Last week I attended a holiday party at an incredible loft, with floor to ceiling windows and views of both the Hudson and East River, in downtown NYC. During the event, I met Mikaela – a fun and outgoing tech executive, with a great smile, powerful energy, and wonderful focus.
We exchanged stories about what we do for a living and she was very intrigued about the types of stock options. She asked me a challenging question about how one would choose the kind and amount of stock options because she was in the middle of negotiating a new job offer.
Types of Stock Options
There are different types of options and the technical terms for them are – Incentive Stock Options (ISOs) or Nonqualified Stock Options (NSOs). These descriptions are conventional.
For me, ISO means “I Sell Out (later)” and NSO is “Not SO much.”
Have you ever stopped to think that options just aren’t these intangible objects floating around somewhere on your Carta login? Perhaps you can consider them as a way to introduce flexibility into your life, to reduce your stress and worry, and pursue that life-long dream hobby?
Walking through Stock Options in a Job Offer
Mikaela was offered $100,000 worth of options as part of her compensation package.
The first question to ask is, “Will the company offer more options?”
If the company is firm on the total amount – $100,000 worth of options – then the next step is to ask about splitting the options into different types.
There is a well thought out process about splitting options into different option buckets – immediate and down the road. The amount of the split is specific to you and your situation, and asking for a split that fits you is ideal.
Technical Nitty Gritty
Then, if you want to exercise your options early there are a lot of things to consider:
- Your personal financial situation
- Viewpoints of the future of the company
- Cost of option exercise
In our example, Mikaela would like to early exercise 25% of her “not so much” options. She feels comfortable exercising the first year’s worth of options and the exercise cost is within her comfort zone – $25,000.
We then went back to the company, and asked them to split the $100,000 options into two types:
- $25,000 NSO
- $75,000 ISO
Typically, companies are willing to do the split.
Since she is early exercising her NSOs at grant, her exercise price will be equal to the 409A value (company value) at the time, so there is no additional income tax to worry about.
By early exercising the NSO grant and filing the 83(b), she starts the holding period for long-term capital gains and the qualified small business stock (QSBS) clock at exercise.
However, if this were an ISO grant, the 83(b) filing doesn’t start the timer for the capital gains holding period because the clock starts at vesting date.
The remaining $75,000 will be an ISO – I Sell Out later – grant. The client will retain the potential favorable ISO tax treatment down the road. Then we can help her exercise options and hold the amount up to the free AMT level in future years. This is a tax efficient way to exercise and hold.
On the other hand, if all the options are NSOs, as the company grows, the 409A value will most likely be higher in the future.
Every time Mikaela exercises down the road, she will immediately pay ordinary income tax on the difference between her exercise price and the stock price (the so-called “option spread”) instead of having a bit more strategy flexibility with ISOs, like she has now.
When you find yourself in a job offer negotiation with different types of stock options, it’s best to ask for an allocation that fits you and your situation – selling out later or not so much.