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How to Advise Clients (and their Employees) on Stock Options

Vieje Piauwasdy Senior Director, Equity Strategy 
Vieje Piauwasdy

Today, 35 percent of private companies grant equity, also known as stock options, to their employees. This gives people “a piece of the company” and in return, they are expected to work hard to make their cut worth it. It can be a great trade, especially for smaller or earlier-stage companies that can’t compete on salary. But it can also be incredibly complicated, tax-wise.

In 2021 alone, startup employees and executives paid $11 billion in unnecessary taxes by not exercising their stock options early enough. In the worst scenarios, people have had to forfeit exercising their right (aka purchasing) because they weren’t tax experts, didn’t think ahead, and by the time they realized, it was too expensive.

If you work with privately backed companies (like venture-capital-backed startups) that offer stock options as compensation, there’s an opportunity for you to help the employees take stock.

How does equity compensation work? The basics

Employees are typically granted stock options when hired, or as bonuses when promoted. Each grant will have a set strike price or the cost to exercise (buy) one share of stock at a certain price. The price is usually set at fair market value (FMV or 409A), which is what the appraisal value of the company is at the time of grant.

The strike price always remains the same, but the FMV is likely to change. Any company offering stock options is legally required to have a third party reassess the FMV at least once a year, and that number can change a lot if there is, say, a new investment round.

When someone exercises stock options, the IRS taxes the difference between the strike price and the FMV (called “the bargain element” or “the spread”). That’s used to calculate the alternative minimum tax (AMT). This is important.. In many cases, this cost can grow so quickly, it becomes prohibitive. If that happens, your client may have to forfeit their stock options or stay on until an exit event, a situation often referred to as wearing “golden handcuffs.” 

Many employees are entirely unaware of these dynamics — all they know is the relative value of what they were granted when they granted it, and assume it’s worth about that much.

The tax benefits of exercising stock options early

While exercising stock options early certainly carries higher risks — the “younger” a company is, the more uncertain an exit is — there are also tax benefits. That’s especially true if the company continues to grow and become more valuable.

Reducing AMT and starting the clock on long-term capital gains

First, the earlier someone exercises their stock options, the less tax they may have to pay. It may even be possible to pay no tax at all. The most common form of stock options are incentive stock options (ISOs) which can trigger the alternative minimum tax (AMT), something most people have likely never encountered before. If their strike price and FMV are still the same, they can avoid triggering AMT. Plus, AMT is only triggered at a certain threshold, so you could advise them to exercise a portion each year to avoid it.

Second, you can help them minimize the tax they’ll pay later when selling those shares, to maximize their gains. Many people are likely unaware of the difference between short-term and long-term capital gains and the preferential treatment of the latter. They’ll need to hold their incentive stock options (ISOs) for at least one year after exercising, and two years after being granted. And with non-qualified stock options (NSOs), you only need to hold for one year.

ISOs vs. NSOs

Most companies issue ISOs to their employees, which have a more favorable tax treatment than other types of stock options, including NSOs. That’s because ISOs only trigger the AMT, whereas NSOs are subject to income tax. And with ISOs, employees may be able to get back most if not all of that payment back when they later sell their shares via the AMT credit.

Typically, employees leaving a company only get 90 days to exercise any vested stock option. Though extended exercise windows of five, seven, or even ten years are becoming more common, there’s still a 90-day window they need to consider — which most employees probably don’t know about. Because after 90 days, ISOs turn into NSOs, so they will lose those tax benefits. 

Helping clients exercise their private stock options

Exercising, even early, can carry a significant financial burden for your clients. But there are options you can explore with them to obtain the cash to do so. Though it’s crucial they understand the potential risks involved. The most common options are:

  • Personal loans: These can have a higher risk but can also have a higher reward due to lower interest rates. The risk is due to the loan needing to be repaid even if your client cannot cash in their shares (e.g. the company fails), and their personal assets (e.g. car, house, etc.) will be on the line. Never let your client take out more than they can afford in a worst-case scenario.
  • Tender offers and secondary market share transactions: A tender offer is a buyback program organized by the company. It allows employees to sell their stock (usually a specified percentage) immediately but forgo any upside if the company exits. Secondary markets work similarly, but are run by a third party. These usually involve a cashless exercise — buying and selling the stock in a single transaction — which can be subject to short-term capital gains.
  • Non-recourse financing: This option is similar to a personal loan, but the employee’s personal assets aren’t held as collateral. There is an interest component on the financed amount, but there is also an equity share fee component because the company financing the cost takes most of the risk. The other major difference between this and a personal loan is that payment isn’t due until their company has an exit or liquidity event. If that doesn’t happen, borrowers don’t usually have to pay back the cash they received in order to exercise their options. Because their equity is the only collateral, they’ll never owe more than the shares are worth.

Take advantage of the Qualified Small Business (QSBS) program

Finally, there is also another tax benefit you should advise clients on, especially those at smaller, newly established companies: the Qualified Small Business program (QSBS). While the requirements to qualify are narrow, it could save people a significant amount of money. In many cases, they can avoid 100 percent of the capital gains tax when they sell their shares.

For a company or exercise event to qualify for QSBS:

  • The stock needs to be acquired when the company has $50 million or less in assets. A startup could exceed this investment level as quickly as Series A or B.
  • Eighty percent of the company’s assets need to be used in a qualified trade or business. Many companies will qualify for this but some may not. For example, law firms, accounting firms, financial services, or consulting firms may not be considered a “qualified trade or business.”
  • The stock needs to be held for at least five years after exercising before selling it.
  • The company must be a domestic C corporation.

Help clients take stock

Let’s remember that in 2021 alone, startup employees and executives paid $11 billion in unnecessary taxes by not exercising their stock options early enough. And an unknown number forfeited their options entirely because they didn’t catch them soon enough. You can help. 

With this knowledge, you’re ready to begin a conversation with clients to help everyone make the most of their hard work, and make that “piece of the company” worth it.

Vieje Piauwasdy
Vieje Piauwasdy is the Senior Director of Equity Strategy at Secfi. As an equity compensation and taxation expert, he guides startup employees through the complexities of private company equity to ensure that no money is left on the table. Prior to joining Secfi, Vieje spent years at PwC, where he specialized in tax reporting and strategy for hedge funds, private equity funds, and asset managers.

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