Am I thinking about my stock options correctly?

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blake22
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Am I thinking about my stock options correctly?

Post by blake22 » Mon Jun 29, 2020 1:17 pm

I work for a private tech company, and had a question about my ISOs and whether I'm thinking about them in the right way. I've worked at several startups in the past, two of which were acquired, so I'm very familiar with ISOs to some degree. But my current company is much larger than the ones I've been at before, with (in my opinion) a higher chance of a great exit.

At the moment I'm 50% vested in my ISOs, about 10,000 shares. My strike price is $2. The company has had a few rounds of investment, and the latest preferred share price is $6. When I joined two years ago, the preferred share price was $4. In the next couple of years we could raise money again or try to go public. No guarantees though, and I put the chance of going public at say 30% and raising more money at 70%.

What I've been wondering is if I should exercise my vested shares in order to lock in long term capital gains, instead of waiting for a liquidity event to exercise, where I'd be paying regular income tax rates. I'm in California, household combined income is $260k.

My logic is this:
  • If the stock goes up to say $10/share and I exercise at the liquidity event, I'd pay ~35% total effective rate on $80,000, so $28,000
  • If I exercise now and the stock goes up in the same way, I'd pay 15% LTCG on the $80,000, so $12,000
  • Therefore, I'm essentially betting $20,000 (cost of exercise) to make $16,000 (delta between 35% tax - 15% tax)
If the stock stays flat, the absolute dollar amounts change, but the logic is the same. I call it a bet because it could also drop below my strike price in the time I'm holding the stock. I'd put the chances of that pretty low (<10%), but we're a consumer-facing company so anything is possible in this volatile environment.

A $16,000 delta is nothing to sneeze at - but is it worth betting $20,000 on it? Is this even the right way to think about it?

HermanMunster
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Re: Am I thinking about my stock options correctly?

Post by HermanMunster » Mon Jun 29, 2020 1:30 pm

Be careful. When you exercise ISOs, the difference between your exercise price and the fair market value is subject to AMT in the tax year that you exercise.

HomeStretch
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Re: Am I thinking about my stock options correctly?

Post by HomeStretch » Mon Jun 29, 2020 1:48 pm

The more favorable L/T capital gain tax rate is outweighed IMO by the risk of holding stock acquired by early exercise in a non-public employer. I personally would wait to exercise in-the-money options until a liquidity event or nearer to the option expiration date.

Topic Author
blake22
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Re: Am I thinking about my stock options correctly?

Post by blake22 » Mon Jun 29, 2020 2:21 pm

The more favorable L/T capital gain tax rate is outweighed IMO by the risk of holding stock acquired by early exercise in a non-public employer. I personally would wait to exercise in-the-money options until a liquidity event or nearer to the option expiration date.
This is my current thinking as well. The upside isn't high enough to justify the risk of exercising early, whereas the downside is large.

As for AMT, I have to admit I don't understand it. I've read up on it a fair amount, but still can't wrap my head around it. We've paid a lot of taxes the past few years.

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oldcomputerguy
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Re: Am I thinking about my stock options correctly?

Post by oldcomputerguy » Tue Jun 30, 2020 4:20 am

This topic is now in the Personal Investments forum.
"I’ve come around to this: If you’re dumb, surround yourself with smart people; and if you’re smart, surround yourself with smart people who disagree with you." (Aaron Sorkin)

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neurosphere
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Re: Am I thinking about my stock options correctly?

Post by neurosphere » Tue Jun 30, 2020 9:34 am

blake22 wrote:
Mon Jun 29, 2020 2:21 pm
As for AMT, I have to admit I don't understand it. I've read up on it a fair amount, but still can't wrap my head around it. We've paid a lot of taxes the past few years.
I know very little about options and AMT. But my wife has stock options for the first time (although we're choosing not to purchase) so I'm interested a little in this topic.

