1. U.S. tax law requires that incentive stock options (ISOs) have a 90-day termination tail on them - that is, the options do not qualify as ISOs if they are not issued under an enforceable agreement by which all vested options must be exercised within 90 days of termination of employment or expire.
2. As a direct result of point 1, the near-universal practice that startups use when issuing stock options is to require employees to sign documentation by which they agree that they lose even their vested options if they do not exercise them within 90 days of their termination date.
3. The original idea behind ISOs (the reason for distinguishing them from "non-statutory" or "non-qualified" options) is that they can be exercised at any time after they vest without triggering ordinary income tax for the exercising employee at the time of exercise (subject to certain monetary limits).
4. However, the "benefit" note in item 3 above, though a very real benefit in days gone by, is often illusory today because the exercise of ISOs requires that the amount of the spread (difference between exercise price and fair market value of the stock at the time of exercise) be included as an item of AMT - meaning that a so-called "ISO" exercise can result in a huge AMT tax. What this means is that an employee holding vested options in a startup whose value has risen greatly faces a dilemma. "Do I exercise now, pay a huge tax, hold only a piece of paper that may or may not be worth anything down the road, and hope that the stock price holds? Or do I wait until a liquidation event, exercise at that time, and thus eliminate the large tax risk of exercising before that time?"
5. Of course, many such employees chose to wait. If you cannot sell your stock right away, it is a very high risk to pay a massive tax on an option exercise only to wind up holding illiquid stock that may become valueless if things don't go right. This is no small issue. People committed suicide during the dot-bust era a decade or so ago after having made the wrong decision.
6. The problem is exacerbated by the 90-day expiration rule on employee termination. It is one thing to wait and wait until the liquidation event. But what if it is a long time in coming? Many employees are trapped in their employment when they face the above dilemma because leaving their employment will force them to exercise or lose potentially valuable options if they don't exercise within 90 days of termination. Even worse, if their employment is terminated by the company, they are put in the horrible position of losing something they worked very hard for because of a seemingly arbitrary and stupid rule saying that the options expire within 90 days of termination.
7. Well, guess what, the rule is stupid and arbitrary in many ways. Why? Because, though the law requires that it be made part of any ISO grant, this does not mean that the startup cannot modify the agreement for the benefit of the employee to eliminate the 90-day expiration provision and to give the employee room to exercise for an extended period. What happens when the company does this in spite of the tax rules? Well, it means that the option loses its character as an ISO. But it does not lose its character as a legally enforceable stock option. It just means that it is taxed as an NQO (non-qualified option). So, in a worst case, the employee exercising an NQO gets immediately taxed on the spread at the time of exercise. But, if that modification gives the employee the flexibility to carry the options unexercised but exercisable for a period going well beyond the 90-day period currently defining expiration of such options, the employee can leave employment, hold the options, and wait for such extended period (e.g., the 7 years discussed in the article here) before deciding whether to take the tax risk of exercising and holding illiquid shares. And, if, in the interim, the company does have a liquidation event, then the employee's dilemma vanishes and he can exercise and sell right away in order to make the profit and pay the associated taxes.
8. The net result of the startup's agreeing to eliminate the 90-day provision is that employees need no longer feel trapped in their employment once their options have vested when the stock price becomes high. They can leave and still keep the option of cashing in on their hard-earned options.
9. So why don't most companies agree to such modifications? Their lawyers will tell you that the law requires the 90-day rule and this is true but misleading because that requirement can be violated in a lawful way that simply changes the character of the options. Thus, if the parties can live with the change, why not do it routinely? Well, I leave it to everyone to draw his own conclusions. Perhaps startups want to keep their employees trapped. Perhaps they are just listening to lawyers who insist on following the rules. Or perhaps a board of directors does not feel it consistent with fiduciary duties to give employees something that appears to be a gratuitous modification that does not benefit the company. Whatever the reason, it remains true that most startups choose to leave their employees trapped in this dilemma without even giving them a good explanation beyond the fact they agreed to the condition and that the the tax laws "require" it.
In any case, kudos to Pinterest for doing the decent thing here. It is indeed all too rare to see something like this and they are to be congratulated for it.
