Fairness remains one of the characteristics of work in a startup. But while it’s something most employees receive, it’s not something everyone benefits from.
Factors abound when it comes to determining if and when to exercise your stock options. In the spirit of tax season and a pent-up IPO pipeline, we spoke with equity experts about what employees should keep in mind when making decisions about their equity.
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But while this is a perk enjoyed by some employees, it carries with it a cloud of mystery and everyone’s situation is different. One factor seems clear: you should think about equity early on.
When employees typically start thinking about exercising their options
Platforms like secfia startup focused on stock planning and stock option planning, usually sees a “mass influx” of people to the platform when there is some kind of financial announcement regarding their company , such as news of a funding round or pending IPO documents, depending on Vieje PiauwasdySenior Director of Equity Strategy at Secfi.
But the optimal time to exercise options is “usually before that,” he said.
“What I always tell people is that it’s hard to predict the future…but if you assume your business is going to continue to grow, the sooner the better,” Piauwasdy said.
The main reason sooner is better? Taxes.
Generally speaking, the valuation of a startup increases over time, as well as with each funding round. Of course, the exceptions are “down rounds” or situations like instagramwho lowered its own valuation after taking into consideration the conditions of the public market.
Startups must obtain what’s called a 409A, or “fair market value,” at least once a year, per IRS rules. A major funding round, acquisition, or other significant event triggers another 409A reassessment. With each passing round of financing, the fair market value of a business generally increases, which will significantly increase a person’s tax bill.
For incentive stock options – popular among startups – in addition to paying the strike price to purchase these stock options, employees are taxed based on the difference in fair market value of the stock options. a business and may also be subject to alternative minimum tax.
Startup employees paid $11 billion in avoidable taxes last year by exercising their stock options after exit, rather than before exit, according to a Secfi report.
What the pros say
Babylon Wealth Management provides financial planning and wealth management services to technology professionals and other employees with stock options. Most people come to Babylon when there is some sort of upcoming liquidity event, such as a takeover bid, acquisition, or IPO, depending on the company founder, Stoyan Panayotov.
“People who start planning early and exercising early tend to have certain benefits in terms of paying taxes, making more informed decisions, and having more flexibility when that payday rolls around” , Panayotov said.
It becomes increasingly cost-prohibitive to exercise your options as the fair market value of your business increases, Piauwasdy said, and many people have found themselves in a situation where a big round of funding occurs and their capital is suddenly unaffordable.
When you cannot exercise your options
A fundraising company that expects to sign a term sheet soon will enter what is known as a “blackout period.” This means that employees cannot exercise their options at this time.
“Really, the goal is to get ahead of that,” Piauwasdy said. “If you know your business is raising money and you know its valuation is going to rise significantly, of course it might be a good idea to exercise at that time.”
Secfi typically sees a surge in the number of people visiting its platform when headlines and rumors about a company raising funds or going public swirl, Piauwasdy said.
Planning early and considering your options well in advance of a big event, like an IPO, has many benefits, according to Panayotov.
By exercising early and paying taxes earlier, employees could save money down the line when they sell their shares. This is because some of their gains could convert to long-term capital gains, which are taxed at a lower rate. Many companies now also offer the option to exercise early or before shares vest.
“Try to exercise them as early as possible, especially if you believe in your business,” Panayotov said. “If you think your business has a bright future, exercise as soon as possible.”
Drawing: Dom Guzman
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