (known as the strike price). Eddy can now choose, within some set time frame, to purchase (or exercise) the options at the strike price of $5.
If the fair market value of Startup, Inc. goes above $5, and only at this time, would it make economic sense for Eddy to exercise his options? If this appreciation above $5 occurs, Eddy’s options are said to be “in the money” by the difference between the fair market value and the strike price, which is known as “the spread.”
Assume the price rises to $10/share in year two. That would mean Eddy’s options were “in the money”, and the spread was $5.
Terminology aside, anyone can see the value in this transaction—Eddy can purchase something worth $10 for only $5.
Once an option goes into the money, this triggers the first decision point, based on stock price expectations.
High Growth Startup Strategy
Let’s assume that Eddy’s company is an early stage startup that has plans to go public in the next eighteen months, and Eddy is fairly certain that the shares could be worth $25 or $30 after the IPO. This is a fantastic planning opportunity if Eddy is confident that the stock will appreciate further.
To understand why let’s go back to the current economic value of Eddy’s options – the spread of $5 per option for a total of $5,000. If Eddy exercises now, he will realize a taxable gain of $5,000 depending on the type of option. It’s important to know that exercising options is a taxable event.
Many people in Eddy’s situation would wonder, “Why go through the trouble of exercising now? I’ll just wait until the stock really shoots up, and then it will be worth it.”
The reason is simple: Tax planning.
An earlier exercise will generate a tax liability on the current spread but they key is to purchase the shares now so that any gain going forward will be at a more favorable long-term capital gains rate, as long as the shares are held for more than one year.
Assume that two years later the shares have appreciated to a price of $30 each and Eddy sells. All in, he’s captured gross economic benefit of $25 ($30 sale price less his cost of $5). Why pay taxes now? Because it’s better to pay a little tax now than a lot of tax later. Here is an explanation.
A (Very) Simplified Discussion of Stock Option Tax
We will assume Eddy is in the 33% tax bracket with payroll taxes of 6.2% and capital gains tax rates of 15%.
If the options are Non-Qualified Options (NQO or Non-Quals), the spread at exercise is taxable at the above mentioned combined ordinary and payroll rates of 39%.
If the options are Incentive Stock Options (ISOs), the $5,000 spread at exercise will be subject to Alternative Minimum Tax (AMT) at 28%.
For this example, let’s just focus on NQOs. In one scenario Eddy exercises in year two (and pays some tax) and then sells in year three when the stock has appreciated. In the other scenarios, he waits until the stock appreciates to $30 to exercise and sell.
Here’s the math:
The key takeaway is that there are higher taxes on the spread, so the smaller the spread, the greater after-tax benefit on future appreciation.
In both scenarios, Eddy has $25,000 of pre-tax economic benefit, but if he exercises and holds, he pays $4,950 in taxes and takes home $20,050. If he waits, he pays nearly twice the amount in total taxes and takes home only $15,250.
Although an extra $4,800 is not life-changing money, it represents a 31% increase in after-tax proceeds from the wait to exercise scenario. Remember, this is a simple example using small numbers. Many times, options in successful startups can provide hundreds of thousands, or even millions, in value to its employees. Just throw a few zeroes at the end of the numbers above, you’ll understand what I’m talking about.
The strategy scales for bigger numbers. By realizing the majority of that value at a lower long-term capital gains tax rate, employees can save large amounts in taxes, especially if they are in the highest tax brackets.
Risks and Other Concerns
As with any financial decision, option holders must evaluate downside and costs prior to execution. This is no exception.
- Risk of Loss Due to Stock Depreciation
This strategy is best when there is a high likelihood of appreciation. If the stock depreciates after exercise, the full ordinary income tax (or AMT in the case of ISOs) is lost. Some can be recovered through subsequent sale at a tax loss, but it’s still a losing transaction.
This is specifically risky in the case of ISOs, where shareholders need to come out of pocket to pay the 28% AMT. If the stock tanks after exercise, shareholders will still owe tax come April 15th, and will have to pay out of pocket. There were tech bubble horror stories of large ISO exercises that generated massive tax bills, only to have stock values evaporate before tax time. This is a worst-case scenario that illustrates the risks of paying taxes out of pocket at some later date.
Our example above left out ISOs, which have different tax treatment, but the core values of the buy and hold strategy still apply.
With NQOs the taxes are often withheld through payroll, which makes the payment more manageable, but the risk of loss is still very real.
- Other Out of Pocket Costs
The buy and hold strategy requires option holders to come out of pocket and purchase the shares at the strike price. This takes money, and sometimes significant amounts of money. Option holders may not have funds to exercise their options in a buy and hold strategy.
If that’s the case, it’s probably not advisable to borrow funds to do this.
The buy and hold option strategy can provide huge rewards in the form of tax savings for those savvy enough to understand and execute it. Understanding one’s planning opportunities are necessary but can be daunting for those without expertise.
Contact a Claro financial planner today to review your equity holdings and start developing a strategy for long-term wealth.