Is there any downside to Pinterest, other than the legal costs of working this out? Increased scrutiny by the IRS? Or just, as the article implies, some loss of golden handcuff leverage over their employees?
Not just leverage over their employees, but they (ie: not pinterest, but most companies) also get to claw back all the options left un-exercised by employees that do quit.
Even just only taxing it once it is sellable stock would be a huge improvement. Getting stuck with a taxbill for something you can't actually sell is ridiculous.
"Phantom stock grants and vesting agreements align employees' motives with owners' motives, i.e. increasing stock prices, while avoiding both taxable compensation and the need to give recipients voting or other rights typically associated with shares."
Yes, there's the AMT trap for ISOs, but there's also an AMT credit that nobody ever seems to talk about, so net-net the AMT issue typically isn't as bad as some people make it out to be.
AMT credit is useful, but typically the issue is that 1. the taxpayer may not have savings to cover initial AMT and 2. the underlying security is volatile and could lose all value. If the security is just taxed a the time of sale, then the taxpayer definitely has the funds to pay (and the amount can be straight-up withheld) and no complex AMT schedules have to be filed.
AMT helps the government get paid sooner than later for fast-growing companies. This mechanism doesn't have to affect non-C-level execs to be effective.
And the "socialist" UK which does this and even gives employee share options special exemptions eg you can transfer vested options into your ISA with no tax.
Doesn't the company have to run an "approved" share option scheme to get all of the tax benefits? I've been offered "unapproved" options before (not recently though) and they would have been pretty ruinous as I think I would have to paid income tax on them and CGT on any gains.
Well then your employer should have done an approved scheme - but GCT only applies when you sell and have a gain greater than your CGT allowance unlike the USA
For non UK residents the first $16k of CGT in a year is not taxed.
It was a small company with no outside investors and they didn't want to spend the money to get an approved scheme setup. I left before it became an issue for me.
Of course, it's very early stage companies that you really want options in...
In the US, the difference between "fair market value" and exercise price is subject to AMT. The short explanation is that if you exercise ISOs, you need to calculate your tax under AMT rules (which consider the spread taxable income) as well as normal rules and pay whichever is more.
It's better for founders too if the employees don't get screwed because a portion of the talent is silently passing over equity opportunities for fear of the complexity, and a founder can't even see or measure the talent that silently passes
Like me! Why can't there be a simpler subset of corporate law? A startup using corporate law that was easy to reason about (like a programming language) would have a huge recruiting advantage.
So a while ago I read all of the UK Companies Act 1985 with someone when we were trying to work out how to set up a non-profit. It's actually not too complicated and looks remarkably like a programming language for company operations. For example, here's some input validation from the more recent version: http://www.legislation.gov.uk/ukpga/2006/46/section/57
But the vast bulk of it was clearly exploit prevention "code". You can quite clearly work out what the scam was that caused each of the overly specific rules. This makes it somewhat irreducibly complicated.
I wouldn't say its "irreducibly" complicated. Production C code has a lot of exploit prevention code that production code in a higher level language doesn't need.
Your comment sounds interesting though I'm not sure I'm following. What can't a founder see or measure? Why would the founder care? For rehire potential?
Most employees have to like your company in the first place before they would ever even return your recruiter email or apply to work at your place. These people do not communicate why they rejected you.
Basically, you have the option of $250k annual liquid compensation from GoogFaceSoft and a low stress & time working environment. Vs. random startup that if it hits it big, you would make more than that amount and have more fun doing it.
Now you starting hearing stories that equity compensation isn't so great:
1. Companies take far longer to get to IPO now. You might not be able to liquidate your stock until 7+ years later. They also don't like it when you try to sell in between.
2. Companies play take back games with dilution, zynga style threats, or even just pure stock buyback options at the original / FMV strike price like Skype.
3. VCs play take back games with liquidation preferences & more.
4. There is this AMT headache that can be double or more than your strike price cost. Founders have 0 AMT, 0 strike price cost, and long term capital gains tax rates!
5. You soon realize it's %70 investors, %15 1 or 2 founders and %15 all employees on a power law! If your facebook then maybe %20 founders, %20 employees. Why become an early start up employee who works just as hard with %0.5-%0.01 when you can be a founder? Thus the 'glut' of start ups with angel rounds.
