The wave of startups and entrepreneurship is upon us. We have witnessed these companies change work culture, disrupt industries, and make billionaires out of 20-some-year old’s. However, what is less publicized is the rise of stock compensation and its different forms. Historically, this type of compensation was given to individuals who were in upper management positions. Today, some companies are granting stock options to general employees when they are hired. When examining compensation packages of thriving startups, one can find Non-Qualified Stock Options (“NQSOs”), Incentive Stock Options (“ISOs”), Restricted Stock Units (“RSUs”), Stock Appreciation Rights (“SARs”), and other types littered throughout. These various terms are actually quite different, so in this month’s blog, we have decided to address two forms of employee stock options we typically see – NQSOs and ISOs. We lay out the structure of each and at the end discuss our thoughts on when to exercise.

What is an employee stock option? Before diving into the details, we first need to understand what an employee stock option is. When an employee is granted stock options by their employer, it provides the employee the right to purchase the employer’s stock at a pre-determined price (exercise price) for a specific time period. For example, let’s say XYZ company grants 10 NQSOs to employee A with immediate vesting. If XYZ’s stock increases above the exercise price, then employee A will participate in the growth of the company. Therefore, employee stock options are typically referred to as incentive compensation. How are NQSOs and ISOs structured? When it comes to NQSOs and ISOs there are four elements that are important to pay attention to. 1. Exercise price

  • The date a stock option is granted to an employee is important as the stock price of the company on that date will be the price at which the employee can purchase the stock at a later date. For example, if XYZ company grants NQSOs on 7/5/2016 and the price of their stock is trading at $10 per share, then the exercise price would be $10 per share.

2. Fair market value price when exercising

  • When an employee decides to exercise their stock option they must be aware of what their company is currently trading at. For example, taken from the above scenario, if Employee A was granted 10 NQSOs on 7/5/2016 at $10 per share and decided to exercise those options on 7/5/2018 when the company stock was trading at $8 per share they couldn’t exercise their stock options because they would be “out of the money”. However, if the stock price instead was $20 per share, then Employee A would be “in the money” and would receive a $10 per share gain. Being aware of the current stock price vs. the exercise price is important, especially if you are granted stock options on a consistent basis.

3. Vesting schedule

  • Understanding your vesting schedule is vital as each grant of options may have a different schedule tied to them. In addition, some may be performance or time-based. Performance-based vesting is typically tied to certain performance goals within the company. For example, XYZ company could grant ISOs to the managers of each of their departments and tie the stock options to the departments’ profitability. If they didn’t hit certain metrics, then they would not be vested in those options. Meaning they will be unable to exercise them. This type of vesting schedule is customized per employer, so understanding exactly how you are vested is important.

  • Time-based is simple and typically has a preset schedule. For example, XYZ company could state that after the first year of employment, 25% of your options would be vested, year two another 25%, year three another 25%, and year four the last 25% would be vested. If you were to leave the company in year three you would only be able to exercise 75% of your options and the other 25% would become worthless. As one can see, understanding when and how you are vested is a key component to understanding this portion of your compensation.

4. Time to exercise

  • When you receive options, there is typically a time frame for when you can exercise your options. The typical time frame is 10 years, meaning if you are granted options on 7/5/2016, you will have until 7/4/2026 to exercise them. If you don’t exercise them before 7/4/2026, they will become worthless.

What is the tax liability of NQSOs and ISOs? Now that we understand what to look for, we can dive into the taxation of each type of option. 1. NQSO taxation

  • Non-Qualified means there is no tax advantage to the structure of the account or instrument. That means NQSOs do not have tax benefits, meaning the gain you receive will be considered taxable income and will show up on your Form W-2 the year in which you exercise. Taking a step back, there is no realization of taxes when the options are granted nor once they become vested. To simplify let’s look at the example below.

  • The employee who received 10 NQSOs on 7/5/2016 was only taxed once they decided to exercise on 7/3/2018. The difference between the value at the time of grant and the value at time of exercise is referred to as the bargain element or, simply put, it is the total gain of these specific options. The total gain amount, as shown, is then added to their Form W-2 increasing their taxable income. Furthermore, if the employee decides not to sell their stock immediately and hold on to their shares, then depending on how long they hold their shares, they will incur short-term or long-term capital gains[1].

2. ISO taxation

  • The “Incentive” in ISO refers to a tax incentive where you realize taxation once you sell the stock. If held for the appropriate time, ISOs can be taxed at long-term capital gain rates instead of ordinary income tax rates. To qualify, the date in which you sell must be two years from the date of grant and one year from the date of exercise. If not, the bargain element will be taxed at ordinary income tax rates. If you are a high-income earner, you need to be aware that when you exercise (not at the time of sale) an ISO, the bargain element will be considered a tax “preference” item for Alternative Minimum Tax (“AMT”) purposes.

How do you exercise? When granted a stock option an employee has the right to purchase said stock at a pre-determined price. For example, if Employee A wanted to exercise 10 NQSOs at an exercise price of $10 per share, then they must buy those shares for $1,000. Now, it may not be difficult to bring $1,000 to the table to exercise 10 NQSOs. However, what if you had 10,000 NQSOs at $10 per share? To purchase your shares, you would have to have $100,000 in cash. Because stock options can become highly valued, there are two primary ways to exercise your options: a cash or cashless exercise.

The prior example represents a cash exercise. An individual must bring actual cash to the deal to purchase the stock at the exercise price. As mentioned, this can become difficult as employee stock options can become extremely pricey as they accumulate. However, if your goal is to hold more shares of the company for reasons that we lay out below then bringing cash to the transaction can become advantageous.

To mitigate this potential cash outlay, there is another way to exercise, called a cashless exercise. Investopedia provides an excellent explanation.

“A cashless exercise is a transaction in which employee stock options are exercised without making any cash payment. Such a transaction utilizes a broker to provide a short-term loan so that the employee exercising the options has enough money to do so. Once the loan to exercise the options is in place, the employee then sells enough shares to pay back the broker for the loan, broker fees and taxes. The person exercising the options then possesses the shares.”[2]

Typically, a cashless exercise is the primary choice when exercising employee stock options because many don’t have the cash on hand nor want to liquate other assets to exercise their options. This can become efficient, especially if you want to exercise and then sell immediately.

When should you exercise?

This is the million-dollar question and, of course, is the most difficult to answer. It can be viewed in multiple different ways from current trading price vs. intrinsic value to your percentage of exposure to the company as it relates to your total investable assets. However, what further complicates this question is that these options are typically given for free and because of this it may cause you to place this money in a “I don’t care; it was money I didn’t have anyways” bucket. Employee stock options can become a large part of your net worth overnight as early employees at Alphabet (Google) or Facebook can probably attest. This mental accounting can force someone to “let it ride” and not examine their total exposure to the company (which can be troublesome as we explained in our February blog “Making the Bet – Part 1: The Game”). With that said, everyone has different circumstances, so to create a blanket statement on when to exercise isn’t prudent. To exercise you must take into consideration exposure, price vs. value, tax liability, etc. The best thing to do is work with qualified professionals to help guide you through this complicated and in-depth decision. At LBW, we would be happy to help work through it with you!

Sincerely, LBW

[1] Short-term capital gains are taxed at ordinary income tax rates. Long-term capital gains are taxed at long-term rates, which are typically lower than ordinary income tax rates depending upon one’s income tax bracket. [2] https://www.investopedia.com/terms/c/cashlessexercise.asp ​

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