I found the following article (https://www.nceo.org/articles/stock-opt ... um-tax-amt) which I thought was good. Note that AMT laws/amounts have changed since the article was written, but I believe the general concept is still valid.

One thing that's most interesting to me is the concept of the AMT credit. If one pays AMT in year 1 do to options, will they receive that money back in future years in which they do not owe AMT? Given that the recent tax changes make one much less likely to owe AMT, doesn't that also mean that one is more likely to recoup that option-induced AMT more quickly. For many, the AMT tax on options (if any) would be more like a pre-payment of tax, rather than an "extra" payment. I'm thinking about that correctly? On my to-do list to research. :)
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes".

crefwatch
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Re: Am I thinking about my stock options correctly?

Post by crefwatch » Tue Jun 30, 2020 9:48 am

Don't you have to buy and hold for one year to make the gains into Capital Gains instead of Ordinary Income? That means 1) Your additional capital invested, instead of a Cashless Exercise, 2)Risk of loss for a year of holding period. If you sell the same day, it's ordinary income, with SS, Medicare, and other payroll taxes.

I guess you said you have experience, but "holding" non-public shares is not very much like holding publicly-traded shares. My wife's options were for very liquid, publicly traded shares. We always did Cashless Exercise because we did not want to hold even more of her employer's shares, despite their relative safety (Fortune 100). Not publicly, but you should compare $20,000 with your annual compensation from the company. Is there any pressure to show your loyalty by holding equity compensation?

JAR89
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Re: Am I thinking about my stock options correctly?

Post by JAR89 » Tue Jun 30, 2020 9:58 am

Three things, as someone who does tons of work with startups:

1. My personal view is that except in rare scenarios, is it is better to hold the option than to strategize for LTCG. I’ve worked with a couple founders CEOs who knew a sale was imminent in the next 12-24 months, knew likely exit scenarios well and PPS, and were looking at tens of millions in gains. We did it there, but for a more rank and file, I always think it is foolish.

2. A $2 common price and a $6 preferred price isn’t very promising. I don’t know anything about your company, when the last preferred round was, etc. but a $6 preferred price is often treated as about a $2 409A. Which means there probably isn’t a ton of growth there. Trying to read tea leaves on preferred prices and 409A prices is a fools game, so I’m overstating it a bit, but for this to even sort of make sense, I would expect something like a last round price to be $20.

3. As someone who works with management in startups, employees are just so often wrong on the direction of the company. Employees are often sitting at their desk running the numbers on what happens if there is a 20X IPO, and then a stockholder information statement comes out for a sale where the common gets $0 the next day.

plog
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Re: Am I thinking about my stock options correctly?

Post by plog » Tue Jun 30, 2020 10:45 am

Bias alert: I've seen a lot of people very dissappointed by the situation you are in now.

"Stock options" is a poor term for what you have, I think "value options" is a better way to think of these. There is no open market to sell on, the price is set behind a closed door and there are many other ways for you to be screwed out of them; this is not "stock" in the common definition. You get paid if someone somehow in the future decides to pay real money for the company. It doesn't mean they are worthless, but it does mean any dollar amount you assign them now is pointless.

My advice to anyone who doesn't have their financial house in order is to cash these things in as soon as they can--the minute they can be turned into real money do so. Don't be the one holding a bag of promises.

My advice to anyone who can afford it both financially and emotionally and is a little bit of a gambler is to let them ride if they think they will be worth more in the future than now.

jajlrajrf
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Re: Am I thinking about my stock options correctly?

Post by jajlrajrf » Tue Jun 30, 2020 11:07 am

You will make your own decisions, but I strongly recommend against exercising early.

Most of the actual value of these options is that they represent the option to reap future gains without assuming any risk. The minute you exercise these options, you are assuming several risks, including some that may not be apparent. In particular, if you exercise you will need to hold for a year to obtain long-term cap gain treatment, and as others noted you'll have a tax liability because of that. So the worst case here is actually really bad: you spend money to exercise the options, AND you need cash to pay AMT, AND at the end of that you still might not be able to sell them for a profit, because the share price (if it ever goes public) might decline. That's a huge amount of risk to assume just to avoid paying a future tax on uncertain profits.