You have overpriced mortgages & rent to pay in the bay area, so money is important.
> You have overpriced mortgages & rent to pay in the bay area, so money is important.
I would turn the point around and start from here. GoogFaceSoft is great comp low stress environment only close to headquarters.
In most other places GoogFaceSoft engs are the guy the headquarter outsourced to, and that is a dramatic shift in stress/job satisfaction.
Bottom line, talent is everywhere, if the product is solid investors will find you; if the startup is focused on angels/exit instead of great products then, well, that's why people want no part in it.
The idea is that some new hires may be missed due to a candidate deciding the options package is too risky. If they know upfront that leaving the company doesn't force their hand, maybe the package is more attractive.
The founders can't see the talented people who didn't even bother applying for a job at the company, and the talented people who instinctivly ignore "start-ups".
In Zynga case there's no material difference between
* asking an employee to give up a certain number of options
* firing the employee, making further option vesting impossible
By not firing immediately and by not requesting 100% of options be cancelled out, Zynga was actually playing nice. If you were among people affected by that offer, the writing as far as future career prospects at Zynga was on the wall.
Firing people to weasel out of paying their unvested options is definitely shady. When those employees were hired, did they tell them "Oh, by the way, if your unvested options wind up being worth a lot more than your fair salary, we're going to threaten to fire you to avoid paying."?
If someone had $1M in unvested options, and you ask them to renegotiate for $200k and keep them there as an employee, that's really tone deaf. Do you really think that employee is going to give their best efforts after you just cheated them out of $800k?
Yeah, no doubt somewhere along the way someone made a negotiation mistake, and is now trying to remedy that, which does not paint them as a man of their word.
From strictly rational perspective, choosing between two messages - "you're costing the company too much, therefore we're reducing your package" and "you're costing the company too much, you're fired, Jonathan will walk you from the building" - is a no-brainer for employees.
> Yeah, no doubt somewhere along the way someone made a negotiation mistake
Is it really a negotiation mistake, rather than a result of growing valuation?
The point of stock options is to grant and receive them early at a low price. There's a good chance that they won't amount to much, but there's also a hope that they will be worth a lot. That's the entire point of accepting stock options over salary as an early employee.
But if stock options are likely to be cancelled if they appreciate in value, then their expected value quickly falls to zero, and it would make more sense to just offer yearly cash bonuses instead.
Yeah. If the options were worth $100k when the person was hired, and now they're worth $10M, is that really a negotiation mistake? Maybe the employee did a great job and that's the reason they are now worth $10M? Would the employee have taken the job if you only offered $1k equity (or been insulted by the pittance)?
By their actions, Zygna also signaled to the other employees that Zynga was going play a "heads we win, tail you lose" in the future. Who in their right mind would ever work for that founder again?
Going in, a startup employee gets some stock (upside) in exchange for risk (downside). Zygna used their relative power to reneged on that agreement to capture the employee's upside. "You can give us your money or we can take it AND fire you. Hey, but its your choice."
I think they clawed back unvested options from many employees, who had unvested options with substantial value. That breaks the implied social contract of a startup. If the company is wildly successful, they'll try to claw back your unvested options, which makes startup equity even less attractive than it would otherwise be.
Zygna isn't the only one that did this. Didn't Facebook also do this?
(So in a startup, you can be screwed with options in three ways. If the startup fails, your equity is worth zero. If there's a low-value buyout, the common shareholders can get nothing. If the startup is wildly successful, the company will claw back your unvested options. Why join a startup for equity if you're going to get cheated when you hit the 100x home run?)
Zygna got what they deserved. With changes to the way Facebook promotes their feeds and the switch to mobile, they lost most of their market.
This is the problem with the US's "at will" employment. It affects white collar tech employees too. If you could only be fired for stated misbehaviour (like in the EU), this wouldn't have been possible.
How do you know they were underperforming? Maybe the board just realized they could get a lot of extra money by looking for an excuse to get rid of them?
"An injury to one is an injury to all" and if you can do this to board members who will have the wealth to fight this - what would they do to the rank and file.
