The original point of ISOs was to offer to employees the opportunity to take an economic risk with stock options (by exercising and paying for the stock at the bargain price) while avoiding the tax risk (by generally not recognizing ordinary income from that exercise and being taxed only at the time the stock was sold, and then only as a capital gains tax).
AMT has since emerged to devour the value of this benefit. By having to include the value of the spread (difference between exercise price and fair market value of the stock on date of exercise) as AMT income and pay tax on it at 28%-type rates, an employee can incur great tax risk in exercising options - especially for a venture that is in advanced rounds of funding but for which there is still no public market for trading of the shares. Even secondary markets for closely held stock are much restricted given the restrictions on transfer routinely written into the stock option documentation these days.
So why not just pass a law saying that the value of the spread is exempt from AMT? Of course, that would do exactly what is needed.
The problem is that AMT, which began in the late 60s as a "millionaire's tax", has since grown to be an integral part of how the federal government finances its affairs and is thus, in its perverse sort of way, a sacred cow untouchable without seriously disturbing the current political balance that is extant today.
And so this half-measure that helps a bit, not by eliminating the tax risk but only by deferring it and also for only some but not all potentially affected employees.
So, if you incur a several hundred thousand dollar tax hit because you choose to exercise your options under this measure, and then your venture goes bust for some reason, it appears you still will have to pay the tax down the road - thus, tax disasters are still possible with this measure. Of course, in optimum cases (and likely even in most cases), employees can benefit from this measure because they don't have to pay tax up front but only after enough time lapses by which they can realize the economic value of the stock.
This "tax breather" is a positive step and will make this helpful for a great many people. Not a complete answer but perhaps the best the politicians can do in today's political climate. It would be good if it passes.
You can keep deducting that capital loss on the options exercise going forward against future capital gains, and up to $3000 more can be deducted against regular income each year until you balance everything out.
BUT
Since the gain is actually unrealized the best answer is ask your CPA. Really.
Only in years where you have no AMT liability. GL with two earners in California. While you have AMT liability you have to keep endlessly carrying forward your 0% interest loan to the govt.
1- I don't know how exactly AMT liability interacts with the capital loss carry over
2- Almost nobody hits the AMT jackpot year after year.
3- Ask your CPA and California's tax system is one of the worst in the country. They keep milking that SV cash cow year after year, and it is drying up but they don't seem to care :)
A lot of people in California (and NY, NJ, etc) hit AMT every year. Two incomes, with very large deductions for state income tax, mortgage interest, and property taxes paid.
Its usually a bad idea to take stock options instead of a market rate salary because most options are worthless in the long run. Lots of people do it anyway because they have a fantasy about making it big. As it stands now this is a life lesson that people spend some time in their 20s figuring out and probably walk away with nothing but some valuable experience.
Under the current scheme exercising illiquid options is a bad idea most of the time if you can't pay the taxes on it and this is obvious. This change doesn't make it a better idea but it makes it much less obvious that its a bad idea.
That 20 something that would have walked away with nothing will be much more likely to walk away with a 6 or 7 figure tax debt that may cripple him financially for the rest of his life.
This is the current meme on Hacker News, but IMHO the pendulum has swung too far.
You should absolutely be very careful about working for an early-stage startup as an employee and taking options or equity in lieu of part of your salary. You should feel that you trust the founders. You should insist that they've figured out a.) who their customers are b.) why they want the product and c.) how to make money, and have some concrete evidence that the customers do in fact want the product. You should ask about the cap table, and liquidation preferences, and anticipated future dilution, and know what percentage of the company you'll own and how much you'll make under a variety of exit scenarios.
But if the numbers look good and you have solid evidence that people want the company's product, oftentimes taking more equity is the right move. Equity aligns your incentives with the company and ensures that if it does well, you do well. Under capitalism, taking cash is a loser's bargain, not in the sense that you always make less money (you often make more), but in the sense that cash dominates equity only if you've picked a losing organization. To the extent that most organizations lose, this can be rational, but to the extent that you're an independent economic actor trying to maximize your returns, it's often worth putting in the research to try and maximize your chance of picking a winner, particularly given the other career benefits of having a hot startup on your resume.
