The surprisingly complex math behind startup equity and taxes

Taxes for employees at startups are weird and can vastly change the amount you make.  To illustrate why, let’s take a simple example.

Suppose we have a group of early employees at a startup, we’ll call them the Unicorn Inc. Mafia.  They’re all fresh out of college and managed to get through it without any debt, so they each have a net worth of $0. They all join the same day and are given the same equity package: $10k in stock options with a strike prices of $1 (so, 10,000 common stock). We’ll take four members of the mafia, each with a different strategy.

Name Description Net worth
Alice Exercise very early, before price changes $0
Bob Exercise somewhat early $0
Carol Wait until liquid to exercise, wait until long-term capital gains apply $0
David Wait until liquid to exercise, sell immediately $0

From here on out, keep in mind that this could be the end of the story. The company could always fold, leaving everyone with zero or, if they’ve exercised, a negative net worth.

However, suppose the company is doing well and lets the employees know that they’re going out to raise a $40M round.  Alice exercises her options before the round happens.  This means that she has to pay for them, so she’s in the hole $10k.  Now if anything goes wrong, she’s out $10,000.

Once the company raises the round, the stock is worth $5/share.  Unfortunately, Bob’s significant other got a job across the country, so he has to find a new job. He feels like the company is going places, though, so he wants to collect his equity before he goes. He exercises his options. Because he is buying his stock for $1 and it is now worth $5, the IRS says that he just “made” $4. So he has to pay normal income taxes on that $40,000. To keep things simple, let’s say everyone’s tax rate is 25%. So now he’s paid $10k for the stock and $10k for taxes:

Name Description Exercise Income taxes Net worth
Alice Exercise very early, before price changes ($10,000) 0 ($10,000)
Bob Exercise somewhat early ($10,000) 25%*$40,000 -> ($10,000) ($20,000)
Carol Wait until liquid to exercise, wait until long-term capital gains apply $0 $0 $0
David Wait until liquid to exercise, sell immediately $0 $0 $0

So Bob’s out $20k if the company goes under (ouch!).

However, luckily for Alice & Bob, over the next several years, the company continues to grow and raise money. Finally, the company goes public for $100/share. Wow! Once the lockup period expires, everyone eventually sells (somehow it’s still exactly at the IPO price) and makes $1M. Our final shakeout looks like:

Name Description Exercise Income taxes Short-term capital gains Long-term capital gains Sell price Net worth
Alice Exercise very early, before price changes ($10,000) 0 0 0 $1,000,000 $990,000
Bob Exercise somewhat early ($10,000) 25%*$40,000 -> ($10,000) 0 20%*$990,000 -> ($198,000) $1,000,000 $782,000
Carol Wait until liquid to exercise, wait until long-term capital gains apply ($10,000) 25%*$990,000 -> ($247,500) 0 20%*$990,000 -> ($198,000) $1,000,000 $544,500
David Wait until liquid to exercise, sell immediately ($10,000) 25%*$990,000 -> ($247,500) 25%*$990,000 -> ($247,500) 0 $1,000,000 $495,000

There are, uh, a couple of different outcomes. Alice obviously has an accountant in the family: she avoided paying any taxes at all! How is this possible? First, she exercised his options before the price changed, so she didn’t have to pay any taxes on exercise. Then she held them long enough to qualify for long-term capital gains. However, she didn’t even have to pay those! It turns out that, if you own stock in a startup before it has $50M in assets, long-term capital gains up to $10M are tax-free (Google “QSBS” for details). However, Alice is also taking on more risk for longer than anyone else: most startups don’t have outcomes like this and she’d have just been out $10,000 if they had gone out of business.

Obviously there are a ton of simplifying assumptions (stock prices never change! Everyone has the same tax rate, which happens to be one that make numbers easy!). However, I wish someone had told me about all this ~10 years ago, so putting this out there in the hopes that it’ll help someone else.

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