Incentive stock options (ISOs) are a common form of equity compensation for startup employees.
How much value you get from your ISOs depends on many factors, including your strike price and the fair market value (FMV) when you exercise — and the future success of your company!
What is an ISO?
If there is one thing that finance and the legal industry have in common, it’s a love of acronyms. Like ISO. What the heck?
However, this is a very important acronym to learn at the start of your journey with equity. And chances are if you’re a full-time startup employee, this is what you own.
When you receive an offer from an earlier-stage startup, your equity compensation will likely be in the form of an incentive stock option or ISO. An ISO is an option to buy a share at a fixed strike price — that could be $0.08 or $0.80 or $8.00 per share. That strike price will not ever change for you, even if the fair market value of the shares rise (and fall).
👉 How fair is your equity compensation offer? Compare your ISO offer to your peers in similar roles at similar-stage companies with our Equity Fairness Calculator.
With ISOs, you will have to shell out money to exercise and convert them into shares. For example, if you are granted 10,000 ISOs with your new job and you leave the company after two years, you may have 5,000 vested ISOs. If your exercise and strike price is $2/share, you’ll have to pay $10,000 to exercise your ISOs. And there’s a good chance you’ll have to pay some additional amount in taxes.
Remember, most equity grants are subject to vesting. Until equity — in whatever form it has been granted — has vested, the company can take it back, so it's not really yours yet. "Vesting" means the release of the company's take-back right, and a "vesting schedule" is the schedule according to which that release happens.
Taxes and your ISOs
Fortunately, ISOs enjoy certain tax advantages — sort of. While you won't be taxed on them at exercise, exercising ISOs may impact your overall income tax profile and you may owe the alternative minimum tax or AMT. AMT is a complicated tax system but the TL;DR is that the difference between your strike price and the fair market value (FMV) at the time you exercise is a paper gain. The IRS sees it as taxable income under the AMT system.
👉 AMT is based on the difference between your strike price and the fair market value (FMV) when you exercise. The IRS views this paper gain as taxable income.
Also remember, you’ll likely owe taxes when you sell your shares down the road. The timing between when you received and exercised those ISOs and when you sell them as shares (either on a public or secondary market) will determine whether you pay short-term or long-term capital gains.
The ideal is to only sell when you have qualified for long-term capital gain treatment. To qualify for long-term capital gains, the date you sold those shares must be:
More than one year from the date you exercised your ISOs; and
More than two years since you were granted the ISOs
Some limitations on ISOs
The maximum value of ISOs that you can receive in a year is capped at $100,000. This cap is based on the fair market value of the company’s shares at the point the ISOs are granted to you. So, if the fair market value at the grant date was $10/share, the maximum amount of ISOs that can vest for you each year will be 10,000. Any options vested above that threshold will be treated as non-qualified stock options (NSOs) instead. (New acronym alert! We have you covered on NSOs here.)
Exercising your ISOs
Exercising your ISOs costs money, so you’ll want to have a plan in place. That might be saving your own money to exercise when you leave your job or making a plan to use option funding if you don’t want to risk your own cash savings.
A basic formula you can use to calculate your potential earnings from an ISO grant: Your net gain = Total sale proceeds - (Your exercise cost + AMT taxes + capital gains taxes).
This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for investment, tax, legal, accounting, or other professional advice. Vested does not provide investment, tax, legal, accounting, or other professional advice. You should consult your own investment, tax, legal, accounting, or other professional advisors before engaging in any transaction or equity decision.