How tech and game devs should view stock options at tax time | Scott Chou interview

It’s a good year for employees to understand the value of their stock options, as tech initial public offerings are expected to make a comeback in 2024.

Big players like Discord, Reddit, Chime, Stripe, and Klarna are expected to have IPOs, and so it’s time for employees to take advantage of this benefit at many tech startups.

I talked to investment expert and ESO Fund CEO Scott Chou about why many employees choose not to exercise their options. It’s often either because they don’t understand their value, or they do not have the necessary financing.

Stock Options are a fairly common benefit at many tech start-ups, but many employees don’t know how to take advantage of it. As companies approach IPO, stock option exercises become more important than ever, but also more expensive.

Organizations like the ESO Fund provide education and financing for employees looking to understand and exercise their stock option benefits. If options holders take the right steps, Chou believes they can take control of their investment future.

Chou told me that many people don’t know the difference stock and stock options. They think they have “stock” as they vest because the concept of “equity vested has gotten large” is floating around the water cooler. That simply means that their time vested stock options are in the money and they still don’t realize that they have to pay for them if they leave the company or else lose it all.

The second biggest mistake people make is not realizing that exercising of stock options can trigger a mountain of Alternative Minimum Tax (AMT) liabilities. We talked about stuff like IRS Form 3921 and more.

Here’s an edited transcript of our interview.

VentureBeat: Is there something about the general economic situation that might affect some of your advice? The game industry in particular has had a lot of challenges around layoffs recently, late last year and into this year.

Scott Chou: A lot of the stock option issues–none of them are specific to the game industry. Of course, stock options in general are popular for all of venture-backed tech. The layoff issue, the number one issue is that we’ve discovered over the years that a lot of people don’t realize that their stock options are not stock. They have to purchase it, and they usually find that out when they get laid off, or when they quit. A lot of people find out a few years after they quit. “What about all my stock?” Well, you didn’t exercise. You had 90 days. So the number one thing is knowing that an option is nothing until you exercise the purchase.

In a layoff situation that’s going to trigger a 90-day window. Of course quitting on your own will trigger it. Often, with these broader layoffs, to prevent the natives from being restless, they’re work out a deal that’s called an NSO extension. You take a qualified ISO and make it unqualified. An NSO grant does not have to expire in 90 days like an ISO does. That can potentially solve the cash crunch that people would have upon exit. Companies in general don’t really care about solving that problem, but they do care about retaining the people they have. If the word from all the people leaving is that, “Hey, did you realize it would cost this much to write a check and get all this stuff?” That would cause the people who are still there to get nervous. They start looking for other jobs. A company can get ahead of that by offering NSO extensions.

VentureBeat: The 90-day thing, is that standard?

Chou: It’s from the IRS, yes. 90 days is the maximum. Uber, back when it was still doing incentive stock options, was only doing 30 days. It can be shorter. It just can’t be any longer than 90 days. Extending it past 90 days turns your ISO into an NSO, and that’s something a company can do to solve some problems. But it’s not something they’re obligated to do. It happens a lot, but it’s not an entitlement.

VentureBeat: What sort of calculation goes into whether or not to exercise? Is it always going to be worth it to exercise?

Chou: The number one factor is the risk. It’s basically a spreadsheet exercise that’s specific to the company, the price you’re paying. You have to make assumptions about what the company might be worth. That’s one of the reasons why people come to us so often. When you let ESO exercise for you, you don’t have to think about all those things. Now, you have to think about it from the perspective of whether you want to do it yourself or use our money. If you use our money, you have no risk, but the majority of the potential benefit is still on the table for you. All the money you save can be invested in something else. Your combined return is probably larger than if you just bought one stock.

At a minimum, it’s more diversified. If you take all your money and, rather than buying all this stock and paying taxes on it, you let us do it, you can take that money and diversify it into safer things. That will also be more liquid, and perhaps the total return is still larger than if you only had the one stock. If you’re doing this on your own, it’s entirely a gut check type of analysis, whether you should pay or not. It boils down to whether the company is going to make it. How much is it going to be worth? From an opportunity cost standpoint, how many years will it take to accomplish that? Is it worth the cost? You could perhaps have invested in something else.

VentureBeat: What does the ESO fund do in this situation?

Chou: Our entire existence is to provide capital for employees to exercise their stock options and pay their taxes. In exchange we’ll take a percentage of the future. They get the net of all that, but they don’t have to put in any money. The fact that we do this, it means they’re always going to get some benefit. In the worst case they get a tax writeoff, because we buy the stock in their name. The biggest portion of our large deals is actually taxes. If a stock fails, the tax refund is yours. By letting us do it, no matter what, you’re going to come out in good shape. You’re not going to lose money and you might make some money.

Of course, if it’s very successful, you could make a lot of money. You’ll have to split that with us, but you’ll make a lot of money.

VentureBeat: Is there a typical percentage you use?

Chou: It depends entirely on the company and the deal and the strike price. Employees who started a long time ago have a very small strike price. They’ll get a better deal. People who worked just recently, or maybe quit after one year, the value of the stock hasn’t risen much above their purchase price, in which case they’re not going to get as good a deal. The tax bracket of the individual also impacts how good a deal. The more tax you put into it, it sort of makes the stock more expensive. ISOs are also cheaper than NSOs, so those deals are better. Especially if you’re in the lower tax brackets. The ISO people don’t pay any tax at all. Those are the best deals you could possibly get.

