The valuation and exercise of stock options with privately held companies introduces unique complexities for investors. In this Insight, I will review some key considerations with a focus on the main differences between common types of equity compensation and their implications for taxes.
This Insight assumes some familiarity with stock options and how they work. For a comprehensive guide to executive compensation and some important related concepts, please see our resource here.
How are stock options valued at privately held companies?
Unlike publicly traded stocks, the stock of privately held companies does not have an easily ascertainable market price. To obtain a valuation for stock options, a 409A valuation is required. A 409A valuation refers to an independent company’s appraisal of the fair market value of a privately held stock, based on criteria established by the IRS.
In short, a company that wishes to issue stock options must secure a 409A valuation or risk tax penalties. These valuations must be renewed every 12 months or after any material event like a venture capital funding round, merger, acquisition, or major shift in revenue.
How are stock options at privately held companies taxed?
Stock options do not begin incurring tax liabilities when they are first granted. Tax treatment at the time of exercise depends on whether the relevant stock option was structured as an incentive stock option (ISO) or a non-qualified stock option (NQSO).
- ISOs are not necessarily taxed at the time of exercise, however depending on your individual circumstance, the alternative minimum tax (AMT) might be triggered. Gains earned from ISOs are taxed as long-term capital gains provided that you held the stock options for at least 2 years from their original grant date, and the associated shares for at least one year after the date of exercise.
- NQSOs are taxed as ordinary income at the time they are exercised, based on the difference between the exercise price and the stock’s fair market value. Provided shares are held for at least one year, subsequent gains are taxed as long-term capital gains.
In both cases, the fair market value at exercise will be established based on the company’s most recent 409A valuation.
Restricted Stock: Pros and Cons of 83(b) Election
Restricted stock is another type of equity compensation commonly issued by private companies. While superficially similar to stock options, restricted stock is taxed differently.
Unlike a stock option, which provides a right to purchase stock upon vesting, restricted stock directly gives an employee shares of stock. These shares are taxed as ordinary income at vesting. Typically, shares begin vesting one year after being granted. With stock options, employees have more control over when to exercise and pay the associated taxes, but restricted stock holders do not have the same control over taxes.
Because restricted stock is taxed at the time of vesting, appreciating stock can result in a tax bill that grows with each vesting period. In this context, an 83(b) election is an important option for limiting potential tax liabilities. 83(b) refers to an Internal Revenue Code (IRC) provision that gives restricted stock holders the flexibility to pay income taxes on the fair market value of their shares at the time they are granted, versus when they are vested. Because an early-stage company’s stock is more likely to appreciate in value over time, the gap between grant and vesting valuations may be substantial. For this reason, an 83(b) election can be a great option for limiting potential tax liabilities down the road (capital gains taxes will still be due on any profits). An 83(b) election must be made within 30 days of when restricted stock is issued.
However, there is some level of risk involved with making an 83(b) election. Doing so is beneficial only if the restricted stock's value increases. If the fair market value falls below a restricted stock’s grant price, 83(b) election can result in excess tax payments, and the IRS does not allow overpayment claims on 83(b) tax payments.
When Should You Exercise Equity at a Private Company?
Ultimately, the right choice for managing your equity compensation will always depend on your personal financial circumstances, goals, and plans. We recommend approaching related decisions with a grounded perspective that balances wealth management expertise with a nuanced understanding of your family’s situation and long-term goals. Waiting for future appreciation may not be worth the risk if the value of your stock options allows you to fulfill your financial life goals today.
If you hold equity compensation that is yet to vest, related financial decisions may feel far off. But planning ahead is the best way to evaluate when stock options should best be exercised (or the associated shares sold) to support your personal financial plan, balance your portfolio, and minimize the accompanying tax bill.
You can learn more about the importance of divesting from a concentrated stock position in this Insight.
Advance planning is also important because unanticipated career changes may compel exercise earlier than planned. Decisions about how to exercise stock options will need to be made in short order when an employee departs a company, whether or not the departure is voluntary. Employee stock options will be terminated at a standard 90 days from the date of departure (known as the “post-termination option exercise window”). In this situation, it is vital to review the precise terms of your executive compensation offer, as this window for exercising your stock options can vary contractually. Even in the event that an employer offers a longer termination window, any exercises of stock options outside of this 90-day period will lose their status as incentive stock options, converting to non-qualified stock options.
If you have questions about how to manage your equity compensation to align with your personal financial plan, the Wealthstream team is here to help. We encourage you to reach out to schedule a complimentary 30-minute consultation with one of our financial advisors.
