Stock options are great for established companies who want to reduce their tax bill, startups who don’t have a revenue stream, and many others in between. But do they always make sense for the employee? Here are some scenarios when you should push back on a stock option offer, and the questions to ask to avoid locking yourself into an unfavorable one.
Unexpected Tax Consequences
Depending on your personal situation, there may be an onerous tax impact from exercising a stock option.
There is an important difference between incentive (ISO) and non-qualified (NSO) stock options. With a non-qualified option, the employee pays tax on the option spread – the difference between the grant price and fair market value – when exercised, while the company gets a tax deduction. This differs from incentive stock options, where the employee pays no capital gains tax at time of exercise and the employer gets no tax deduction.
However, ISOs do have a tax implication: the Alternative Minimum Tax. Upon exercise, the option spread added back as income under the AMT calculation, regardless of whether you keep the stock or sell shares immediately after exercising your options. Although the new Tax Cuts and Jobs Act will make it less likely employees will get hit with AMT tax, it is still a real possibility for high income households.
ISOs can be much more favorable from a tax perspective, but only if you the hold the shares for one year from exercise and two years from grant. You could very well end up with a large tax bill and no cash to pay for it – as many employees from the early 2000s could attest.
Such individuals should conduct an in depth tax analysis when considering an options offer.
Ask: Are the options ISOs or NSOs?
It’s important not to overlook the fact that depending on whether the company is publicly traded or not, stock options could potentially leave you with a liquidity problem.
Shares of publicly traded stock can be sold at will through a broker who sells them on the public market; shares of a private company’s stock can be sold back to the company, or you have to find a buyer yourself. The risk is the potential to be left with a concentrated position in a stock that you can’t get rid of. If you find yourself with a sudden need for cash, this can be problematic.
Holding a large position in any one company (more than 5% or so of your total wealth, generally) also fails the diversification test – it’s the typical case of putting all your eggs in one basket. Employees should know whether their options are going to render them with shares of a public or private company, as well as what any transfer restrictions may be.
Ask: Is there an internal or secondary market for shares?
Devalued Stake due to Dilution
Don’t just consider the amount of shares offered; look at what this really means in terms of your proportionate stake of ownership in the company. You may get an offer to purchase 100,000 shares of your company, but if there are billions of shares outstanding it can translate into a measly 0.00067%. Especially in the case of startups that are venture funded, it’s important to consider where you fall in the capital structure relative to more senior tiers such as debt or preferred stock.
Remember that with stock options you are exchanging your salary today for a share of what you think the company is going to be worth in the future. Take a good hard look at all aspects of the company’s financing, as well as their plans for the future, and weight that versus what you theoretically have forgone in outright salary.
Ask: What is the current funding stage of the company? When do they expect to raise more capital?
While you may be dazzled by the amount of shares or the prospect of owning a stake in a hot commodity, don’t trust that every offer is a good one. It’s not just a matter of plugging the number into some calculator. Knowing if a stock option offer is right for you entails a thorough analysis of your personal tax situation, as well as the qualitative characteristics of the options themselves. Do this or face the consequences of a bad decision which range from an onerous tax liability, inability to access your capital, or loss of the personal wealth that you worked so hard to create.
Posts are general in nature and do not constitute the rendering of legal, investment, accounting or other professional advice.
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