Everything You Need to Know About Your Startup Stock Options

Everything You Need to Know About Your Startup Stock Options

Stock options are one of the biggest perks of joining a startup. In exchange for taking a lower salary than you’d earn at a more established company, you get the opportunity for a huge payday if the startup has a big IPO or gets acquired. Landing at the next Google or Meta could make you a millionaire.

But stock options can be confusing. They have different rules than the restricted stock units (RSUs) you may have earned at your last job, and they often come with provisions that can lead to unpleasant surprises if you’re not aware of them.

Here’s what you need to know about your stock options if you work at a startup.

What are stock options?

A stock option gives you the right to buy a share of a company’s stock. When you receive an option, you don’t own a share of stock yet, you have to pay money to convert the option into a share. That process is known as exercising an option, and the price you pay to exercise an option is called the strike price. 

The strike price is determined by a third-party evaluator based on how much they think the startup is worth. The evaluator’s judgment is known as a 409A valuation. 

What does it mean when my options “vest”?

A stock option vests when your employer gives it to you. If your offer to join a startup includes options as part of your compensation package, the offer will outline the total number of options you’ll receive and when you’ll receive them.

For example, a company may agree to give you 4,800 stock options over four years. Every month, you get 100 of those options. If you stay for four years, you’ll get all 4,800.

Many companies, though, will make you wait a year before you receive the first 12 months’ worth of options to give you an incentive to stick around. After you’ve made it a full year, a portion of your options will typically vest every month, or every few months, going forward.

I used to work at a public company. Are stock options different from the RSUs I got at my old job?

Yes, the big difference between stock options and RSUs is that you have to pay money to convert an option into a share of stock. RSUs become shares automatically once they vest.

So why do some companies make you pay for stock and others don’t? One of the main reasons startups tend to give employees stock options is that they don’t automatically trigger taxes when they vest the way RSUs do. 

The IRS treats stock you get from your employer as income, so when a company gives you shares, you have to pay income taxes on them. That requirement is easy to handle if your company is public and its stock trades on major exchanges. Public companies will usually sell a portion of the shares in your RSU after it vests to cover your tax burden.

But it’s harder for private companies to sell their stock, so to make sure their employees don’t automatically get hit with big tax bills, startups give employees the option to buy shares, rather than the shares themselves. That way, employees can decide when they’re willing to pay the taxes they’ll owe when they take possession of the shares.

Many startups begin giving employees RSUs instead of options as they get closer to an IPO. But they structure those RSUs, known as double-trigger RSUs, so the company has to go public or get acquired before they vest, which means employees don’t get hit with a tax bill before they can make money from their shares.

How do the taxes on my options work?

There are two points at which you might have to pay taxes related to your stock options: After you exercise an option, and after you sell the stock you received after exercising the option.

Whether you pay taxes after exercising an option depends on whether your employer gave you non-qualified stock options (NSOs) or incentive stock options (ISOs). When you exercise NSOs, you pay income taxes on the difference between the strike price and the current value of the startup’s shares based on its most recent 409A valuation, assuming that valuation has increased since the startup issued your options. 

So if your options have a $1 strike price, and the startup’s shares are worth $4 when you exercise the options, you’ll pay income taxes on the $3 difference between those two numbers for every share you receive. If the startup’s shares are worth less or the same as the strike price, you don’t pay taxes when you exercise.

When you exercise ISOs, you don’t owe any taxes unless you’re subject to the alternative minimum tax or sell the shares immediately, in which case you’ll pay taxes on the difference between the strike price and the value of the shares.

Regardless of whether your options are NSOs or ISOs, you’ll have to pay capital gains taxes if you sell the shares you got from your options for a profit.

Can I sell my stock options?

No, you can’t sell stock options in the same way that you can sell stock, but after you exercise your options you may be able to sell some of your shares even if your company hasn’t gone public yet. Sometimes, private companies hold what are known as tender offers, where employees can sell some of their shares to the company or to outside investors. 

Do I get to keep my stock options if I leave my company?

Once you leave your company, you usually have a limited amount of time, often 90 days, to exercise your options before you forfeit them. 

This can be a challenging situation if the company isn’t going public soon. You may have to choose between paying thousands of dollars for shares you won’t be able to sell for a while, taking out a loan to cover the exercise costs, or losing out on a significant amount of money in the future.

Can my options expire if I stay at my company?

Yes, all stock options have expiration dates, usually 10 years after they’re issued. Most of the time, that isn’t a problem, since startups tend to go public around the 10-year mark, but it’s possible for a company to wait long enough before going public that some employee stock options or double-trigger RSUs expire or come close to expiring.

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