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There are a lot of rapid-fire, huge funding rounds happening right now. Capital is flowing at historically low prices, huge rounds are happening faster than ever, with more competition than ever, and cleaner terms than ever. This is great for companies and tenured employees, but can be perilous for new hires. Last week, we talked about the nuances of what happens when you join a company on the threshold of a round, and how to prevent a strike price surprise, and this time we’re going to discuss some quirks of what happens if you miss the window and land on the other side.
If you’ll recall from my last article, grants that are approved after a term sheet is received don’t get issued with a strike price associated with them. The strike price ends up being determined after the new 409A/Fair Market Valuation is determined in an audit process after the round has been closed:
Where this starts to get really quirky is if you, as a prospective new hire to the company, receive an offer with a set number of options before the terms sheet is accepted, but your strike price ends up being the strike price determined after the round.
Let’s say, for example, that you receive an offer to work for a company:
Valued at $500M
With 20M outstanding shares
Are offered ISOs for .1% of the company (or 20,000 options)
Now the $500M valuation is likely what investors are paying for preferred stock ($25 / preferred share), which isn’t what you’re receiving (you’ll get common stock, priced at the Fair Market Value, let’s assume $10 / share, a 60% discount off preferred). Altogether, if you received the $10 strike price, and were to exercise all of your stock, it would cost you $200,000.
But you got a little bit unlucky, needed time to finish out at your old job, and couldn’t get on board with a grant approved before a fundraise happened. The company’s doing pretty well, so they get a hefty valuation step-up of 2.5x with a fairly standard 20% dilution. This lands the company, now, at:
$1.25B post-money valuation
25M outstanding shares, imputing a preferred share price of $50
A slightly narrower gap between FMV and preferred price, so a new FMV of $27.50 (45% discount off preferred)
They issue you a grant, now, of 20,000 options, but instead of the previous $10 strike price, you get the new $27.50 strike price. At first blush, this seems not so bad! Sure, you have to pay more to exercise your options, but before the fundraise, your options were worth $300K before taxes (.1% x $500M - $200K exercise cost), and after it, your options are worth $450K (.1% x $1.25B - $550K exercise cost). You started a little later, but made $150K more!
However there’s a funny little quirk of the US tax code that makes this situation a bit more complicated, and that’s the $100K ISO limit (IRS tax code language, for the legalese-inclined).
$100,000 ISO Limits
When you really boil this particular wrinkle in the tax code down, essentially what it says is: if you vest shares in a year that are worth more than $100,000, only the first $100,000 will qualify as ISOs, and the rest are treated as NSOs.
If that doesn’t scare the living shit out of you, you haven’t been reading my other blog posts, but I digress. Let’s break this down, piece by piece, to understand the intricacies of what’s going on here.
How is the value of your options determined?
There is an important element of the language of the tax code that states: “The fair market value of stock is determined as of the date of grant of the option for such stock.” This is particularly important because it’s a little bit different than the FMV that most startup people talk about, which is whatever the current 409A valuation is. The value of your stock, for the purposes of this $100K limit, is actually your strike price, not the company’s current FMV.
What’s vested in a single year?
The easiest way to calculate exactly how much gets vested in a particular year is to look at your option grant, look at your vesting schedule, and divide the value of the option grant by the number of years over which it vests. For standard vesting schedules, that’s going to be four years. However, because most grants include a one-year cliff, whatever tax year your one-year anniversary falls in will actually have a much higher value than subsequent years.
If you happened to start in December of a year, you can use the dumb calculation, becuase you’ll vest a year’s worth of equity in December, and then any further vesting happens in the next tax year. However, if you start in any other month, you’ll vest 25% of your total grant on your anniversary, and then typically 1/48 of your grant every month thereafter, usually on the same day of the month (I’m not actually sure what happens if you start on the 31st of a month, but would assume that you just vest on the final day of each month). The degenerate case here is a January start date, in which you vest a year’s worth of options in January, and then 11 more months of equity over the course of the year.
Coming back to our examples, let’s consider the two situations:
In situation 1, you have 20,000 options, with a $10 strike price
December Start: you’ll vest 5,000 options in December of the year you start in, which is worth $50,000, so they can all be considered ISOs
Janauary Start: you’ll vest 5,000 options in January of the next year, plus 4,583 options in the next 11 months, for a total of 9,583 options, worth $95,830, so you just squeeze in under the $100K mark, and these are all ISOs
In situation 2, you have 20,000 options, but with a $27.50 strike price
December Start: you’ll vest 5,000 options in December of the year you start in, but they’re worth $137,500, so 3,636 of the shares can be treated as ISOs (valued at $99,990), and the remaining 1,364 options are treated as NSOs (valued at $37,510)
Janauary Start: you’ll vest 5,000 options in January of the next year, plus 4,583 options in the next 11 months, for a total of 9,583 options, worth $263,532.50. This breaks down to the first 3,636 options treated as ISOs as above, but now 5,947 NSOs valued at $163,542.50
Why do I care?
There’s a big difference between NSOs and ISOs in terms of tax treatment. When you exercise an ISO, you have the potential to trigger AMT depending on the difference between the company’s current FMV and your strike price, but you don’t actually pay taxes unless you end up owing AMT. Even if you do end up paying AMT, you will get AMT credits that can be used to offset AMT in future tax years. However, with NSOs, you pay short-term income tax on those same paper gains, no matter what. NSOs generally mean big tax bills.
It is worth mentioning that if the company FMV and your strike price are the same when you exercise (which is typically the case if you exercise before any further funding has been taking by your company since your start date), there is no taxable gain at exercise time. The bills come when your company takes more funding, the 409A valuation increases, and now your exercise has paper gains that the IRS treats as income.
Accelerated vesting is another thing to watch out for
Less common for non-executive employees, but very common for C-level and VP-level employees is vesting acceleration clauses. Usually these occur as a part of a change in control of the company (the legal term for a merger or acquisition). Sometimes executive equity contracts will accelerate the vesting schedule by a year, or a percentage of equity that gets vested in some set of criteria is met. This is another big situation where ISOs may inadvertently convert to NSOs, leading to large, potentially unexpected tax bills.
Candidly, if you’re in a situation where you’re hitting the $100K ISO limit, I don’t feel too bad for you. This is definitely champagne problem territory we’re talking about here. That said, nobody loves unexpected tax bills, and these types of bills can be really unexpected and pretty dramatic. Always better to do your homework, and know what you’re getting yourself into. And if this impacts you, I’ll leave you with a congratulations on your offer and your company’s funding!