Equity Compensation at Early, Mid & Late-Stage Private Tech Companies
Have you ever felt like you were in way above your head when you joined a private tech company and the offer letter started diving into the equity portion of your compensation? (I.e. ISO’s, NSO’s, Double Trigger RSU’s and Restricted Stock)
Same!
I’ve been there. All these fancy terms used to make no sense to me when I was working in the tech industry. It all sounded good and we really liked the idea of a potential big payday down the road, but I had no clue what to make of it and how to be smart when it finally vested. This is what led me down the path of becoming a CFP® and starting Asbury Capital. This guide was meant to highlight as much of that knowledge as I can in a relatively short format so others that are in my shoes can approach it with confidence as well.
Double Trigger RSU’s
In my previous article “Your Guide to Equity Compensation at Public Companies'' I touched primarily on Single Trigger RSU’s which tend to be more common in the public sector. Double Trigger RSU’s are very similar in the sense that they essentially act as a cash bonus for the employee after a certain vesting period, but the “double trigger” portion of it comes into play when some 2nd event happens like the private company going public or raising money through something called a tender offer. How this applies to you is that you no longer just have to wait for the RSU’s to satisfy the time component to take ownership of them, but you instead also have to wait for that 2nd trigger as well.
Unlike Public companies, late-stage private companies don’t have a market for you to sell your RSU’s into once they vest. To avoid the employee getting taxed immediately on the shares when they reach their time requirement, they created the 2nd trigger to basically say you won’t actually take control of them until one of those other two events happen so you’ll be able to sell the shares immediately after they vest and not be stuck with some enormous tax bill with no funds to be able to pay it. From a planning perspective, your advisor should help you model out these equity grants so when the company announces an upcoming tender offer or public listing, you’ll know which tranches to sell from, how much to sell, whether to sell or not and what the potential tax ramifications of it will be for each.
Double Trigger RSU’s are taxed as ordinary income when they fully vest at that 2nd trigger regardless of whether you sell them or not. When thinking through how to approach it, you can do a couple things. 1. Sell to cover, which basically means you only sell enough RSU’s to cover your tax bill. Or, 2. Sell all or a portion of them to diversify and fund other goals. Either way, it's imperative that you model out the potential tax ramifications because a lot of tech employees only withhold 22% of their RSU’s for taxes, when their margins rate is 37% which can lead to a significant under-withholding penalty from the IRS. A good Tax Planner can help you model these out and pay estimated tax payments to avoid this.
NSO’s
NSO’s or Non Qualified Stock Options are another form of equity typically given out at mid to late stage private companies. Unlike RSU’s, stock options simply give you the option to take ownership of the shares after a certain vesting period, so you aren’t taxed on them immediately at vest unless you choose to exercise them.
When you exercise NSO’s, you have to pay for them in full at whatever their exercise price is. For example, you might have 10,000 shares vested at that time with a $10/share exercise price and a 409A valuation is also $10/share, you’ll have to pay $100,000 to take ownership of the shares. With the 409A valuation being the same as the exercise price, no tax is owed on the shares. However, if the 409A at the time of exercise was say $15/share and the exercise price was still $10/share, you’ll have to buy them out at the $10/share price, but you will also be taxed on the $5/share spread as ordinary income. The reason for that is you essentially paid for something that has a higher value at a discounted price, so the government sees that $5/share spread as an economic benefit to you.
Lastly, when you go to sell the shares, depending on if you hold them for more than 1 year from the exercise date and 2 years from the grant date, the gain above that $15/share price will be taxed as either short term capital gains (your marginal rate) or long term capital gains (0, 15 or 20% depending on your income). If you and your advisor choose to hold out 1 year before selling, you can save yourself a substantial amount of taxes. It does come with risks, however, because if the company value goes down after you exercise them, you run the risk of them becoming virtually worthless.
83(b) elections are a common strategy for NSO’s that most employees don’t know too much about. These elections, when made within the proper time frame (usually within 30 days of the option grant) allow the employee to shift forward the date of the tax event and exercise them before the scheduled vest date. Say the employee submitted an 83(b) election on the shares above when the 409A valuation and the exercise price were both $10/share. The employee wouldn’t pay any ordinary income on the shares because there was in theory no economic benefit to the employee. The reason this is so valuable is because come the vest date you won’t have to pay any tax on the difference between the exercise price and the 409A valuation (That $5 spread from earlier) like you originally would have. This then makes the next taxable event the date you choose to sell them, which when done properly should result in a significant portion of it being taxed at far lower long term capital gains rates.
ISO’s
ISO’s or Incentive Stock Options are primarily handed out at early to mid-stage private companies. These act very similarly to NSO’s except they receive far more favorable tax treatment. Unlike NSO’s, when these options finally vest, exercising them tends to be far less cost-intensive because you only have to buy that out at the pre-determined strike price and if the 409a value is higher than that strike price you don’t have to pay taxes on that gain until sale. If you wait 1 year from the exercise date and 2 years from the grant date, you’ll then only be taxed on the difference between the sale price and the original exercise price at more favorable long term capital gains rates. However, if you don’t wait the proper time period, you run the risk of disqualifying your ISO’s favorable tax status, turning them into NSO’s which forces you to pay ordinary income tax on the difference between the 409A price at sale and the exercise price.
The only downside to ISO’s is something called AMT or Alternative Minimum Tax. This is essentially a 2nd tax code that runs parallel to the normal tax code and only kicks in when the amount of AMT tax due is higher than the amount you pay under the normal tax code. It was essentially created to keep high net worth individuals from gaming the system and not paying any tax at the end of the year. The bargain element, or the spread between the 409A and the exercise price, is considered an AMT add-back item so under this parallel code, if you exercise too many ISO’s at once, there’s a really good chance you’ll get surprised with a big tax bill at the end of the year. One of the things we specifically help clients with in modeling out their ISO’s is ensuring there is no AMT surprise at the end of the year. Occasionally, it can even be beneficial to incur a slight AMT tax to offset any big refund you might get after you file.
Lastly, certain states have their own AMT system as well such as California, Colorado, Connecticut, Iowa, Minnesota, and Wisconsin. When proper planning is done around your ISO’s you can save a ton of money in taxes at the state level too.
Restricted Stock
Restricted Stock, along with ISO’s, is the form of equity you’ll most often see in the early stages of a private company. These are usually awarded to top level executives whereas RSU’s are usually reserved for lower level employees. When restricted stock is granted, the employee has to choose whether or not to accept or deny the grant. If they accept, they immediately take ownership of the shares, and they may have to pay the employer for them at whatever the initial grant price was (which is usually a very low amount). Like RSU’s, after the vesting requirements are met, the employee is taxed on them at the FMV (Fair Market Value) regardless of whether or not they sell them.
83(b) elections also come into play here very commonly because the value of them is usually very low in the beginning and if you can push the tax date up to grant instead of the vest date, you can usually save a significant amount of money in taxes in the long run with more favorable long term capital gains rates. This does come with risks though because if you do this and leave the company before the shares vest, you essentially pay taxes on shares you don’t even get to keep.
What does all this mean for you?
Equity compensation at private vs public companies is treated very similarly but there are stark differences that you need to be aware of when planning ahead. Equity in general is a fantastic way to build wealth for those in the tech community so the goal of this article is to arm you with as much knowledge as possible to make sure you never leave any money on the table. When done right, these grants can change your life, so I set out with Asbury Capital to build a firm that caters to these specific needs. If you’re interested in learning more about our process and what we do for our clients, reach out using the link below! I’d love to chat.