I've nearly gone bankrupt due to AMT on ISOs, and I've also been forced to put up considerable money to exercise Non-Quals after leaving the company. I definitely applaud Pinterest's move here. My former employer went public, the top execs are still making a ton of money, and yet Finance still hasn't implemented a similar post-termination plan. A lot of former colleagues are still at the company due to 'mildly-golden' handcuffs-- the tax liability that their options present is now large and complicated. Companies that fail to adopt changes like these disadvantage themselves in a variety of subtle but important ways.
What would be even better is if smaller companies / start-ups just did 83(b) elections up-front (say on day one or year one upon cliff). Another (for larger companies) option is to just offer RSUs.
The bottom line is that opportunities via tax law complexity are not particularly motivating to the majority of employees (i.e. ICs), and yet ICs are the most likely to suffer near-bankruptcy due to unexpected income tax. This is a nice step in the direction of transferring deserved wealth from 'the top' to ICs, but there's still plenty of progress to be had.
But for 83(b) to be feasible, the company has to be worth essentially zero.
Let's say you join a startup that the IRS can claim is worth $20M (based on e.g. money raising valuation), and get 1% in RSUs worth $200K - depending on your other income that year, the tax bill can easily be close to $100K (if you made $100K in salary and live in NYC) for doing an 83(b), and it is still likely to be worth zero being a startup.
And before you say "the fact it raised $2M on $20M makes preferred reflect that value, not common which is still worth zero" - that is a common position, and the IRS almost never challenges 83(b) election valuations - but are you willing to risk that they won't start challenging them? I gave up more than one offer because I wasn't.
The bottom line is that the US tax system's taxing of virtual, unrealized, unrealizable profit is insane - I am not aware of any other western country that does that.
Hmm, in my case the 83(b) election would have cost me about a quarter year of salary, and the AMT I ended up owing was well over a year's worth of salary. My original grant was small relative to the pool because I was a mid-stage IC with essentially no prior experience. Perhaps for very early startups, or those growing quickly through valuation raises, the situation is different. My company only took on capital when we really ended it and it was cheap, but the C-levels were pretty consistently getting offers (so the valuation grew constantly, just not on paper).
Agree that the taxes on unrealized gains are insane, but they were intended to protect the government's income source from different problems. Tech compensation and VC has evolved dramatically since AMT was introduced.
It's not that tech compensation and VCs evolved - it is that AMT was not indexed to inflation (until 2013). When it was enacted, it applied to 155 families[0]. In 2008, it applied to nearly 4 million[0 again].
And I think sanity should not be judged by intention, but rather by action - especially when we've had more than 40 years to evaluate.
Agree that more use of 83(b) would reduce the frequency of startup equity taxation horror stories.
The value of startup equity, given all the risk factors and historical outcome data, is extremely low. It's usually easy to show that an entire startup is worth less than $1K. Using 83(b) to pay tax on the equity FMV when awarded rather than when vested/exercised/etc can make a big, big difference. If you win the equity lottery, that is.
> What would be even better is if smaller companies / start-ups just did 83(b) elections up-front (say on day one or year one upon cliff). Another (for larger companies) option is to just offer RSUs.
I was giving the choice and I elected 1/2 RSUs and 1/2 stock.
Well the RSUs required one of two things: laying down a whole lot of money to purchase them up front or accepting the loan and promissory note from the company. I'm the only one that went 50/50. I had thought i was being clever and getting the options first (highest risk in first 2 years) and the RSUs second, but it turns out that even though i had a vesting schedule like that it was valid because the board would have had to vote on something like that. It's almost moot at this point though.
Looks like the Fortune article missed a big point: The exercise of the options often requires a big pile of money to be paid by the leaving employee to the company (ie, the strike price of the option. This occurs regardless of tax issues.)
The advantage is seeing how well the stock performs, then performing the exercise. If the company has gone public, then no real money needs to be put up by the employee; Exercise and sale can occur in one fell swoop.
You lose the reduced taxes of long term capital gains if you wait, for whatever reason, to exercise and sell the same day. You have to hold the shares for 1 year + 1 day from the day you exercise for the subsequent sale to be taxed as long term capital gains. For even the top tax bracket, the difference is 20% in taxes.
