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Options (as part of Compensation)
Ever wondered about how options work as part of total comp? Read on to learn about CSOs and ESOs, including ISOs and NSOs.
Disclaimer: I am neither a CFP nor a CPA. Any financial discussions are solely my own opinion. Always make sure to confirm your understanding with a CFP or CPA. Secondly, while I discuss tax prep software, like TurboTax, I am not being sponsored for this post.
When you think of total compensation, or "total comp" as it is frequently shortened to, the three main components are: salary, bonus, equity. Not all companies offer an annual bonus, but the gist is that you get cash compensation, as well as some form of equity. The ways that companies go about providing equity packages are myriad. A common way is to provide RSUs, whether public or private, but another way that is more often seen in startups is options. This post is about options as a form of equity in a total comp package.
Aside: You may be thinking, "Hang on, aren't options those weird derivatives things that Wall Street Bets talks about all the time on Reddit?" While there are options in the stock market, such as the ones discussed by Wall Street Bets, that's a topic for another post because it's a whole subject in and of itself. For this post, we will solely be discussing private equity in the form of options given to you should you join a startup.
What is an option (for compensation)?
Options within the realm of compensation are entirely different from options in the stock market, though they both have the name "option". Briefly, there are two kinds of options in the stock market: call options and put options. All option strategies revolve around use of these two types of elemental options. Call options give the buyer the right, but not the obligation, to purchase stock at an agreed upon price (the "strike price") at a future date in time (the "expiration date"). Put options give the buyer the right, but not the obligation, to sell stock at an agreed upon price (the "strike price") at a future date in time (the "expiration date").
Options provided to you as part of a compensation package do not follow this call-put model. Rather, they are a way to incentivize employees, beyond their cash compensation, to work at a company. Generally, that company is a startup. The reason for this is that more established companies tend to provide RSUs, whether they are public or private. Startups like options instead of RSUs because they can limit dilution and because it's cheaper to offer options than higher cash comp. However, unlike with RSUs which could grow slowly over time, the potential upside with options can be massive (since they normally start with very low strike/grant prices and therefore have large upside potential if the company is successful). With great potential upside also comes great risk (haha, you thought I was gonna say "with great power, comes great responsibility" 🤣) because the options could become worthless if their FMV drops as little as 1 cent below your grant price (I'll explain why they are worthless in that situation in a sec).
Options are generally provided in one of two different forms:
Cash-Settled Options (CSOs)
Equity-Settled Options (ESOs)
These two forms of options factor into your earnings in different ways, which means they are also taxed differently. Let's begin by discussing each type.
Cash-Settled Options (CSOs)
CSOs are more rare than ESOs, but they are a possibility when the company wants to provide another component to your total compensation that incentivizes you to stay at the company, and yet not cause dilution by giving you any equity. I'm also starting with them in this discussion because they are easier to understand than ESOs.
CSOs are granted at a certain strike price (or, "grant price") and then are vested normally in the same cadence that RSUs would be (1-year vesting cliff, followed by monthly or quarterly vesting of remaining grant).
What you are being provided are units of exercisable options that will turn into cash if you exercise them AND there is gain above the strike price. Yes, cash, NOT stock/equity.
So as an example, if the company grants you CSOs at a strike price of $1 and then does not grow, your CSOs are worth $0. If instead, the valuation grows and you are told that the Fair Market Value (FMV) of your options is now $2 per option, then you have a gain of $1 per option. However, this is only a gain on paper. Your company needs to have what's called a "liquidation event" where you will be able to exercise your options. It's basically an event carried out in which you indicate that you want to capture some of the gain you've had on paper by exercising a subset of your vested CSOs and turning them into cash. The proceeds you receive from the company are treated as additional cash income (so they will just increase your AGI; refer to my Taxes post if you need a refresher on AGI).
One nice thing about CSOs is that they cost nothing to exercise.
Note: Options can only be executed if the company has grown in value. If the company has stayed at the same valuation, then your options' FMV would not have increased, so there would be no gain. If the company has dropped in value, then your options' FMV would be less than their grant price, so they can't be exercised. This is starkly different from RSUs, which can still drop in value relative to their price at grant date, and yet you can still realize some cash out of that.