The upside scenarios here are actually "The stock doesn't appreciate all that much, in which case exercising early assumed risk for no good reason, or the stock appreciated a lot, in which case the profits from exercise-and-sell are big enough that you should feel OK about it."

I've known lots of people with ISOs, and my generic advice to people is that you accept the tax hit of exercise-and-sell as the cost of doing business. Exercising early is how people in California lost their houses during the tech bubble, when they owed taxes on exercised options but couldn't sell them for a profit.

Good luck with whatever you decide to do.

chocolatemuffin
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Re: Am I thinking about my stock options correctly?

Post by chocolatemuffin » Tue Jun 30, 2020 12:35 pm

Even in a liquidity event, it doesn't mean you will be paying the income tax rate.

If it's an IPO, you just need to wait an year before selling. You are usually locked in for half an year anyways.

If it's an acquisition that involves stock instead of cash, you may be able to carry on the holding period and get long-term capital gain treatment as well, although the rule I think is somewhat complicated.

milktoast
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Re: Am I thinking about my stock options correctly?

Post by milktoast » Tue Jun 30, 2020 12:44 pm

Definitely don't exercise and hold near the IPO. That's how you lose your house due to AMT.

I would suggest figuring out whether you are willing to buy stock in your company at the price of $2 + AMT rate on gain. If that seems like a good investment, then go for it.

This isn't typical boglehead advice, but I've been down this road several times. And sometimes you have to take a concentrated risk to get the reward. Exercising early also gives you ability to change jobs without losing all potential upside from the stock.

At this stage of my career, I would turn down any offer that didn't allow an 83b election with option for immediate exercise.

Edit: for your original question, don't think of the bet as $20k. It's 20k + AMT. Yes, you'll get AMT credit back over time. But thinking about it that way helps avoid the most catastrophic ISO mistake (exercising, not considering AMT, company folds before April 16th of the next year, owe more taxes than you have cash).

Topic Author
blake22
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Re: Am I thinking about my stock options correctly?

Post by blake22 » Tue Jun 30, 2020 2:19 pm

Thanks everybody - this has been super helpful. Sounds like I need to do a lot more reading on AMT before making a decision, but I'm definitely leaning towards not exercising anyways. But I have no idea what the cash implication of AMT is, so that seems like a black hole. I have the cash on hand to cover the $20k exercise, but I don't want to lose my shirt on unexpected taxes.

At a previous startup I had good fortune by filing 83b right when I started, and we got acquired 18 months later and I did pretty well, and the decisino paid off great. My current company doesn't offer early exercise through 83b, though. And I didn't join early enough to get a really cheap strike price.

JAR89 - I'd be super curious to hear more about this, if you're still around:
A $2 common price and a $6 preferred price isn’t very promising. I don’t know anything about your company, when the last preferred round was, etc. but a $6 preferred price is often treated as about a $2 409A. Which means there probably isn’t a ton of growth there. Trying to read tea leaves on preferred prices and 409A prices is a fools game, so I’m overstating it a bit, but for this to even sort of make sense, I would expect something like a last round price to be $20.
Understanding the relationship between preferred and strike price is a black box to me. I've watched it go up 50% between rounds in my time here, and might expect the preferred price to be $10+ if we raise again. And I thought that was good - but sounds like maybe it's not.

milktoast
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Re: Am I thinking about my stock options correctly?

Post by milktoast » Tue Jun 30, 2020 2:33 pm

blake22 wrote:
Tue Jun 30, 2020 2:19 pm
But I have no idea what the cash implication of AMT is, so that seems like a black hole.
The delta between your strike price and the FMV of the stock is your AMT gain. You can assume that AMT tax will be about 25% of the AMT gain.