That's correct, but remember that stocks go both up and down. Back in the bubble, a lot of people got very burned: They tried to save the diff between short- and long-term cap gains and ended up losing far more because of variations in price.
To add insult to injury, many got nailed by AMT at the point of exercise. By the time they figured this out, the entire grant would not cover the bill to the Feds.
Companies allowing current employees to exercise options 1+ year before a liquidity event would prevent the tax issue. For a company like Pinterest that is virtually guaranteed to have a good liquidity event, the risk of losing your principal is minimal and you are likely being paid enough in salary to afford the early exercise strike price.
If the exercise event and the liquidity event are not in the same year though, you might not have enough cash to pay the taxes. And if the liquidity event is postponed forever (e.g., market crashes like it did in 2001 and 2008), you're stuck with a big tax bill and no way to pay for it.
Yeah, I left a startup last year and exercised my options on the way out. The check I had to write for the strike prices was a lot bigger than the AMT hit. (Which is not to say that that's always the case, but it definitely was for me.)
Disclaimer: I'm with EquityZen. EquityZen helps employees get liquidity for some of their options/shares before the company exits, so not only can they afford the exercise, but also finance life events.
This is a great move and incredibly employee-friendly. We'll see if this is the beginning of other companies following suit, but I doubt it.
As has been discussed before it's not the mechanics that matter here, but rather the psychology of founders.
More often than not, there is the belief that even if you've been an employee for 2+ years, if you're not "in it for the long haul" then you don't deserve to hold on to your equity without paying for it in cash (or taking the tax hit).
Not to mention there's very little incentive to amend these policies outside of generating general goodwill.
> Not to mention there's very little incentive to amend these policies outside of generating general goodwill.
There is now an incentive for other companies to follow suit since savvy employees will value offers from Pinterest and other companies with this policy much more highly.
It's rare that a company like Pinterest breaks ranks on things like this. I hope they get a lot of goodwill from employees and applicants as a result.
If the options aren't that far in-the-money, and he doesn't need the cash now, it's actually better to wait to exercise.
If he exercises now, he only gets the raw value (current price - strike).
If he waits to exercise, he get the time-value of money and implied leverage (he doesn't have to cough up the strike until he exercises), and the optionality part (if Netflix goes below the strike, he can decline to exercise).
He also can hedge by short-selling (and lock in a sure profit no matter what), but you'd need a big-value account at a brokerage to hedge on favorable terms.
> He also can hedge by short-selling (and lock in a sure profit no matter what), but you'd need a big-value account at a brokerage to hedge on favorable terms.
It's interesting, because I thought about this. When I worked for the company I wasn't allowed to hedge, because you can't buy shorts in the company you work for.
Now that I'm out I can, but the problem is, the company gave me such good options there is no way I can buy an opposite option for the hedge. For example, there is no retail short for more than two years, but my options still have between 6 and 9 years left.
But if he doesn't hold the stock for at least one year, he gets short-term capital gains rate of 35%, rather than the long-term one of 15%, which might tip the scale the other way.
But then again, if he exercises in one year and does not sell that year, he gets the tax bill in the exercise year, potentially with no way to cover it.
Good call. I sold my small business in London about a month before my son was born. Now, 11 months later, apart from a small amount of consulting from home, I haven't really been employed for that time.
Financially, the move hasn't made a lot of sense. We moved to a cheaper country and we've not been short of rent/food/baby clothes etc, but I have drawn down quite a lot on my capital.
Nonetheless, I am 100% positive I made the right decision. I expect to look back in years to come and be grateful of being able to spend so much time with my newborn.
The awesome part is every dad I've talked to had either one of two responses: 1) I did the same thing and it's the best thing I've ever done (like you) or 2) I wish I had done that when my kid was born.
I'm curious about how this works. I thought, legally, ISOs must expire within 3 months of leaving the company. Assuming they've been issuing ISOs up to now, are they converting them to something else, like NQSOs or RSUs?