The optimal long term strategy for managing a portfolio of independent investments is to always pick a mix that maximizes the expected value of the log of your net worth. This leads to a more conservative investment strategy than the naive "maximize your expected value", and explains such things as why money-losing investments into buying insurance can be a really good idea.
In general this is probably not a bad life strategy.
Let's use the back of the envelope that of VC backed companies, 10% are great successes, 60% die, and 30% will last a good amount of time but don't recoup the investment. The average employee in a successful startup will get a nice payday, but not exactly a life changing amount.
This is doubly true for people capable of being software developers. Your expected income from work is already sufficiently high that a million dollar payday does not change the log of your net worth by that much. Having worked in a hot startup is good for your salary, but usually not by a factor of 2 let alone enough to really change the log of your net worth.
The end result is that it is economically irrational to give up, say, 5% of your salary in return for a chance at hundreds of thousands if the startup sells for hundred's of millions.
Now there are lots and lots of reasons to be an employee at a startup. If you do, there are lots and lots of reasons to pick one that you think has a good shot. But the hope of becoming rich off of options is only one of them if you derive great entertainment value from it.
I get that your utility function from money is non-linear, but I would expect a more accurate model to be a step-function, with large steps at "out of debt", "can tell a bad boss sayonara", "can buy a house", "can pay for kids' college eduaction", and "never have to work again". Equity payouts from a typical startup exit often line up nicely with the middle three, and if you hit the Google/Facebook jackpot, sometimes the last.
Log is often used because it makes linear proportional returns. It makes the most sense when gains are considered derived from the principal, ie proportional returns from capital. See an example below.
As others have mentioned, maximizing log is equivalent to maximizing the underlying.
But when considering returns on accruing capital, a 20% loss is much worse than a 20% gain is good, and similarly a 100% gain is much less good than a 100% loss is bad. This is correctly captured by taking the log. In the case where money is simply accrued from some external source, and their is no proportional return, log isn't necessary.
Independent investment opportunities generally have the effect of multiplying your value by a random amount over a specified interval. When you take logs, you are adding a random amount instead. From the strong law of large numbers, after enough intervals, it is statistically certain that the sum of the logs of those random numbers numbers will converge on the number of intervals times the expected value of the log of your investment strategy.
Therefore maximizing the expected value of the log maximizes the long term rate of return that you (with 100% probability) will observe.
Well, he's suggesting maximizing the expected value, which is a little different. For example, a situation where you have a 10% chance of making $10M and a 90% chance of making zero has an expected value of $1M, but its expected value in log10 space is 0.7 = only about $5, while a 100% chance of making $100K has an expected value of $100K, but in log10 space = 5 = $100K.
I still quibble about the use of log for this purpose (and even if you do, what base?), but I see his point. A non-linear utility function penalizes low-chance but high-value outcomes.
The most general (correct) form of this statement is "use the expectimax algorithm". Yeah, it's a bit weird that he's prescribing log as the mapping from dollars to utility.
If log is the correct mapping for you, it actually doesn't matter what base you use. It just comes out as a constant factor on the expected utility.
How does the expected value of the log of your net worth deal with the possibility of a negative net worth? Any finite probability of zero net worth will weigh infinitely in the log domain, right?
The pendulum hasn't swung far enough, because the predominant meme on HN (because it benefits the YC model directly!) is that investors and founders are kinda sorta the same class, and early employees and everyone else can eat shit and die ("Graduate to better things").
These same folks will balk at a few points of stock, will backload options so folks're basically handcuffed to a desk for a few years until vested, and will buy into the rubbish pushed by Scott Kupor that explicitly views early employees as obstacles to be stripped of their equity to fuel later growth ("Are there any other management practices where one would optimize for former employees at the expense of current employees?").
This exploitation is slowly getting the results it deserves.
> Equity aligns your incentives with the company and ensures that if it does well, you do well.
There is not a strong correlation between how well the company does and how well you personally do. You can be relieved of your options through contractual shenanigans, you can be put (even with this bill) in a place where you can't afford to exercise them within their window, you can be burned out or injured to the point where you have to leave and then the company reaps the benefits of your work and you don't.
