New legislation was introduced in July and passed the house last week called the Empowering Employees Through Stock Ownership Act (EESO) and it is aimed at providing employees of privately held company employees the flexibility in handling the tax obligations with exercising stock options for a period of up to seven years.
Startups typically grant employees ownership in the company they are working for in the form of stock options, incentive stock options (ISOs). Awesome right? Sometimes. If you work for a fast growing startup with a lot of traction, perhaps a unicorn, maybe your options are worth a lot. Do you think unicorns make any noises like a horse would? Except I imagine it would be more magical sounding. I digress….
The problem arises if and when you want to leave the company. Employees typically have 90 days to exercise their options or lose them. Ninety days after an employee’s separation from the company, the ISOs (incentive stock options) automatically convert to what are called non-qualified options (NSOs), which wind up resulting in even more taxable income. Private company employees often cannot or do not have the ability to liquidate shares to cover the tax liability like a public company employee would. So in a sense you are handcuffed to the company. Let’s look at an example.
Let’s say you are an early employee at a Unicorn startup and you were given 0.5 percent of the company when you started five years ago. At this time the company was valued at $50 million, then your ownership position would have been valued at $250,000 ($50 million x 0.05%). Fast forward and the company is now valued at $10 billion. Now your ownership stake is worth $50 million. Whoa….we are paper rich yall! Holla! That is a paper gain of $49,750,000.But there is bad news if you would like to leave. Of course there is. Mo money mo problems. So if you decide to leave you will face a short-term gains tax of 40 percent, $19.9 million, plus the $250,000 needed to exercise the options. You would have only 90 days to come up with the $250,000 and then the remaining tax would be due by the next tax deadline of April 15.Some companies like Pinterest and Quora tried to ease the burnden by giving them years to exercise. However the truth is that many companies with these employee dilemmas choose not to do anything about it, because they believe “locking people in” is good for business. Any stock that is not exercised can be returned to the option pool and granted to other employees.
The Problem is Exacerbated by Two Main Factors:
1) Companies Are Staying Private Longer; and 2) The Option Plan Structure Startups Use Make it Hard for Employees to Leave.