Understanding Startup Stock Options

This is not legal or tax advice. Consult your own professionals before making any decisions.

If you’ve just received stock options, are thinking about joining a startup, or are negotiating an offer right now, options are worth understanding before you sign. Equity is one of the biggest reasons to join a startup early, but when you exercise, how you get paid out, how much you make, and how much you owe in tax are none of them obvious. How you use your options can change the outcome by hundreds of thousands of dollars.

What a stock option actually is

A stock option is a contract that gives you the right, but not the obligation, to buy a share at a fixed price on or after a set date. That fixed price is the strike price (or exercise price). If your employer grants you 100 options, you don’t own 100 shares. You have the right to buy 100 shares at the strike price, and buying them is called exercising.

Most startups grant Incentive Stock Options (ISOs); some use Non-qualified Stock Options (NSOs). This guide assumes ISOs throughout. Options only have value when the market price rises above your strike price:

• Alice gets 10,000 ISOs at a $1 strike. Five years later the company is public at $10/share. Exercising all 10,000 nets her $90,000 ($10 × 10,000 minus $1 × 10,000).
• Bob also gets 10,000 ISOs at a $1 strike. Five years later the company is public but trading at $0.50. His strike is above the market price, so his options are worthless. Exercising would have cost him $5,000 for nothing.

Reading the equity part of an offer

Five things to pin down on any grant:

• Number of options. How many shares you have the right to buy.
• Percentage ownership. Your share of the company’s total outstanding equity if you exercise everything, calculated as your options divided by total outstanding shares.
• Strike price. The per-share price you pay to exercise.
• Vesting schedule. You earn your options over time rather than all at once. The standard is four years with a one-year cliff: leave inside year one and you get nothing; stay past it and 1/4 vests at your one-year mark, then 1/48 each month after. Others exist too. Some run five years with a six-month cliff; at Amazon 5% vests after year one, 15% after year two, and 40% in each of years three and four.
• Post-termination exercise (PTE) window. After you leave, you often have just 90 days to exercise or forfeit everything, which is what traps people in “golden handcuffs.” Some companies now offer 5-, 7-, or 10-year windows. One catch: past 90 days your ISOs convert to NSOs regardless of the window length.

When options turn into cash

Options convert to cash at a liquidity event. The usual best case is an IPO: the company goes public, you exercise, and you sell on the open market. An acquisition is the other common path, and it’s less predictable. Your options might convert to cash, roll into options in the acquirer, or become worthless, all depending on the deal terms. Before any of that, you can sometimes sell shares on a secondary market, and a few companies have run one-off buybacks of employee stock. If none of these happen, the options are worth nothing.

What your equity is really worth: dilution

A common recruiter pitch is “we’re offering 0.1% equity, so if we’re worth $1B one day, that’s $1M.” That math ignores dilution, which is the whole reason you can’t multiply 0.1% by $1B and call it your payout.

Startups raise several rounds before a liquidity event, and each round usually issues new shares, which shrinks your percentage. Take a seed-stage company valued at $4M with one million shares outstanding. It raises a Series A, selling 25% of the company for $2.5M at a $10M pre-money ($12.5M post-money) valuation. Buying 25% means issuing 250,000 new shares, bringing the total to 1,250,000.

Say you hold 1,000 shares. Before the round you owned 0.1% (1,000 / 1,000,000). After it you own 0.08% (1,000 / 1,250,000), diluted by 20%. But your stake is worth more, not less: 0.1% of a $4M company was $4,000; 0.08% of a $12.5M company is $10,000, a 2.5× gain. Extend that 0.08% to a $1B outcome and it’s worth $800k, not the $1M the recruiter implied.

And that’s only one round. Most companies raise several more before going public. Capshare’s cap-table data puts typical dilution around 25% at Series A, 24% at Series B, 13% at Series C, and 14% at Series D. Join at Series A and expect a D round before exit, and your original ownership drops by roughly 43% (1 − 0.76 × 0.87 × 0.86).

When to exercise

Exercising costs real money, so the right timing depends on your finances. The tax consequences of each path are large, so understand all of them before you commit.

