Come time to compensate employees through equity ownership, employers typically gravitate towards one conventional framework:
Option grant of <insert number> shares, vesting over 4 years. 25% vest after a one year cliff, with the balance vesting ratably afterwards. Accelerated vesting in the event of a sale. Options must be exercised within 90 days after employee separation.
Since this structure is so incredibly common, then surely it must be tried and true as the most efficient way to deliver value to all parties, right? Not so. By a long shot.
From an employer’s standpoint, there are several considerations that would suggest modifying the conventional framework. For example, if the company’s goal is to provide a more attractive employment offer, why not offer a bigger option grant, but then have it vest over a longer period of time?
And, while considering what type of behavior you’d like to reward (for instance, longer commitment to the company), how about weighting the vesting schedule more heavily to the later years? From an employer’s perspective, back-loaded vesting lessens the risk of bad hires (fewer shares vest in the initial year where the employee is both unproven and still learning how to best contribute) and better aligns compensation with contribution (high number of shares vest in later years when the employee’s productivity is at peak).
So employers could do a better job of aligning their goals and interests with their employees through pulling levers other than the sheer size of the share grant. Similarly, they could also structure the option plan itself to optimize for after-tax gain for the employee.
I wrote in my previous post about how the tax treatment of share appreciation creates a very painful, often untenable, situation for employees when they exercise in-the-money options. By way of a quick refresher, the employee is responsible, upon exercise, not just to cover the price of the option, but also the difference between the strike price and fair market value, taxed at the rate of ordinary income. Stepping through an example of an employee who exercises options to realize $10 of share appreciation, the tax consequences are stark:
Let’s say a key, early employee originally received an option grant for 10,000 shares with a strike price of $0.10/share. Now, four years later, the latest fair market valuation for each share is $10.10. Counting her good fortune, the employee scrapes together $1k (10k shares to be purchased at the strike price of ten cents a piece) and thinks of her plans for the anticipated windfall of $100k (10,000 shares * $10 per share appreciation). However, she is surprised — and more than a little disappointed — to discover that she’ll need to find an additional $35k or so to purchase the shares, as, at the time of exercise, the IRS collects tax at an ordinary income rate (for the purposes of illustration, I used 35%) on the difference between her strike price ($.10/share) and fair market value ($10.10/share).
(NOTE: this example assumes the grant was for non-qualified stock options. ISOs — Incentive Stock Options — do not trigger a withholding tax at time of exercise, but are subject to holding period restrictions and are subject to AMT consideration.)
Since this is the natural result of the industry standard options grant structure, both the tax consequence and its unfortunate timing are unavoidable, right?
There’s a different options structure available which, with a slight amount of up-front risk, creates a significantly different outcome for the employee: early exercise options.
Here’s how Early Exercise Options work (in this same example):
- These options vest immediately, but the underlying shares which are purchased are restricted, vesting on a pre-determined schedule over time.
- The employee, upon joining the company, exercises her options immediately, paying $1,000 (10k shares at $0.10 per share) to the company to do so. (There is an obvious opportunity for the company to assist with this purchase through a signing bonus.)
- The employee makes an 83(b) election within 30 days of exercise by sending a form letter to the IRS. This election sets the value of the underlying restricted shares to the strike price ($.10) for tax purposes. (Without the 83(b) election, the employee would have to pay taxes on the difference between the strike price ($.10) and the fair market value of the restricted shares as they vest, so this is a step not to be skipped.)
- At the end of the end of the vesting period on the restricted stock, the employee owns the shares outright with out-of-pocket expenses of only $1k (paid at the original exercise date). She is free to hold or to sell her shares; when she does sell, she is taxed on the share appreciation as capital gains (either long- or short-term depending on the length between vesting and sale). Not only does this provide flexibility, it also lowers her tax burden as the long-term capital gain rate is significantly lower than her ordinary income rate. (Of course, as described in a previous post, if this qualifies as a QSBS sale, she will avoid taxes on the appreciation altogether.)
- Had the employee left her position prior to the full vesting of the restricted shares associated with her early exercise option grant, the company has the right to repurchase these shares at the original strike price.
Again, for the purposes of this discussion, the example discussed is for non-qualified stock options. The same principles can be applied — and the same advantages realized — for ISOs, albeit with respect to AMT vs. ordinary income tax.
The downside to this structure — immediate cash outlay to exercise options on an investment that is both risky and illiquid for the employee, slightly more administrative overhead for the employer — pales in comparison to the tax savings this may enable. This is especially true for early employees when the fair market value (and corresponding option strike price) is relatively low.