They automatically convert from ISOs to NSOs according to Sam Altman's post[1]:
> There are some tricky issues around this—for example, the options will automatically convert from ISOs to NSOs 3 months after employment terminates (if applicable) but it’s still far better than just losing the assets.
What restrictions do you mean? ISOs are better for the employee because any gain on exercise is not taxed as regular income. If the value is high enough the employee might be subject to alternative minimum tax (AMT), but the possibility of paying no tax is a benefit over NSOs whose gain is taxed as regular income and is subject to tax withholding.
> If the value is high enough the employee might be subject to alternative minimum tax (AMT)
I've never run the numbers, but my impression is that the AMT level is low enough that AMT will be triggered for any exercise where the number and value of options is meaningful.
>but the possibility of paying no tax is a benefit over NSOs whose gain is taxed as regular income and is subject to tax withholding.
It's not "no tax". It's "deferred tax". But again, in the real world of 6-figure salaries and big mortgage interest deductions in Silicon Valley, the deferral is probably mostly theoretical. Whereas the time limits on ISOs are real and unavoidable.
Good point, "deferred tax" is more appropriate there. "No tax" is misleading.
You might be able to stay out of AMT by splitting ISO exercises across multiple tax years, but that's splitting hairs. You make a good point that this discussion is most interesting in cases where you'd likely be in AMT anyway.
With ISOs, at least 2 years must lapse between the grant date and the employee’s sale of the stock, and at least one year must lapse between the exercise date and the sale of the stock. (This is a restriction - not related to capital gain treatment)
If NSOs are granted with a strike price equal to FMV, there are no taxes due until exercise. If granted at a discount, taxes are due on the difference between grant price and FMV.
The only downside there is the 2-year requirement between grant date and sale of stock, but that is unlikely if the company is still granting ISOs rather than RSUs. The second clause of that sentence is standard long term capital gains, which applies to NSOs as well; there's no restriction on either grant type on when you are allowed to sell the stock units once you exercise the option.
This is really great, I hope more startups follow. In today's funding environment startups that are angling for an IPO can stay private for a very long time. Many companies are raising billions of dollars over 5-10 rounds before looking to the public markets. That can mean a long time before employees may choose to exercise their options.
Pinterest seems to recognize that if you put in two years at an early stage of the company you deserve to share in future financial success.
I wonder why they made this move now? Specifically, I wonder if it came from the executives, investors, or both?
This ties into the whole issue with bloated valuations [1]. VC's are paying for preferred shares and other deal points that make all classes of shares appear to outsiders to be vastly more valuable than they are. Employees then wind up paying inflated taxes on value that doesn't actually exist. The valuations are mostly made up, but the taxes are very real.
But taxes are normally paid based on the latest 409a valuation, which can be way below the preferred stock value from the latest funding round.
My impression is that companies rarely sell common stock to investors for that reason (among others). Since investors valued the preferred stock, common stock holders can ignore their massive valuation for tax purposes, and use the 409a.
Still, an appraiser brought in to do a 409a valuation wouldn't be doing their job if they completely ignored the valuation from the latest funding round. The value will be lower by a subjective amount determined by the appraiser, but is still likely to be somewhat inflated if the preferred rounds were also inflated.
Is that a better deal than Quora's "you may exercise options within 10 years of grant date, whether or not you still work for the company"? Per http://blog.samaltman.com/employee-equity .
Really depends on the average tenure of the employees. In general, I think Pinterest's is better. Also, Quora only offered that to employees recently, 5 years after the company started, so any employees that left before 2014 when that was enacted wouldn't be entitled. It's possible the same is true for Pinterest though.
Love this move. I, like many here, am feeling this squeeze after being terminated from a startup in the 1B club. I need to decide to exercise or not. I don't have the cash for the taxes.
Does anyone who has found buyers for their private stock without the company's blessing care to post about their experience? Any recommendations for brokers or investment groups that engage in such transactions but aren't predatory? What snags did you run into and how long did the process take?
If you are very early, when the company is worth nothing, then the company can give you a big chunk of stock with no tax consequences. But once the company is worth something, then getting the stock is income, and you have to pay taxes immediately on the market value. It's not as good from the company tax perspective, either.
