For employees at late-stage private companies, having Incentive Stock Options where the 409A valuation (or, stated simply, the current valuation) exceeds the grant price might feel like buying a new home that requires renovating. Your cynical side wonders whether the home is actually worth what the appraiser says, and if you should really be putting any additional money into it. Your pragmatic side embraces that this wealth-building opportunity could build a legacy.
To stick with the home renovation analogy, even if you think you know where the pipes are, you should still hire professionals to work on the electrical and plumbing. In this case, we recommend working with advisors who understand the ins and outs of equity compensation and related tax concerns.
In this Insight, we highlight some of the most important related concerns, including three characteristics of the alternative minimum tax (AMT), and how they can be applied to the tradeoffs that come with exercising a stock option.
Let us assume you have unexercised stock options at a late-stage private company. Let’s also assume that the options are vested. And, significantly, that the 409A valuation per share of common stock exceeds the grant price. The latter means the option is “in the money.” This term bears emphasis because while valuations can change, an in-the-money option signifies that the company’s appraiser believes, in its professional opinion, that the option is worth more than the cost to acquire it.
Does this mean you should exercise it?
Here's where tax and wealth management considerations enter the picture. If it costs $1 to buy an option that the company’s appraisers say is worth $10, then the IRS (and potentially states and localities) will want to share in the opportunity by imposing taxes. Even if you can afford the $1 grant price, the funds you use to pay the grant price and taxes change the composition of your personal balance sheet and might foreclose certain financial or investment opportunities.
Let’s start with the main reasons why it might be necessary to exercise stock options sooner rather than later. The first is expiration. The specifics differ widely, but options expire, and if the option is not exercised in a timely manner, then you lose the ability to buy stock at a discount.
The second is for better tax treatment. The specifics vary widely, but in general, if you hold an option for more than a year from the date of exercise (and, for Incentive Stock Options, two years from the date of grant), then upon selling the stock, the gain is subject to a lower tax rate.
How much lower are these taxes?
Again, the specifics and mechanics vary based on state residency and other factors. But let’s consider solely the federal tax side. Savings are ~15%, which, is the difference between the 23.8% top long-term capital gains and net investment income tax and the 37% top federal tax rate for ordinary income plus medicare taxes.
On a large stock position, those tax savings are considerable. Especially when the difference, re-invested over multiple decades, compounds in the form of investment returns. So, if options can expire, and the tax savings from long-term capital gains are significant, then the prospect of exercising merits close examination. Which brings us back to cost.
When you exercise an ISO, there are two types of cost. The first is the grant price. From the example above, the $1, which is due at exercise. The second type of cost is the Alternative Minimum Tax. It’s true that some number of ISOs can typically be exercised before reaching AMT. But let’s turn to what happens under AMT rules.
AMT is an alternative tax system. One of its features is to tax the difference between the 409A per share of common stock and the grant price. Let’s assume for simplicity that tax is 28%. We can summarize that 28% rate for AMT by highlighting three characteristics:
With these three characteristics in mind, let’s take a closer look at an example that applies these characteristics of the AMT to a more detailed example.
In this example, assume 100,000 ISOs are vested, and each has a $1 grant price. The per-share 409A valuation is $20. The company raised a Series D one and a half years ago. It’s rumored that family offices are interested in acquiring stock at $30 per share of common stock. The company has been valued at $2B.
We hope this explanation of AMT and associated tax and financial tradeoffs provides valuable context when considering your strategy for exercising ISOs at a late-stage private company. Even when capital markets aren’t in full swing, the tax-advantaged status of ISOs – and the lower relative cost of acquiring them when 409A valuations are muted – are a potential call to action.
For a specific discussion of these and more advanced planning strategies, consult experienced financial teams and tax advisors who concentrate heavily on serving those with equity compensation.
If you have questions about how to manage your equity compensation, 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 planners.