A potentially huge tax savings available to founders and early employees is being able to…
Regardless of risk appetite, startup employees should understand how changes in the company valuation affects them.Cybersecurity startup Cylance is experiencing tremendous growth, but this growth might burn employees with cheap stock options. Many employees assume as the company grows, they will make a ton of money on exit; however, the timing of their exercises can change the outcome significantly. The main contributing factors are the different tax rates employees are subject to over time.As demonstrated below, Cylance has been growing at about 10% a month while experiencing non-existent churn. Few startups can boast such a growth rate. However, high growth may come at a price to employees with stock options.
Cylance Growth and Churn
As a company scales and grows, the valuation of the company grows just as quickly. As the valuation rises, the potential AMT tax bill for an employee with stock options rise as well. Uber – the famous ridesharing company – 40xed in a single year! Many early employees saw their tax bill 40x as well. What may have been a small $10,000 tax bill transformed into $400,000 in less than a year.
Cylance's growth rates are reminiscent of a rocketship. Cylance's valuation has already hit $1B and has the potential to continue to rise. Employees at the company would benefit from exercising earlier in order to protect themselves from a ever-increasing and compounding tax bill.
Employees at other rocketship companies such as Stripe and Slack face similar issues. Employees at earlier stage rocketships such as Pindrop Security, Collective Health, or NerdWallet stand to benefit the most from exercising early.
|Low||Net-exercise At exit||Ordinary Income Tax|
|Medium||Exercise as you vest||Short Term or Long Term Capital Gains with potential AMT|
|High||Early exercise (might not be allowed)||Short Term or Long Term Capital Gains without AMT|
Low Risk: Employees that play it safe tend to stay at a company until exit. The employee would net-exercise when the company is bought or goes public. They would earn a large payout, but they will be taxed at the Ordinary Income Tax Rate which worst-case can be as high as 52.90% (up to 39.60% Federal + 13.30% for California). If an employee wants to leave or move on, they may find themselves with a massive tax bill or losing all of their options.
Medium Risk: For employees confident in their company, a good strategy would be to exercise as you vest. This strategy requires risking money by buying shares in the company. As a result, if the company fails, the employees may lose their entire investment including any taxes they paid. If the company succeeds, employees who exercised their shares a year before the exit will be subject to the Long Term Capital Gains Tax Rate which worst-case can be as high as 37.10% (up to 23.80% Federal + 13.30% for California). The difference between Ordinary Income Tax and Capital Gains Tax could result in up to 20% of savings. A caveat however, is if the difference between the strike price and the fair market value of the company is already massive at the time of exercise, the employee may be subject to a large AMT tax bill (up to 35%, 28% Federal + 7% for California).
High Risk: If offered the opportunity to early exercise, the savings can be the greatest; however, the risk is also the highest. Employees who exercise all of their options stand to lose everything they invested if the company fails. If the company succeeds, the employees will almost always be subject to the Long Term Capital Gains Tax Rate (if the company exits a year or more after exercising). This is most advantageous if the strike price is equal to the fair market value (409A value) at the time of exercise.
Regardless of risk appetite, startup employees should understand how changes in the company valuation affects them. In high growth situations, understanding the nuances of the different tax rates can help employees optimize their own financial gains and interests. A viable option for many employees is to let the Employee Stock Option Fund to invest on their behalf, which can result in a good balance between eliminating risk and optimizing tax benefits.