Startup Stock Options: Taxes and Risk

One of the supposed benefits of working at a startup is the equity you’re offered as part of your compensation package. Given that more often than not this equity is in place of a 401k and a portion of your salary, in theory it may offer great reward in the long run.

However, what I didn’t realize about stock options (ISOs and NSOs) years ago is that in order to actually receive the stock, you still have to pay for it. Options just mean that you are able to buy the stock at a strike price, which is “low” but may very well still be higher than what the stock ends up being worth.

There are a ton of different tax rules that apply to stock options, many of which I still don’t 100% understand. The difference between the strike price and the amount you pay on the option is considered a gain and must be taxed (I think) and then the amount that is gained on the option once it’s exercised is also taxed — either at the capital gains rate if you hold if for two years, or at income rate.

With all the risk involved in stock options, it seems you’d be better off making $10k – $30k more at a job in a larger corporation and investing that money in ETFs. That is, unless your startup happens to be Facebook. And even then, you’ll be in pretty big trouble when it comes to taxes unless you’re already independently wealthy.

At my last startup, I also learned something about stock options — even when the company is sold, you may not get the best deal possible due to reasons beyond your control. For example, I owed a small number of shares at my last company which were exercised on the day I left the company. Less than a year later the company was sold to a much larger private company that is doing quite well for itself. While I did make a small profit on my stock, the much larger profit — available in exchanging the shares of my former company with shares of the larger acquiring company — was not available to me because I wasn’t an “accredited investor.” So my stock was worth $3,000 instead of $200,000. Granted, the $3,000 was “real” and the $200k would have still been paper. But I was still shocked that I was basically told “sorry, you don’t already have a million dollars in networth, so you can’t have the opportunity to make more money.”

Had I actually been involved in the projects that ultimately led to that company being acquired, I’d be a bit more peeved about the whole scenerio, but it did serve as a warning — does it even make sense to play the stock option lottery?

At my current company, when all is said and done my stock will cost $20,000 to exercise. $20k is not a small amount at all as my entire networth is just $125k. Then, due to the various tax issues with stock options, if the stock ends up actually being worth a decent sum, I could end up owing quite a lot in taxes before I’m able to realize any actual gains.

While others who I work with are undoubtedly already millionaires who can afford the risk of stock options, and also would qualify if an accredited investor issue ever came up to qualify for a more profitable trade option, do stock options actually make sense for someone like myself?

Then again, it seems the only shot I have at getting rich is to play SOME lottery, and it might as well be tied into my professional growth, and feeling like I’m a large part of a company’s success — even though the finances may never actually turn in my favor.

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4 comments

  1. It would have been nice if you had those same options from a public company. Scottrade will let you make the buy and sell in the same transaction so you don't actually have to have the upfront cash. I don't know who does that for private companies though.

  2. Perfect Dad says:

    You don't usually have to prove that you're accredited, just claim you are. Basically they want the person buying in to those "president's club" shares to know what's going on so they don't come back later and say they didn't know the risks — which you obviously didn't.

    That said, being part of a startup is an awesome way of getting rich. You take a cut on the pay usually but the upside potential is huge. If you think the company is going somewhere then get as many shares or options as possible. You should only decline the options if you don't believe in the company.

    You pay money on income and gains. So in most places, when they issue you an option it has a value and you get taxed on it (or maybe the company might also pay the taxes in the form of extra pay). I don't know if you have to pay tax on execising the option, but you would definitely have to pay tax upon selling the final shares — and that tax would be the gain from the initial value of the option to the final sale price of the share. Again, you might get taxed on that in two tranches, part when you exercise and part when you sell the share.

    Where do you live (state/province)?

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