With hopes of a hotter IPO market on the horizon, many private company employees seek to better understand their equity. Two major factors come into play when thinking about equity in startups: how to value it and how the option-related taxes work.

Employees need to understand their equity’s value to confidently exercise or sell, and the related taxes to optimize their profits. Below we will dive into both subjects in a way that makes sense for the everyday startup employee.

How to Value Stock Options

When granted stock options you are given a strike price at which you can purchase shares of the company’s stock (a process called exercising). This strike price represents a safe value at which your options are worth when granted and is based on the current Fair Market Value (FMV).

Over time as the company grows in value, they are required to update the FMV. As this number increases, so does the value of your equity.

The Fair Market Value used by the IRS for calculating taxes. When you exercise, you owe taxes on the gain from your strike price to the FMV. Thus, it is a reasonable, safe value for your equity.

In most cases, your equity is worth somewhere between the FMV and the price of the last round of preferred stock (Last Round Price or LRP). This number is publicly filed by companies whenever they issue a new round of preferred stock. LRP represents the price paid by Venture Capital investors when purchasing shares during a funding round. Technically preferred stock is more valuable than common stock (equity given to employees), so this value represents a ceiling for the value of your equity.

If your company has an active secondary market, you can use the available pricing as a value for your stock. Usually, it will be a partial discount to the LRP. This price is a great indicator of your equity’s value as it is a legitimate price that shares are being transacted at.

Unfortunately, many companies do not have a secondary market presence, so it is important to understand how the FMV and LRP create a range of reasonable values for your shares. You know the stock is worth at least as much as the FMV, and investors will lose money if the shares exit below LRP.

How to Reduce Option-Related Taxes

Assuming you believe your equity is worth investing in, it can make a lot of sense to optimize your tax burden. A drawback of private stock options is that you pay taxes on “on-paper” gains even though you often can’t sell the shares.

To understand stock option tax optimization, you must first understand how stock options taxes work.

When you exercise, you owe taxes on the spread between your strike price and the current FMV. ISOs are taxed via Alternative Minimum Tax or AMT, and NSOs are taxed as ordinary income. Once you’ve exercised, you don’t owe additional taxes until you sell. At that point, you have tangible cash to cover the tax hit.

Early Exercise

For companies that allow Early Exercise, tax optimization begins the day you are granted options. Early exercise allows you to exercise before vesting, thus locking in a lower tax rate, if you file an 83(b). When you are granted your options, your strike price is equal to the current FMV, meaning you will owe zero tax if you exercise.

Basically, it is a tax-efficient bet on the company you are joining. While tax friendly, exercising early brings on additional risk because you have not yet seen your options grow in value. The other pitfall of early exercise is if you leave prior to vesting, the company will repurchase the shares at cost. Once your options have appreciated enough that the taxes are sizable, early exercise loses some of its appeal, but can still make sense prior to a big jump in FMV like a funding round.

ISO Optimization

If you have ISOs, the main factor you can take advantage of is the annual AMT Exemption. Basically, each year you can deduct a certain amount of your ISO-related taxes (just like the standard deduction for normal income). This means you can exercise a certain number of ISOs each year without paying AMT. This number depends on your situation, but is a great way to exercise yearly without getting crushed by taxes.

The basic way to figure this number out is to enter your normal taxes into a tax software without including the ISO exercise. To do this, you note the amount you either owe or get back, then input your ISO exercise and see if it changes. Any change represents the AMT hit from the ISO exercise. Play around with the number of ISOs until the tax amount doesn’t change and that is the number of ISOs you can exercise without paying AMT.

NSO Optimization

If you have NSOs, the only major way to optimize your taxes is to ask your company if they support 83(i) elections. If they do, you can defer your NSO related taxes up to 5 years. While you still owe the taxes, this gives you time to come up with the money and gives the company a chance to reach liquidity before taxes are owed.

The final way that anyone can optimize their stock option-related taxes is to hold their shares for at least one year between exercise and sale. This allows you to qualify for Long-Term Capital Gains which is taxed at a significantly lower rate than short term income.

With everyone’s fingers crossed for a more fruitful IPO market in 2024 and beyond, it is important to understand your equity’s value and ways to reduce option-related taxes before things really heat up. That way, you are ready and educated to confidently exercise or sell when the time is right.

Jordan Long is a graduate of Wake Forest University where he studied Mathematical Economics and Spanish. He has spent 5 years as the Head of Lead Generation at ESO Fund, running the day-to-day marketing efforts for the fund. Before ESO, Jordan worked at Telemundo and DidjaTV in a research capacity, working with audience profiling and the deviation from traditional linear television use. Jordan grew up in the Bay Area and now resides in New York, New York.