Evaluating Startup ISOs

Who is this for

Those who are contemplating a job offer that includes Incentive Stock Options (ISOs) or those who already have ISOs and want to better understand their value. To better understand how ISO are taxed, you should also read Taxation of RSUs, ISOs & NSOs

TLDR

If you are contemplating a startup job that provides ISOs as part of your compensation, understand that they will likely turn out to be less valuable than the equivalent Restricted Stock Units (RSUs) you might receive from a public company unless the startup has an IPO. If you already have ISOs and you are either thinking of leaving the company or an IPO is imminent, read this article and get professional advice ASAP.

Disclaimers

First some disclaimers, there are lots of corner cases and including them all here would make reading this document an impenetrable mess for all but the most diligent. My goal is to give you a more intuitive feel for how ISOs work and where the sharp edges are so that you can make better decisions. Employers often offer facts to prospects in ways that lead them to make incorrect assumptions.

The Basics

An Incentive Stock Option has a number of properties

number of shares you can buy
strike price – the price you can buy those shares
expiration date – when this option expires (this is normally 10 years)
vesting schedule – when this option is yours (most common vesting is over 4 years)

Unlike RSUs, becoming vested in an ISO is not a taxable event (i.e., it doesn’t show up on your taxes).

The strike price of ISOs are required to be issued at fair market value (typically from 409a valuation). This means the options only become valuable if the fair market value (FMV) of the company rises. This is VERY different from RSUs. If you get 1000 shares of company X worth $10K via RSU, then when it vests you have earned $10K even if the company’s FMV has not changed. If the FMV of the startup doesn’t change or goes down however, then your ISOs haven’t earned you anything yet.

Companies will often tell their employee prospects what the preferred stock price was at the last funding round. They are hoping the prospect will infer that the strike price they are receiving is at a discount to its true value. This is NOT the case! ISOs are for common shares not preferred shares. Preferred shares typically have liquidation preferences which cause them to come out significantly ahead of the common shares in all but the most optimistic outcomes (e.g., IPO). These differences in liquidation preferences are what cause common stock fair market value to be as little as 10% of the preferred price in early rounds and up to 40% of the preferred price in later rounds.

An Example

Let’s take a look at an example of how things might progress for a company that makes it to an IPO. Here is example information that might be provided to a prospective employee.

# Shares: 10,000
Strike Price: $1
Expiration Date: 10 years
Vesting Schedule: 4 years (25% per year)
Preferred price at last funding round: $10

You might be tempted to value these options at ($10-$1) * 10K = $90K, but let’s see how it really works out.

Let’s say 2 years go by and there is a new funding round at a preferred share price of $15. The fair market value of the common stock might now be $3 (notice how the discount off the preferred shares went from 90% to 80% because the business is in better shape now). So that means our options are now worth $2/share ($3-$1) * 10K = $20K. And we have vested in half of that.

Another 2 years go by and the next funding round is at $20 and pre-IPO talk is in the air and the common stock is now worth $8/share. Again, notice how the discount has dropped to 60% because there are fewer obstacles to reaching an IPO. So our options are now worth $7/share * 10K = $70K. And we are fully vested now.

Finally, the company has an IPO at $40/share. The options are now worth $39/share * 10K = $390K.

This all assumes that everything goes well. If the company has to have a down round of fund raising or sell itself for less than the investors have invested, the common shares will be worthless. And depending on the liquidity preferences, that could be true for a company being acquired for up to double the amount investors have put in. And then there needs to be enough value left over for the common shares to be worth more than the strike price. This is the reason for those big discounts in common stock prices vs preferred share prices. Under most scenarios other than an IPO, the typical employee common share holders are not going to be large winners.

Questions to ask

OK, so you’ve decide you want to take the lottery ticket ride. What else do you need to know.

Does the company offer regular liquidity events (i.e., the ability to sell your shares)? Sometimes you stop believing in the company or just need the extra money and want to cash out. Even if your options are in the money (e.g., fair market value is above the strike price). You may not be able to easily sell the shares unless the company provides regular liquidity.

How often are 409a valuations performed? They are typically performed at each fund raising round and at least annually. As the company matures it will often migrate towards semi-annual and then quarterly valuations. These updates will let you track the value of your options.

What happens to your ISOs when you leave employment? Typically your are given up to 90 days to exercise your ISOs, and if you don’t they may expire or convert to NSOs.

Lastly, if you are joining early in a companies life when valuations are very low or are thinking of exercising your options significantly before an IPO, it behooves you to find out the liquidation preferences of the preferred shares if you can. This will allow you to more accurately judge your outcome in non IPO scenarios.