It's also a problem in that if the stock is already valuable, giving you the stock is the wrong reward structure. Companies are giving you options so that you have an interest in the stock going up. Suppose when you show up the share value is $40 and they give you 1,000 shares. if while you're there the stock goes up to $60, you will have received something worth $60,000, even though you only contributed to creating $20,000 of that. With options, they can give you 3,000 options with a strike price of $40. If the stock goes up to $60, then you still make $60,000 ($20 gain * 3000 options). But if it doesn't go up at all, then your options would be worthless.
> you only contributed to creating $20,000 of that
That's an interesting way to think about it, but as long as the employee is getting a base salary, the employer couldn't justify granting enough options to achieve this goal of compensation being equal to (theoretical) value added.
If we consider base salary fixed, then options are more leveraged, but a similar reward structure could be achieved by granting the same number of RSUs and reducing base salary by the exercise cost.
Sorry, I didn't mean to suggest that the goal was for compensation to be equal to value added. I think the goal is for it to be proportional, or at least more proportional than a pure stock grant would be.
If you receive a nice grant of stock from your company, it will probably be few years before you want to sell that stock for cash. In fact, it will likely be several years before there is a reasonable way to sell the stock even if you wanted to. Selling stock in a privately-held, early-stage startup is often not a simple matter.
Despite that, the US IRS will want you to pay taxes on the current value of that stock in cash this year. The IRS doesn't care that you don't have the cash. And, they don't care that there's a very large chance the stock will turn worthless before you can sell it for cash.
Options however are not taxed until they are exercised. In practice, exercised options are usually converted directly to cash. That makes paying the taxes much easier. And, if the company folds you get nothing, but at least you didn't pay taxes up front on a stock that turned worthless.
So, it's a bit complicated, but options are usually more friendly to employees than direct grants in general. Details in the options like "What happens to my options if I leave the company?" are important. They can also be complicated and possibly employee unfriendly. I'll leave the discussion of that detail to the rest of the crew here.
One thing I don't see addressed is what this means regarding dilution and such. With something like this, is the company more likely to dilute its stock to try to dilute out people who have long since left the company?
If Joe Schmoe leaves the company with, say, .05% of the company, and in 7 years those shares would be worth $25m or something, wouldn't the company want to dilute that person out in order to give their current employees value?
I guess I don't really see what the big deal is on this. It would seem to me that the company would aggressively issue more stock to ensure that anyone who left the company 7 years ago couldn't possibly control more stock than current employees.
As long as the board doesn't do anything really shady, dilution generally affects all shareholders equally. (Well, the effect can be slightly different for preferred stock holders, but at least former employees will generally be in the same boat as founders and current employees.)
Wow! Pinterest is so generous! In my previous company, I had to exercise my options in 3 months after leaving. Now that stock's price increased by 50%.
Early exercise still seems like a better option than waiting if there is a positive exit event since you get to pay capital gains rates, rather than income tax rates if you hold it for more than a year.
It certainly depends on how much risk you're willing to take on though.
It reduces anxiety. Say you are slightly unhappy at your current job. On a normal stock plan, you might start feeling that "golden handcuffs are tying me to this company", which makes you feel even worse about your position, and might actually precipitate you leaving.
Now, consider this policy instead. You'd get a feeling of "I could leave if I really wanted to, nothing is tying me to this place". You get a greater feeling of agency, of personal freedom. That relaxes you, and you feel more comfortable staying with the company.
The employer does not benefit from having an employee hanging around just because they can't afford to exercise their options. If they want to leave but can't because they have this huge potential for loss hanging over them does the company really benefit from having them there when they don't want to be?
> What argument is there for this policy against the employer, besides it's a nice thing to do?
You don't get stuck with an unmotivated employee who has checked out but can't access his options in liquid form.
This is not an infrequent problem in startups. The folks who "storm the bastions" early on often do not have the skills nor the desire to be a "well-behaved corporate citizen" for IPOs and such.
It's great they are giving new employees some flexibility here. It would be really hard to exercise a grant on an $11 billion valuation. Especially without knowing the details of the liquidation preferences.
Why is this better than Pinterest covering the tax bill for employees that leave and/or are terminated? Is the latter impossible or impractical for some reason?