The AMT rate only has two marginal rates 26% and 28%. And it only kicks in if the AMT tax computation is higher than your normal tax computation. When that occurs for ISO, you'll owe extra money. 25% of the delta is a safe estimate (unless you are exercising enough for the AMT gain to be most of your annual comp). That extra money becomes an AMT credit in future years. When your normal tax computation is lower than AMT tax, you'll be able to use up the credit to lower your taxes.

In the end, AMT is really complex. But unlike back in the mid 90's, TurboTax takes care of all of it for you.

Honestly, AMT is no big deal. If you can cover the bill in cash. If you can't, big trouble.

JAR89
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Re: Am I thinking about my stock options correctly?

Post by JAR89 » Wed Jul 01, 2020 6:52 am

blake22 wrote:
Tue Jun 30, 2020 2:19 pm
Thanks everybody - this has been super helpful. Sounds like I need to do a lot more reading on AMT before making a decision, but I'm definitely leaning towards not exercising anyways. But I have no idea what the cash implication of AMT is, so that seems like a black hole. I have the cash on hand to cover the $20k exercise, but I don't want to lose my shirt on unexpected taxes.

At a previous startup I had good fortune by filing 83b right when I started, and we got acquired 18 months later and I did pretty well, and the decisino paid off great. My current company doesn't offer early exercise through 83b, though. And I didn't join early enough to get a really cheap strike price.

JAR89 - I'd be super curious to hear more about this, if you're still around:
A $2 common price and a $6 preferred price isn’t very promising. I don’t know anything about your company, when the last preferred round was, etc. but a $6 preferred price is often treated as about a $2 409A. Which means there probably isn’t a ton of growth there. Trying to read tea leaves on preferred prices and 409A prices is a fools game, so I’m overstating it a bit, but for this to even sort of make sense, I would expect something like a last round price to be $20.
Understanding the relationship between preferred and strike price is a black box to me. I've watched it go up 50% between rounds in my time here, and might expect the preferred price to be $10+ if we raise again. And I thought that was good - but sounds like maybe it's not.
Tough to say, I don’t know anything about your company. But you usually see a common option price come in at around 33-50% of the preferred price for a midstage VC/PE backed company (so like a Series C type). Not saying either of these is the correct valuation of the company - both preferred pricing and 409A pricing are a little bit of a fiction for a variety of reasons.

Preferred prices going up is a good sign, at least someone diligencing this thinks value is going up. But these may not be huge gains. Also depends whether it is an inside or outside led round, and other terms on the preferred, which aren’t always known to employees. Also depends if the preferred doubled from a $16M valuation to a $32M valuation (where there is a huge margin of error) or $225M to $450M.

Don’t want you to read into it too much. But just saying if all I had was these facts, I probably wouldn’t exercise. But I lean towards not exercising in general, and I know zero about your or your company.

Just one more data point, when banks get warrants, they never exercise unless it is coming up on a termination date. They believe in the value of holding the option

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Tamarind
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Re: Am I thinking about my stock options correctly?

Post by Tamarind » Wed Jul 01, 2020 7:06 am

OP, I went through this thought process a few years ago. I agree with your risk assessment and encourage you to wait for a liquidity event. Even if the company experiences a positive exit, a number of things can happen in a private company transaction that may disadvantage regular option holders. Wait to exercise until you have full information.

As for AMT, when you do exercise the options, you'll have to fill out an extra tax form. The AMT exemption is much larger now, so even with your income you may or may not have to pay AMT when you exercise, depending on the rest of your tax situation. All that is certain is you'll have to fill out the form. You can fill it out now with mock scenarios to get comfortable with how the math works, if that will make you feel less uncertain. You can use your 2019 form 1040 and plug in different scenarios for the value of your shares at exercise. I'd suggest budgeting a big chunk for taxes and otherwise not worrying about it until the exit comes.

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