Moreover, your incentives are never aligned with the company, because companies are utter sociopaths and fear no backlash from screwing you over if it makes economic sense. You will almost never legally be in a strong enough position to fight the company with its resources if you find yourself in a bad place--unless the company has grossly fucked up. There can be no meaningful alignment of incentives under such an environment.
> Under capitalism, taking cash is a loser's bargain, not in the sense that you always make less money (you often make more), but in the sense that cash dominates equity only if you've picked a losing organization.
This is a gross over-simplification. If you are unable to maintain a large enough equity chunk, you may not make more than a salary would've provided. If the company stock tanks, you may not make more than a salary would've provided. The idea of "a losing organization" just isn't very useful here, because a lot of organizations "lose" for any number of reasons--unless the definition here is being picked as "an organization whose equity is worth more than salary", which is a cop-out.
I'd add that it's entirely optional for anyone to take any job and this includes a start-up. If you want a regular job with regular hours with regular stress levels, then please, don't even bother looking at entrepreneurial employment opportunities.
But if you do, you might as well go all in and mix your salary with options, work your ass off for a couple of years, learn as much as you can, build a network, and then if it pays off, great. If it doesn't, don't have regrets that you "lost" a larger salary during that time. Be thankful for the opportunity.
Obviously some situations can unravel in a highly negative manner (the partners sell, but disavow all options, the partners fire you before paying out options to other employees, etc), but those are just normal risks in start-up land. Buyer beware.
But if I were actually in my twenties right now, I would bust my ass at a start-up, have a blast, kick-ass writing code, learn a shit ton of technology, and be grateful for the opportunity.
I think this is kind of an unrealistic view of startups that's been championed a lot. I'll concede that I only have 4 data points (4 jobs), but when I worked at a startup, my responsibilities were much more limited and defined than where I am now (200+ people, 80 IT). A lot of that was due to cycling through management styles like scrum and kanban, but this is to be expected at startups that haven't figured out what works for them yet and want to copy everyone else. I also think I've learned a lot more at my current company than at my startup where I was surrounded by "fake it to you make it" people. I value the network I've built up there more too. Before you jump into that circus, look at the middle. It's not startup or 5000 person company. There are plenty of established companies in the 50 - 300 person range that are nice places to work and to learn and pay market rates. I was able to jump into trading from there and get 2-3x market rates
You're forgetting that options/equity/shares/whatever have many conditions AND on top of that there are complex schemes which can render them nil. The stockholders/VC know that and they are very good on the legal stuff.
A salary comes with no trap. You can ensure every month that you got the money.
No, I remember all those. You should know what they are and how they may be used against you, and you also should have a fairly good idea if your founders are likely to do that. Just because some people are untrustworthy sociopaths does not mean all people are.
If your boss wants to fuck you over, there are plenty of ways for them to do so, in career-ruining ways, even at a salaried job.
> You should know what they are and how they may be used against you, and you also should have a fairly good idea if your founders are likely to do that.
That's what everyone is saying: knowing all of that stuff, the reasonable thing is to take salary. You're just choosing to ignore that that line of reasoning makes sense because you'd prefer yours.
Have you ever been on either side of this sort of thing when it's gone down, or are you just regurgitating the party line?
I've worked as an employee for 2 startups, both of which failed. I had options for one and took all-cash compensation for the other. I've also founded two, one of which outright failed and the other of which is still in search mode. And I worked at a big company, where roughly 50% of my rather generous compensation was in equity.
I'm arguing that the reasonable thing to take is not salary, the reasonable thing to do is get a different job. It's not worth fighting over the scraps of a company that's going nowhere. Find someplace where the pie is expanding and then you avoid all the fights and backstabbing over who gets the pie. If you can't find such a place, create one. (That's why I'm founding a startup now; I'm not averse to working as an employee for someone else as long as they have their shit together, but I see relatively few such companies that I'd like to work for right now.)
Honest question: do you think you could have chosen that companies were not "losing bargains" seven years ago? How many companies are there today that you think would grant you significant equity and also will reach liquidity in the next seven years? How would this change if you were an early twenty-something with few connections and little savings?
Off the top of my head I can only think of a handful of companies today, and even with those I'm not sure I would take a six-figure gamble with most of them. If I were a decade or two older things would be significantly different.
