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.
Recently, more and more companies have been consolidating. In 2018, total merger and acquisition global deal volume was $4.2 trillion, compared to the $3.7 trillion volume in 2017. We’re continuing to see acquisitions of recent startups (Google getting Looker, Edgewell buying Harry’s) and public companies (Salesforce with Tableau and the IBM / Red Hat deal).
If you’re an employee at a company that is getting or has potential to be acquired, you may want to know how a deal could affect your equity.
Acquisition factors that may impact you
There are a variety of factors that can impact your equity—from terms that are listed in your individual grant or security to the ones that get negotiated before the deal closes. Here are some of the most important factors to be aware of:
- Exercised shares: Most of the time in an acquisition, your exercised shares get paid out, either in cash or converted into common shares of the acquiring company. You may also get the chance to exercise shares during or shortly after the deal closes.
- Vested options: Sometimes a deal might state that any vested shares are cashed out net of the strike price, which could mean your gain is small if the acquisition price is close to the exercise price in your grant. Either way, this effectively turns your vested options into a bonus, which can have tax implications. There can also be acceleration clauses in the event of an acquisition.
- Unvested options: Often, companies have entire troughs of shares dedicated to creating new option grants for employees at acquired companies, similar to new-hire option pools. A few things can happen to your unvested options, depending on the negotiations:
- You may be issued a new grant with a new schedule for this amount or more in the new company’s shares.
- They could be converted to cash and paid out over time (like a bonus that vests).
- They could be canceled.
- Closing: You won’t get your new cash or options right away. First, the deal is announced, and then it has to close. In some cases, a regulatory body—like the Federal Trade Commission—has to approve the transaction.
- Vesting: You may also have to reach certain milestones—generally time spent at the new company—before the acquirer gives you cash or stock for your prior shares. This occurs when companies want to retain specific talent. For any new options or bonuses, you will likely get a fresh new vesting schedule or one that matches your old grant.
- Acceleration: There may also be accelerated vesting of options (when they are given to you faster than your normal vesting schedule) or cash dependent on tenure, milestones, or termination at the new company.
- Escrow: A portion of the cash or stock that you get for your common shares and vested options may be held temporarily in a separate account once a deal closes. This is meant to cover any outstanding issues (like taxes, lawsuits, etc.) post-closing. It may take some time to get this amount back, even up to a year or more.
- Holdback: This occurs when part of your vested value is held back, though this is usually just for founders or executives. Holdbacks often have their own vesting schedules and specific terms. These incentivize the founder to stay on for a certain amount of time.
- Triggers: If you’re a senior employee, executive, or founder, you may receive different terms and potential deal-closing bonuses.
- Single trigger: This usually means all your stock vests upon “change of control” (basically an acquisition or IPO) at the company.
- Double trigger: This would mean all your stock vests after change of control AND upon termination from the new company.
- Retention: Before deals close, companies typically go through a list of all employees and determine who they will be able to retain. Some administrative job functions can be duplicative of the acquiring company’s operations and capacity. The acquiring company will decide who gets a new offer (and option grant), who won’t, and who may be terminated after the acquisition is complete. Some acquisitions are contingent on a certain number of employees agreeing to stay on.
Here’s a simplified example of a typical employee’s breakdown of $100 of common stock, $100 of vested shares, and $100 of unvested options and how it might look after a cash acquisition:
And here’s how that same breakdown might look if the employee were a founder with a holdback in their agreement.
All of these terms are subject to negotiation during the acquisition process.
How you, as an employee, are impacted by an acquisition depends entirely on the framework of the acquisition deal, your option grant, and your company’s previous funding rounds. The fine print can vary based on a number of variables like your company’s latest valuation, preferred rights for investor shares, your unvested vs. vested shares, and accelerators.
Details about an acquisition are discussed between the two parties and their CEOs, boards, corporate development teams, and lawyers. Here are the most common scenarios of what can happen to equity based on the type of acquisition:
What to look for when you get issued equity
When Amazon acquired Eero, employees at Eero were left with stock that, allegedly, was worth a lot less due to the conditions Eero negotiated in their funding rounds and the financial terms of the acquisition. It’s important to be aware of the equity implications of any potential exit, and your best time for insight often comes when you join a company.
When reviewing your offer to join a company, here are some issues to be aware of:
- Liquidation preference: Whenever you’re considering an offer from a company, ask about liquidation preferences—aka “who gets how much” in the event of a merger or acquisition (if a company IPOs, preferred stock usually converts into common stock). Even if you’re already at a company, it’s worth asking about what can happen. Smart companies know that employees have job optionality, and volunteering this information about overall liquidation preferences builds trust.
- Exercising early and taxes: There can be tax benefits to exercising early. If the acquiring company pays cash for your vested shares, you will suddenly have a large chunk of income to pay taxes on. Exercising early can set you up for more favorable tax treatment, depending on the type of stock and when it was issued. You may also want to familiarize yourself with the alternative minimum tax (AMT), which can be triggered when you exercise incentive stock options (ISOs).
- If the acquiring company is public: Public companies have different restrictions than private companies, like trading windows and regulations, that may result in you not being able to sell right away.
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. Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. 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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