Summary of conditions that need to happen for you to realize value on CSOs:
The company needs to have an updated valuation that is higher than its valuation was at the time the options were granted to you (if the value is the same or lower, your options are essentially worthless).
The company needs to open a liquidation event for you to exercise some options.
You need to have some options available to exercise (which means, you have some options that have vested from your grant by the time of the liquidation event).
Equity-Settled Options (ESOs)
Equity-Settled Options (ESOs) have a primary difference from CSOs in that, when exercised, they turn into shares of the company that issued you the options. ESOs also can generally be exercised at any time: they do not require liquidation events in order for you to exercise and convert the options into shares.
Note: Just because you can generally exercise ESOs whenever does not mean you can sell the resulting shares whenever. You still need the company to have a liquidation event to sell the shares. So be careful because you may get into a situation where you have a bunch of shares that you cannot actually sell, since the company has not opened a liquidation event.
The two types of ESOs are:
Incentive Stock Options (ISOs)
Non-qualified Stock Options (NSOs)
While they will both result in you receiving shares of your company, they utilize different mechanisms for you to pay for those shares and they have different taxation rules. In some cases, their access may also be limited by your country (for example, international employees of startups in the U.S. may only be granted NSOs, whereas the domestic employees could have been given a choice between ISOs vs NSOs when they were granted ESOs).
ISOs require you to pay for the cost of exercise. What that means is that you will be paying for:
Strike price/option * # options to exercise
AND, for taxation purposes, the government may charge you an additional tax called Alternative Minimum Tax (AMT). You can think of AMT as being calculated in parallel with standard/regular taxes from income. It's meant to be a floor, a minimum, in how much you pay in taxes. AMT is calculated against the difference between the FMV of the options at time of exercise, minus the grant value.
Let's do an example:
You are granted 1000 ISOs at a strike price of $1. The ISOs vest quarterly, after a 1-year cliff in which 1/4 of your options vest. Say the company does a valuation before end of the year and the updated valuation is higher than the valuation of the company at the time the options were granted to you. Additionally, let's say the FMV of the options is now $3. The company then opens a liquidation event for employees to exercise some of their ISOs and gain shares. Let's also say that the liquidation event opens right after your 1-year cliff, so you have 250 ISOs to exercise. Let's also assume that the company will allow you to exercise all vested ISOs (this is not a given, they may restrict you to 25% or less, but I'm gonna keep it simple and say that you can exercise everything that's vested).
On-paper gain would then be:
Number of options to exercise: 250 Gain per option = Current FMV - Grant Price = $3-$1 = $2 Total on-paper gain: 250 options * $2 gain/option = $500
Now, where does this AMT thing come in? AMT is primarily for high-income earners who made a lot of gain in a year, but the income came from primarily options and not cash/standard income. So under standard taxation rules, it would appear initially that they don't owe much in taxes because they didn't make much standard income. To counteract that and make sure they pay at least a minimum amount of taxes, the government also calculates the tax value using AMT rules.
But wait? Why should you even be taxed on not receiving cash? After all, the result of an ISO exercise is stock. Well, think of it like this: your grant price is lower than the FMV of the options at time of exercise, so it's essentially like you got shares at a discount. That discount is referred to as the "spread" and it's the core focus of AMT taxable income calculation.
The gist of how the process works is that the IRS calculates your standard taxable income (cash, bonus), but this time with less exclusions and deductions as compared to standard tax, and then they subtract an AMT exemption amount (a minimum amount of paper gain you must have realized in order to be subject to AMT).
Refer to IRS Form 6251, Alternative Minimum Tax (make sure to check filing status: individual, married filing jointly, etc.) to see which exclusions and deductions are not counted (but would've been in standard tax rules) and what the exemption limits are per filing status type. As of the time of writing this post, the AMT exemption amount for 2023 single filing status is $81,300. Note: Tax preparation software like TurboTax can do all these steps automatically for you, but it's always a good idea to at least scan over the form in its original source (from the IRS website) that the tax prep software will be pre-filling for you.
Then any positive delta (after exemption amount is subtracted) is taxed at either 26% or 28%, based on how high AMT taxable income is (refer to IRS Form 6251 for the instructions).