Obviously I didn't choose right - the first two startups I worked for both failed. And then I was like "Never again" - I was the voice on HN saying that early employees get screwed, c. 2008 - and that blanket prohibition made me miss out on being employee #2 at DropBox (along with 10 or so other startups that went nowhere).
More to the point, though - I don't think that the point of a career should be to minimize risk. Or rather, you certainly can choose to minimize apparent risk - but that usually means that whoever owns the least risky option (probably Google, today) will use that as a lever to get you to accept whatever terms they give you, which is its own form of risk. Ironically, very few of the senior software engineers I knew at Google actually had "Work at Google" as a career goal - most of them were ex-startup-founders, or Ph.D dropouts, or had toured in a punk rock band decided they want an office job, or washed out of law school and figured programming looked more interesting. You gain a lot of confidence by failing at something you thought was important to you, and that helps you focus on the next thing that's important to you.
I think that your goal, when you're a 20-something with few connections and little savings, should be to gain experience as quickly as possible. That's what lets you take prudent risks when you do have the means to do so. If you've never failed at something or gotten screwed over when you're 40, you're probably about to start, and your failures will be much more visible, painful, and harder to recover from than if you fail when you're 22.
> and that blanket prohibition made me miss out on being employee #2 at DropBox (along with 10 or so other startups that went nowhere).
That seems to have worked out ok, though, if you only had a 1/11ish chance of jumping on a startup being the right decision at that time, anyway. It doesn't dissuade me from the "options are most likely worthless, and akin to a lottery" viewpoint.
However...
> I think that your goal, when you're a 20-something with few connections and little savings, should be to gain experience as quickly as possible.
This is good advice, and I'm no longer in the 20-something bucket myself, but the trap I see friends among that group falling into these days is jumping from the "akin to a lottery" thing into a "I'm going to gather as many tickets as possible" job-hop-every-year strategy.
The downside is they aren't gaining much useful experience, and their "connections" are mainly just to an insular group of VC-funded founders and other inexperienced engineers. Being the most experienced engineer (with 2 years of experience before joining) at a company of 20 people with all the other engineers being straight out of school isn't particularly useful experience. You can make it work, but it's much harder - nobody to learn from, no mentor, etc. And if the projects you're working on are just basic social or game apps over and over, your experience isn't very deep.
So if that tight-knit pool dries up... what are you bringing to the table when you're looking for a job at somewhere a bit larger and more stable?
What about the alternative of building up wealth? It's the conservative view, but if you get to 30 or 40 with significant assets, you have a lot more flexibility to explore what you want without worrying about money. With the supply demand curve favoring devs for the time being, why not jump from job to job taking the compensation increase each time? I think my 2-3 year stints will catch up to me at some point, but if I have 1-2m in liquid assets, I think I'll have a much wider set of means than if I had optimized for experience. You'll still fail and learn, but you'll be sitting on cash instead of worthless options
>> If you've never failed at something or gotten screwed over when you're 40, you're probably about to start, and your failures will be much more visible, painful, and harder to recover from than if you fail when you're 22.
Really good advice. Which at 40 I will now ignore ;-)
Exactly--this bill is a pernicious half-measure that only serves to further obfuscate the problem. One can exercise in-the-money but illiquid options without grappling today with the problem of selling them while being anchored to a heavy tax obligation ("seven years is a long time, surely by then there will be a market").
No, you realize ordinary income tax on the spread, which is payable in full in the year realized (or in the year to which it is deferred under this measure) while the loss of the stock value is a capital loss, which can only be offset against other capital gains or deducted at the rate of $3,000 per year. So you could easily have a situation in which you realize tens or hundreds of thousands in ordinary income on which you must pay tax and have only the ability to deduct $3,000/yr against that income, i.e., a tax disaster.
Yes, that is correct and thanks for pointing out that I had not included the "/yr" after the $3K. I have now corrected it in the comment above. So, yes, you keep carrying any capital loss of this type forward until you get to deduct the whole thing over time, either at $3k/yr or as an offset against future capital gains.
Citation / reference on most options being worthless? I feel that most companies that make it to that stage pan out beyond being worthless. I must be missing something, since I'm not that familiar with how options in startups work.
