ISOs are a type of stock option that qualifies for special tax treatment. Unlike other types of options, you usually don’t have to pay taxes when you exercise (buy) ISOs. Plus, you may be able to pay a lower tax rate if you meet certain requirements. Here’s what you need to know.
Part 1: Startup stock options 101
Companies often offer stock as part of your compensation package so you can share in the company’s success. But they don’t usually explain what you need to know so you can make informed decisions. Here’s how to make sense of your offer letter and option grant.
Imagine you just got a job offer from a new startup called Meetly. In your letter, they offer an annual salary of $100,000 and 100 stock options.
Like most offer letters, it does not tell you what stock options are, what to do with these options, what kind of options you get, or how much they are worth. Unfortunately, this is pretty standard at most companies (though we’re trying to get companies to send better, more transparent offer letters).
There are four basic things you should understand to properly evaluate your offer.
Types of startup stock options
Stock options aren’t actual shares of stock—they’re the right to buy a set number of company shares at a fixed price, usually called a grant price, strike price, or exercise price. Because your purchase price stays the same, if the value of the stock goes up, you could make money on the difference. We’ll elaborate on this in part 2 of our equity 101 series.
There are two types of employee stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). These mainly differ by how and when they’re taxed—ISOs could qualify for special tax treatment.
Note: Instead of stock options, some companies offer restricted stock, such as RSAs or RSUs. Restricted stock is different than stock options and is treated differently for tax purposes.
Stock option agreement
While your offer letter might mention how many stock options the company is offering, you need to receive and sign the stock option agreement (also called an option grant) if you want to purchase your shares someday—just signing the offer letter isn’t enough.
Stock option grants are how your company awards stock options. This document usually includes details like the type of stock options you get, how many shares you get, your strike price, and your vesting schedule (we’ll get to this in the vesting section).
Your stock option agreement should also specify its expiration date. In general, ISOs expire 10 years from the date you’re granted them. However, your grant can also expire after you leave the company—you may only have a short window of time to exercise your options (buy the shares) after you leave. Make sure you know when your grant expires—if you don’t exercise your options before then, you’ll lose the opportunity to purchase them.
Your option grant will probably look similar to Meetly’s, pictured above. Ask your company if you didn’t receive one. If you just joined in the last month or two, it’s possible that the board has not approved your options yet, in which case you should receive it shortly after the next board meeting.
Remember: If you hope to purchase and sell your stock someday, accepting your stock option agreement is the first step you have to take. It doesn’t cost anything to accept the agreement, and you’re not obligated to actually exercise your options. By accepting it, you’re simply giving yourself the opportunity to exercise in the future.
Keep in mind that if your company uses Carta to issue options, you won’t receive a paper version of your stock option agreement. Instead, simply log into your portfolio to accept, view, and print the actual agreement.
Vesting means you have to earn your employee stock options over time. Companies do this to encourage you to stay with them and contribute to the company’s success over many years.
Meetly has a traditional vesting schedule. The first part is called a “cliff.” A cliff is the first chunk of shares that vest. In this example, you have a one year cliff, which is standard. This means after one year of working at Meetly, you can buy a quarter of your options, or 25 shares.
Without the cliff, you could accept the offer, work at Meetly for a month, buy a bunch of the company’s stock, and then quit. If your option grant includes a cliff, it prevents that.
The other piece of your vesting schedule to keep in mind is the total length of the vesting schedule. This outlines how often, and for how long, your shares will vest. In this example, after you reach your cliff, your remaining shares will continue to vest for three years—two shares each month.
If you leave the company, your shares will stop vesting immediately and you can only buy shares that have vested as of that date. And you only maintain this right for a set window of time, called a post-termination exercise (PTE) period. Historically, many companies made this period three months. However, some companies offer more generous PTE periods now. At Carta, for example, you have as long as you worked at the company to buy your shares.
Don’t forget about these windows. Your company isn’t obligated to remind you when you leave — they usually only tell you in your option agreement when you first join.
Below is a quick recap of what we’ve covered:
- We described the two kinds of employee stock options — ISOs and NSOs.
- We went over stock option agreements: an important document you want to make sure you receive and sign.
- We covered vesting schedules and how companies use cliffs to incentivize employees to stay longer.
- Finally, we discussed what happens to your stock options if you leave the company.
These are the four things that every startup employee should think about when they receive their offer letter and join a new company. In our next section, we cover how to think about what your options are actually worth.
Read Equity 101: Part 2
Read Equity 101: Part 3
Special thanks to James Seely for writing the first version of this article.
DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.
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