You then pay the income tax that is highest:
Income tax = max(tax_regular, tax_amt)
But, do not despair. In subsequent tax years, you can claim an AMT tax credit! Refer to IRS Form 8801 for instructions. With this form, you will calculate both a credit for the current tax year, based on AMT paid in prior years, and any credit you can carry forward to the next tax year.
Qualifying vs Disqualifying Dispositions
ISOs have yet one more wrinkle to consider. Remember how I said that in order to actually get cash from ISOs, you need to exercise them to gain shares and then you need to sell those shares? Well, when you sell shares can determine whether or not you get to use those AMT tax rules, which believe it or not, are actually preferred to what I'm about to describe.
A Disqualifying Disposition for ISOs is when the resulting shares from an exercise are sold before a required holding period: one year after exercise, two years from grant date. (There's technically another requirement that you must not have left the company more than 3 months before exercise date.)
The taxation is worse. At the time of exercise, you now have to recognize the paper gain (spread * number of shares) as ordinary income.
Then, when you sell the shares, you will be subject to short term or long term capital gains, if there is a gain.
Let's contrast this with Qualifying Disposition ISOs. What that means is at the time of exercise, you will only pay AMT tax, if any (remember, it's subject to an exemption minimum limit, so if you don't hit it, you will not owe AMT tax). And then when you sell the shares, you will be subject to long term capital gains, if there is a gain.
NSOs are a lot simpler to understand. Unlike with ISOs, where you have to pay to exercise them, NSOs provide you a choice: you can either pay to exercise or you can sell some of the resulting shares to cover the cost of exercise. In this way, NSOs are a very attractive option for employees who do not have a lot of cash set aside to exercise ISOs.
However, NSO paper gains are taxed as ordinary income at the time you exercise and are subject to FICA taxes (Social Security, Medicare). Like normal shares, they are then taxed as short or long term capital gains, if there is a gain.
Choosing ISOs vs NSOs
If your company provides you a choice between ISOs and NSOs for an ESO grant package, then there are some situations you can consider to help you make the decision:
If you have a lot of money set aside AND you believe in the company, ISOs might be a good option because of their preferential tax treatment and because you don't think you could make more of a gain elsewhere.
If you do not have money set aside, you should strongly consider NSOs. Exercising options can get really expensive and while you will not retain as many shares should you pick NSOs (because some of them will be sold to cover the cost of exercise), you will still have some and it will be less risky than say, taking out a loan to exercise ISOs.
If you do not have long term belief in the company (whether with a large amount of money set aside or not), NSOs provide you with the most flexibility.
As you can see from everything you just read, options as part of a compensation package are far more complicated than just receiving RSUs. They require you to have a deeper understanding of taxation rules and require a bit more strategic thinking. For example, if you have a mix of CSOs and ESOs, maybe you exercise some CSOs in a given year to protect downside risk and in the next year, you exercise some ESOs. And even with the case of solely having ESOs (instead of a mix of CSOs and ESOs), you have to deeply analyze whether to pick ISOs or NSOs, depending on your financial goals.
Another insight you might have gleaned while reading this post is that your strategy is highly dependent on liquidation events, which are not a given and are not easy to predict ahead of time. Imagine that you have ISOs (because the company only has ISOs available, or they offered you a choice between ISOs and NSOs and you picked ISOs), you pay to exercise them, and then you get shares, but at a later point when you want to sell them, you can't because the company hasn't opened a liquidation event. That is super frustrating.
This dependence on liquidation events to actually realize gain is a similarity between literally all forms of non-public equity. With public RSUs, you can sell them at any time to the broader market. But with private RSUs, CSOs, and ESOs that have been exercised (and are therefore shares), you need to have a liquidation event. You can think of private RSUs as like a shortcut between ESOs and shares: instead of needing to exercise to get shares, you were just immediately granted shares. But, they're still private and therefore still require a liquidation event.
So why would anyone want to have options as part of their compensation package?! Seems like madness, right? Maybe, but with great risk, may potentially come great reward. Options are normally granted at very low strike prices. I'm talking like single digit dollar strike prices. So the company does not have to grow by much in order to realize a paper gain. However, like I said earlier, your ability to realize that paper gain into cash is dependent on liquidity events. For startups, the most common liquidity event that would have a massive payout to you would be an acquisition. If not an acquisition, then an IPO, because the share price would likely grow beyond the options' grant price.