One year before the IPO

Exercising a year before you sell, with a grant date at least two years before the sale, means your profit is taxed at the long-term capital gains rate instead of the much higher ordinary income rate. If the fair market value (from the most recent 409a valuation) has risen above your strike, you may owe Alternative Minimum Tax at exercise: the federal AMT rate is 28% of the spread between fair market value and strike. The catch is cash. This route often means fronting a large sum to exercise, and if you can’t, you wait until after the IPO.

Exercise and sell after the IPO

If the company is already public and you can’t fund the exercise, you can do a cashless exercise: your employer or a brokerage loans you the money to exercise, immediately sells the shares at market, and repays the loan from the proceeds. You just receive the net. The tradeoff is tax. Holding the stock under a year means your gain is taxed as ordinary income.

Early exercising

Many startups let you exercise before your options vest. It makes sense when you have high confidence in an exit or the cost is small enough to risk. Two advantages:

• You owe zero AMT at exercise if your strike equals the last 409a valuation.
• The one-year clock for long-term capital gains starts immediately.

It’s also risky: only early exercise if you’re comfortable losing the entire amount. Cost swings hard with stage. At a seed startup with a $0.01 strike, early exercising 50,000 options costs $500. At a Series A with a $0.50 strike, the same 50,000 options cost $25,000.

If your startup lets you early exercise while you’re negotiating, ask for a signing bonus equal to the exercise cost. They write you a check, you write one back to exercise a few days later. Employers are often more open to this than a normal signing bonus because most of the cash comes right back and it signals you’re invested. Signing bonuses are taxed heavily, so account for that.

If you early exercise, file an 83(b) election within 30 days to notify the IRS. Miss it and you’ll owe extra tax as your options vest.

The QSBS exemption

A company qualifies for Qualified Small Business Stock (QSBS) if it’s a US-based C-corp with under $50M in assets. If your employer qualifies when you exercise and you hold the shares at least five years before selling, you pay $0 in federal tax on the sale. On a $2M gain that would otherwise cost $467,000 in long-term capital gains tax, QSBS takes the bill to zero.

Leaving before unvested options vest

If you early exercised and leave before everything vests, the company typically has 90 days to repurchase your unvested shares at what you paid. If it doesn’t, they’re yours. Terms vary, so check your grant letter or ask.

The same grant, three ways

It’s 2012 and you join a seed-stage startup with 100,000 ISOs at a $0.01 strike, four-year vesting, and the company qualifies for QSBS. It goes public in 2020 at $10/share.

1. Early exercise. You exercise all 100,000 right away for $1,000, owing $0 AMT (strike equals market). Everything vests by 2016. After the 2020 IPO you sell all 100,000 at $10 for $1,000,000. QSBS applied at exercise and you held five-plus years, so you owe $0 tax. Net profit: $999,000.
2. Exercise one year before IPO. In 2019 the company files its S-1. You exercise for $1,000; the latest 409a put the price at $1, so the spread is $99,000 and you owe $27,720 in AMT (28%). A year later you sell for $1,000,000. Long-term capital gains would be $200,000 (20%), minus the $27,720 AMT already paid, for $172,280 in tax. Net profit: $799,000.
3. Exercise and sell after IPO. After the 2020 IPO you exercise for $1,000 and sell the same day for $1,000,000. Held under a year, it’s taxed as ordinary income at 37%, so $370,000. Net profit: $629,000, and less after state tax. In California you’d owe another $107,205, landing at $521,795.

Same grant, same exit, same $1M of stock. The gap between the best and worst timing here is nearly half a million dollars.

Ten questions to ask before you sign

1. What is the total number of outstanding shares?
2. How many shares are in my grant?
3. What’s my equity percentage in the company?
4. What’s the strike price on my options?
5. What was the last 409a valuation?
6. What was the valuation in the last funding round?
7. What’s the vesting schedule?
8. How long do I have to exercise if I leave?
9. Can I early exercise?
10. Does the company qualify for QSBS?

Options are confusing, and plenty of employers explain them poorly. Walk into the conversation with these ten questions and you’ll know what your offer is actually worth.