Comments on this thread are not very interesting and generally off topic. This article points out an issue in SV which is that it's hard for employees to get value out of options held in companies that do not go public.
One reason for this not mentioned in the article is that in the US the tax burden is extreme - partially because when it was implemented it expected companies to go public.
If you hold options in a private company you get taxed on the exercise of those options based on the fair market spread which is the difference in price between your original strike price (the price of the options when they were granted to you) and the current fair market valuation. This is taxed as income.
This is problematic since once exercised you're holding shares of an illiquid asset (since the company is not public) and they're difficult to sell. This means even if you save up enough money to exercise your options you'll get hit with a potentially enormous tax bill due that year that you can't easily sell your newly exercised options to pay for. Additionally when you sell the actual shares after you've exercised them you get taxed again on the sale.
The one exception to this is if your options are ISOs (incentive stock options) then the delta between the strike price and the fair market value isn't taxed immediately, but it does count towards AMT (Alternative Minimum Tax) and it's fairly easy to hit the AMT while exercising options (meaning you could only exercise a tiny amount per year tax free).
All of these things make it extremely difficult to realize any value in a private company without enormous amounts of upfront cash and also losing roughly half to taxes. It also makes it extremely difficult to exercise options outside of a liquidity event. This can also make it hard to leave a company since the agreements are often 90 days to exercise after leaving or you lose your options (there's also usually a ten year expiration date).
If companies in SV intend to stay private and don't want their employees to view the options as impossible to liquidate we'll probably see an uptick in liquidity events like this one. The companies that value their employees will probably figure out a way to make this work.
It's worth noting that most startups nowadays also include a non-transference clause in the options contract. This forbids any private sale of shares outside of a liquidity event. This is terrible for an employee leaving a company. Not only is the employee on the hook for a big tax bill if he exercises, but he can't even sell any of his shares to cover the cost.
AFAIK, this is a response to Facebook employees selling equity on private markets.
Yeah, the ISO spread with the AMT is bullshit that basically keeps the plebes in their place by not actually letting them get any windfall. However it seems like the real problem is exercising post-IPO. In the post-IPO world, you're dealing with say a 5x to 10x spread, possibly even more. In the pre-IPO world, your spread is probably 2x at most, which is much more manageable.
One clarification with what you said, is that with the AMT ISO exercise is that you're not actually taxed on both the exercise and the sell. What's actually going on is that you're prepaying your taxes when you sell the stock. When you sell the shares, you'll only have to pay the taxes (either regular income or capital gains) based on the difference of the fair market value of the stock when exercised and when sold. If it went up, and you sold in less than year from exercise or less than 2 years from ISO grant, then it's regular income, otherwise it's capital gains. So you could actually get a tax refund when you sell. (Same is true if the market price actually declined between exercise and sell.)
The argument is that when you exercise, you received something of value for less than market and so you made money, but in reality you actually haven't realized any gains, and actually are at cash loss. I understand the argument, but I don't agree with it, because you did not actually realize any gain.
FWIW, San Jose's congresswoman Zoe Lofgren has repeatedly tried to fix the AMT and ISO taxation, but hasn't had much success.[0]
Where I disagree with you is thinking that private companies are going to "figure out a way to make this work" in a way that's beneficial for workers. I'm sorry, but I've never seen high finance work out for workers. It's basically a play for the financially desperate. It's no better than selling you shares on sharespost or something. If it's illiquid market, you're never going to get full value, and you know damn well those that are buying are going to expect a few multiples in gain. They can just wait a bit longer. Workers on the other hand, are busy trying to scrape together a down payment on a $2,000,000 shack in the valley.
Thanks for the clarification about post exercise selling of shares (that you're taxed on the difference between exercise price and sale price).
I agree the argument that you make money on exercise doesn't make sense - especially since the company could easily crash afterwards and you can still get stuck with a huge tax bill for value you never actually realized (except on paper).
Agreed you won't get full value, but I think the existence of liquidity events like this one is an example of private companies "figuring out a way to make this work". They're letting employees realize some value from their equity.
Nothing can be done about the 2 million dollar shack in the valley though (unfortunately).
One other option sometimes available that I didn't mention is filing an 83b election with the IRS and exercising options early before they've vested and before there's a fair market spread. You can avoid taxes this way, but you're putting money at risk very early and often you're not able to do this anyway (there are rules about early exercise).
I don't care to nit pick but it's not quite that simple. The AMT credit you receive at exercise can in theory be used to offset the tax due at sale, but you can only claim amt credit if your traditional tax liability is higher than your amt liability that year. While that may be true if you sell a lot of stock it's not a lock esp in California where a working married couple with a home can have a lot of high dollar deductions. In that case you keep the credits until you can use them.
Amen I remember that when I had shares in o2 from a employee scheme. The company did an exercise in buying out small shareholders for around 50p - Less than a year later the sahres got brought by telephonica for £2.0
Yes it's a capital loss. Which means you can use it to offset an unlimited amount of capital gains, but only 3k of ordinary income. So how long it takes to redeem could be a long time if you never incur capital gains.
The notion of "realizing" seems like nonsense to me. You get given a piece of paper worth $100, you should get taxed for $100. Whether that piece of paper is a federal reserve note or a stock certificate should be an irrelevance, no?
If you exercise shares in a dark market why don't you just mark them at zero? If they aren't trading you can just make up the price and that goes for any good not just shares of companies.
Just because a company isn't public doesn't make it a 'dark market' (not sure what that is).
The 409A valuations are real and there are rules surrounding how exercise happens. You can't just sell them outside of that and not pay taxes. You could theoretically sell the shares once exercised to some other private investor if you can find one, but you'd still have to follow the same exercise rules.
Feels like there should be some kind of "shotgun clause" equivalent. The government wants to value your illiquid asset at $x for tax purposes? Fine, but if you disagree with that valuation you get a corresponding right to sell that asset to the government for 90% of $x and make it their problem.
They could buy and hold - the government has a long time horizon. Or they could auction it off. They could abstain from votes, or they could do something more complicated.
One reason for this not mentioned in the article is that in the US the tax burden is extreme - partially because when it was implemented it expected companies to go public.
If you hold options in a private company you get taxed on the exercise of those options based on the fair market spread which is the difference in price between your original strike price (the price of the options when they were granted to you) and the current fair market valuation. This is taxed as income.
This is problematic since once exercised you're holding shares of an illiquid asset (since the company is not public) and they're difficult to sell. This means even if you save up enough money to exercise your options you'll get hit with a potentially enormous tax bill due that year that you can't easily sell your newly exercised options to pay for. Additionally when you sell the actual shares after you've exercised them you get taxed again on the sale.
The one exception to this is if your options are ISOs (incentive stock options) then the delta between the strike price and the fair market value isn't taxed immediately, but it does count towards AMT (Alternative Minimum Tax) and it's fairly easy to hit the AMT while exercising options (meaning you could only exercise a tiny amount per year tax free).
All of these things make it extremely difficult to realize any value in a private company without enormous amounts of upfront cash and also losing roughly half to taxes. It also makes it extremely difficult to exercise options outside of a liquidity event. This can also make it hard to leave a company since the agreements are often 90 days to exercise after leaving or you lose your options (there's also usually a ten year expiration date).
If companies in SV intend to stay private and don't want their employees to view the options as impossible to liquidate we'll probably see an uptick in liquidity events like this one. The companies that value their employees will probably figure out a way to make this work.