A friend of mine got caught that way. He wound up owing more tax than his net worth, even though he'd never had that "income" from the options. He had to make a deal with the IRS, lost everything he had, and had to start over (despite being middle aged).
When a new round is raised, the price paid by the investor gets her a preferred share. How does one compute the FMV of common stock compared to this? Specifically, are there any regulations regarding the max discount that can be applied to the price paid by the last investor to get the FMV of the common stock?
I recently came across a case where the FMV of common stock was only few %ge points less than what the last investor paid. But the investor was rumored in the press to have gotten significant privileges (a ratchet) for that price. So I was surprised that the prices were so close. Does anyone know why that could be so?
The FMV of common stock should be calculated through a 409a valuation, which should take into account the preferences. The company is supposed to do this on a regular basis, and certainly should have a current 409a a the time of an option grant. An individual can't really calculate an FMV on their own (outside of a sale, which unto itself creates an FMV).
If one receives options before they are valuable, then there is a high valuation during which assets are illiquid and one defers taxes, then the value collapses as the company folds, are you still stuck with a huge tax bill? If so nothing has been fixed. There's no point in patting politicians on the back if there is a simple fix and instead they passed a complicated partial fix.
The sad thing is that it could have been relatively easy to address by allowing something like a disqualifying disposition as long as the tax is deferred.
I'll probably take advantage of it to exercise some of my shares, but I will have to stick within the range of where I know I'll be able to pay it off within the next seven years even if I never see value for the stock.
I'm at a startup and haven't exercised for this exact reason I was hoping this was to fix that.
It's unclear to me that if I defer it and the company goes out of business before then, does that mean I pay no taxes?
And if the price goes up do I pay capital gains or income tax on the difference in value between now and what it went up to? What about the difference between now and my excise price.
In my unprofessional opinion you need to know at least two things to get an idea of whether or not you will owe taxes when you exercise: 1) the strike price you pay to exercise your options, 2) the current fair market value (FMV) of the stock
You will only run into this AMT trap if there is a difference between 1 and 2. This could happen if you were granted options a long time ago and your company has since raised new rounds which increased the valuation. This is when the IRS eyes your exercized options as 'income' unlike the normal case with ISOs where the strike price and FMV are pretty close.
Thank you for this clarification. I was wondering how holding these options would screw the average employee, since I didn't think the value was taxable, but the impact on the AMT is the piece I was missing.
I've got to think that once we start making loopholes in the AMT there will be no stopping it, and it'll quickly turn back into the regular tax code.
AMT has since emerged to devour the value of this benefit. By having to include the value of the spread (difference between exercise price and fair market value of the stock on date of exercise) as AMT income and pay tax on it at 28%-type rates, an employee can incur great tax risk in exercising options - especially for a venture that is in advanced rounds of funding but for which there is still no public market for trading of the shares. Even secondary markets for closely held stock are much restricted given the restrictions on transfer routinely written into the stock option documentation these days.
So why not just pass a law saying that the value of the spread is exempt from AMT? Of course, that would do exactly what is needed.
The problem is that AMT, which began in the late 60s as a "millionaire's tax", has since grown to be an integral part of how the federal government finances its affairs and is thus, in its perverse sort of way, a sacred cow untouchable without seriously disturbing the current political balance that is extant today.
And so this half-measure that helps a bit, not by eliminating the tax risk but only by deferring it and also for only some but not all potentially affected employees.
So, if you incur a several hundred thousand dollar tax hit because you choose to exercise your options under this measure, and then your venture goes bust for some reason, it appears you still will have to pay the tax down the road - thus, tax disasters are still possible with this measure. Of course, in optimum cases (and likely even in most cases), employees can benefit from this measure because they don't have to pay tax up front but only after enough time lapses by which they can realize the economic value of the stock.
This "tax breather" is a positive step and will make this helpful for a great many people. Not a complete answer but perhaps the best the politicians can do in today's political climate. It would be good if it passes.
Edit: text of the bill is here: https://www.congress.gov/bill/114th-congress/house-bill/5719... (Note: it is a deferral only - if the value evaporates, you still owe the tax).