1. U.S. tax law requires that incentive stock options (ISOs) have a 90-day termination tail on them - that is, the options do not qualify as ISOs if they are not issued under an enforceable agreement by which all vested options must be exercised within 90 days of termination of employment or expire.
2. As a direct result of point 1, the near-universal practice that startups use when issuing stock options is to require employees to sign documentation by which they agree that they lose even their vested options if they do not exercise them within 90 days of their termination date.
3. The original idea behind ISOs (the reason for distinguishing them from "non-statutory" or "non-qualified" options) is that they can be exercised at any time after they vest without triggering ordinary income tax for the exercising employee at the time of exercise (subject to certain monetary limits).
4. However, the "benefit" note in item 3 above, though a very real benefit in days gone by, is often illusory today because the exercise of ISOs requires that the amount of the spread (difference between exercise price and fair market value of the stock at the time of exercise) be included as an item of AMT - meaning that a so-called "ISO" exercise can result in a huge AMT tax. What this means is that an employee holding vested options in a startup whose value has risen greatly faces a dilemma. "Do I exercise now, pay a huge tax, hold only a piece of paper that may or may not be worth anything down the road, and hope that the stock price holds? Or do I wait until a liquidation event, exercise at that time, and thus eliminate the large tax risk of exercising before that time?"
5. Of course, many such employees chose to wait. If you cannot sell your stock right away, it is a very high risk to pay a massive tax on an option exercise only to wind up holding illiquid stock that may become valueless if things don't go right. This is no small issue. People committed suicide during the dot-bust era a decade or so ago after having made the wrong decision.
6. The problem is exacerbated by the 90-day expiration rule on employee termination. It is one thing to wait and wait until the liquidation event. But what if it is a long time in coming? Many employees are trapped in their employment when they face the above dilemma because leaving their employment will force them to exercise or lose potentially valuable options if they don't exercise within 90 days of termination. Even worse, if their employment is terminated by the company, they are put in the horrible position of losing something they worked very hard for because of a seemingly arbitrary and stupid rule saying that the options expire within 90 days of termination.
7. Well, guess what, the rule is stupid and arbitrary in many ways. Why? Because, though the law requires that it be made part of any ISO grant, this does not mean that the startup cannot modify the agreement for the benefit of the employee to eliminate the 90-day expiration provision and to give the employee room to exercise for an extended period. What happens when the company does this in spite of the tax rules? Well, it means that the option loses its character as an ISO. But it does not lose its character as a legally enforceable stock option. It just means that it is taxed as an NQO (non-qualified option). So, in a worst case, the employee exercising an NQO gets immediately taxed on the spread at the time of exercise. But, if that modification gives the employee the flexibility to carry the options unexercised but exercisable for a period going well beyond the 90-day period currently defining expiration of such options, the employee can leave employment, hold the options, and wait for such extended period (e.g., the 7 years discussed in the article here) before deciding whether to take the tax risk of exercising and holding illiquid shares. And, if, in the interim, the company does have a liquidation event, then the employee's dilemma vanishes and he can exercise and sell right away in order to make the profit and pay the associated taxes.
8. The net result of the startup's agreeing to eliminate the 90-day provision is that employees need no longer feel trapped in their employment once their options have vested when the stock price becomes high. They can leave and still keep the option of cashing in on their hard-earned options.
9. So why don't most companies agree to such modifications? Their lawyers will tell you that the law requires the 90-day rule and this is true but misleading because that requirement can be violated in a lawful way that simply changes the character of the options. Thus, if the parties can live with the change, why not do it routinely? Well, I leave it to everyone to draw his own conclusions. Perhaps startups want to keep their employees trapped. Perhaps they are just listening to lawyers who insist on following the rules. Or perhaps a board of directors does not feel it consistent with fiduciary duties to give employees something that appears to be a gratuitous modification that does not benefit the company. Whatever the reason, it remains true that most startups choose to leave their employees trapped in this dilemma without even giving them a good explanation beyond the fact they agreed to the condition and that the the tax laws "require" it.
In any case, kudos to Pinterest for doing the decent thing here. It is indeed all too rare to see something like this and they are to be congratulated for it.