Qualified Stock Option

Finance Allah shmoop What is a qualified versus nonqualified stock

option plan qualified for favorable long term gains tax treatment

Thank you very much if you have qualified stock options

a incentive stock options or ISOs as they're called around

Silicon Valley And yes those air relatively rare They're generally

on ly given to the very first I'ii single digit

number of employees joining a company Then those employees get

the benefit of being able to buy out their stock

options and having them become fully owned Common shares on

very favorable tax bases The ability to buy them out

not have to pay big taxes at the time you

do is a big benefit and well you'll see why

not just for the meaningful vibe of being able TTO

feel like and actually be a co owner of the

company But because it usually means that the employees investors

will qualify for much cheaper tax rates when they eventually

do sell if the employees does not buy out the

options While there's no difference in tax treatment that is

these options are treated just like the nonqualified non stock

options or en esos got it non stock options Gordon

ISOs Well the number which can be granted within a

companies E stop or Employee Stock Option Plan program are

limited And if a company violates this number by granting

too many qualified stock options well then the company is

taxed heavily as it is viewed by the IRS is

having used quote falsely cheap unquote stock to pay key

employees Catch Aly That's called the cheap stock rule applies

to our issues and some other things as well Well

the granting of these kinds of compensatory stock options can

only be given to employees slash insider's of the company

they have to be granted at a fair market value

strike Price III Whatever the four o nine evaluation calculated

by lawyers and bankers and bean counters said the company

was worth That's the valuation the strike price has to

reflect for the the common stock meaning they get an

appraisal from a bunch of bankers and lawyers And they

tell you what the common stock is worth today And

it's usually in an early stage company worth a whole

lot less than the preferred stock because the company's odds

of going bankrupt are really high at that point So

these type of stock options carry a maximum life of

ten years usually And then there are the ten percent

rules that is for at least ten percent of the

shareholders The exercise price of these options has to be

ten percent greater or more than the fair market value

of the company at the time Well because these options

receive such favorable tax treatment there strike price has to

carry a premium right That's that ten per cent thing

And lastly the maximum cap or value of the stock

options for any individual cannot exceed one hundred grand at

least in today's world as exercised or bought out in

any one year In other words they're designed only for

the very early employees with companies carrying very low valuations

E early start ups Okay so that's qualified stock options

The other end of the world nonqualified stock options Yeah

that's for the rest of us blue collar slobs Well

those options can in fact also be bought out But

upon that transaction employees are taxed as if they are

direct compensation and those taxes are levied as ordinary income

I either very high tax rates So in practice most

employees getting qualified stock options by them out almost immediately

And usually there's a negotiation before that employee has hired

such that their commitment to the company has made clear

by their tacit agreement to buy out their qualified options

and have financial skin in the game For employees with

nonqualified stock options and the buyout usually doesn't happen and

those options are viewed as well Gentle lottery ticket potential

big wins way down the line Should the company do

well that's not always the case Sometimes people buy him

out but the big tax treatment favorability eight there So

you and your roommate both joined Shmoop flicks early You

both received the same grant of one hundred thousand options

at a dollar a share strike price How was this

dollar calculated Well lawyers and bean counters were hired for

small feet to make their own valuation assessment of the

company And when they completed that review they determined that

if the company were sold today it's common shares would

command a dollar each on the open market or eBay

or Rush Watch or Fidelity or wherever the company was

sold That number's called the four o nine evaluation in

the strike price of those options applies to pretty much

all the flavors of options you know qualified or ISOs

and nonqualified stock options Unfortunately because you only majored in

E con your package gave you nonqualified stock options whereas

your roommate was an engineer So she received qualified stock

options Not a big deal of the time You didn't

really even care notice other than the one little thing

which was that your roommate borrowed one hundred thousand dollars

to buy out all of her options at that time

a risky move because of the company had gone bankrupt

or done poorly Well that hundred grand would have been

probably zero fast however because they were ice oes She

did not pay any tax on that exercise so pay

it when she sells them at a long term gain

Right Right So then along comes an Ai po and

the stock rocks in the four years Pass and Shmoop

Flix is conveniently for this example problem Hovering around thirty

one dollars a share it is thirty bucks in the

money and then you both go to sell well Your

roommate pays a twenty five percent ish long term gains

rate tax on the thirty dollars times one hundred thousand

or three million bucks That is she pays seven hundred

fifty grand in taxes to net to point two five

million You however pay fifty percent ordinary income tax on

the three million bucks in gain to net one point

five million And remember she had a hundred grand invested

with the company for four years and it took a

lot more risk than you did So if you're feeling

bad well tough beans you paid a lot of tax

so it's a good problem to have But wow the

little word non on your qualified options A plan cost

you seven hundred fifty thousand dollars of winnings in the

form of taxes Ouch So this sounds like Silicon Valley

magic where everyone gets rich and becomes a millionaire by

the time they finish their bar mitzvah speech Oh so

not the case In fact most startup companies in Silicon

Valley go fully bankrupt So had a tax avoiding Mohr

greedy than fearful employee about out all their options qualified

or not And then the company was sold for two

thirds of the value of its preferred stock investment Will

the common stock would be wiped out worthless and all

the money the employees spent buying out there ISOs would

be gone So the business of betting big on start

ups is not one for the faint of heart but

going in The presumption is that well you've carefully watched

this video and others on shmoop finance and you know

the witch and the warlock dance between risk and reward

makes sense you know make dollars