Other considerations are things like the stage of the company. If the company is really cheap when you exercise, that’s the same as investing. You’ll get the qualified small business stock tax break that the VCs get. That means $10 million of exemption from federal taxes, which is huge. That’s more of a gain than most ordinary people get.

The other thing that’s popular among founders is the use of IRAs. If you’re a founder, the day you create the stock, it has a par value. It’s .001 cents per share. It’s nothing. In other words, each of the co-founders contributed a few hundred bucks to buy all their founding stock, the hundreds of thousands of shares of founder stock. They take a portion of that and toss it into an IRA. They’ve contributed maybe 50 bucks into the IRA as their annual contribution. The benefit of doing so is that the stock is now tax deferred until retirement. Rather than losing half of it when you sell it after the IPO, you can buy a bunch of other stuff and never pay tax. It’ll just keep compounding all the way to retirement.

An even better trick is to deposit it into an IRA, but then flip those shares into a Roth IRA. When you do a conversion, you have to pay tax on the value of all those assets converted on the spot. But in this case, it’s only about 50 bucks worth of stuff. You go ahead and pay your taxes on that, and now those founder shares you put in there will be tax-free, subject to IRS limits. That was abused heavily. People made billions on Facebook back in the day, tax-free. As a result of all the bragging they did I think Congress now has limits on the profits. But still, it’s a huge benefit. You’re basically going tax-free all the way to the back end.

VentureBeat: What are some mistakes people make around understanding tax?

Chou: A common mistake–they need money to exercise. They exercise to get some shares, sell those shares for a profit, and then use that profit to exercise for more shares they can keep. They’re paying taxes twice. You pay taxes on the exercise and pay taxes on the profit when you sell. Then you take what’s left after taxes and exercise more, but that’s a lot of shares lost to tax. There are things like a self-recovery swap exercise where you don’t have to do that. You only have to pay taxes on the exercise. You don’t pay taxes on the act of selling, so long as all those proceeds are used for exercising other shares. ESO can help simulate that and exercise for you.

One way to mess it up would be to sell for a real profit, keeping some money and only using half the proceeds to exercise more. That would probably invalidate the whole transaction. It would work out like a regular sale for profit.

VentureBeat: And I suppose a lot of people don’t understand how much tax they’ll owe.

Chou: Right. They don’t know that. They don’t know what causes taxes. A lot of people don’t know that ISOs are supposed to be tax-free. They are for most people, but in California the incomes are high enough that they can trigger alternative minimum tax. That was designed to target very rich people. But the threshold there is well within the reach of California techies. There are other tax planning things we help people with. They could do this on their own if they know it, things like exercising just enough each year to stay below triggering the next tax bracket. That involves typing up your tax return, or a simulated tax return, and then you start with exercising one share. You keep moving up until the taxes move. That’s when you find the threshold and you start to create incremental tax.

You can exercise, at a minimum, the number of shares that are tax free each year. Also people don’t know that exercising NSOs reduces the AMT on ISOs. They can do them in pairs. That requires a bit of a spreadsheet exercise to plan that out. In terms of calculating taxes, TurboTax does understand that. But in terms of planning, people don’t realize that NSOs, because you already paid tax once, you don’t have to pay tax on the difference between the fair market value at the time of exercise and the final sale. It’s less.

Other people who are less sophisticated may have an even worse understanding than that. We encounter this every day. They think that because of the tax they paid on exercise, it’s now tax-free forever. That’s not true. You still have to pay long-term capital gains on the back end, on the additional profit over the fair market value. We provide strategies to mitigate all those things, to defer or sometimes outright reduce. We have something called a disqualifying disposition of AMT. Rich people have been using vehicles like deferred sale trusts to spread out or defer their capital gains taxes for up to 15 years. That’s a huge benefit. That’s kind of like selling out of an IRA. When you sell out of an IRA, you don’t lose half the proceeds to taxes on the spot. You take the entire principal and you reinvest. It’s not until you retire that you start paying taxes. The benefit’s huge.

IRAs are limited to just a bit of capital each year. That doesn’t move the needle much for wealthy people, so they set up these vehicles. These vehicles are stand-alone entities that require trustees who pay taxes and incorporation fees and all this stuff. There’s overhead to doing this. But conceptually, the same benefits that come from a deferred sale trust, ESO can help you with using something like an AMT disqualifying disposition. We do that on a cookie cutter basis. We already have a contract worked out for you. We’re a bona fide third-party transactor. You’re eligible. For people who have giant AMT–literally, we’ve had people come in with $20 million deals where there’s $7 million in AMT as well, just to exercise the stocks that they got a long time ago. We basically make that go away.

VentureBeat: When someone’s option grants mature, do you have a clear recommendation on whether they should exercise right away, or whether they should wait until they leave?

Chou: There are a couple considerations. If you’re eligible for a QSPS – that’s only for the early stage people – you get a bigger tax break. What you’re asking is about a spreadsheet exercise. We help people set that up and see if it’s worth it or not. There are some big assumptions in there. What’s known is how much you’re going to save on taxes, whether it’s long-term capital gains – everyone gets that benefit – but wealthy people still have to pay higher long-term capital gains. Then there’s what state you’re in. Once you turn your stuff in to taxes you have the power to switch states. Source income gets dinged by California no matter what you do, but once it’s stock, it’s not source income. It’s not taxed until you sell it. You have time to move to cheaper states before you sell, and you don’t have to sell it all at once. You can sell it in bits and pieces to stay in lower tax brackets. There are all sorts of tax planning things like that we help people with.

But your primary question was, should you exercise sooner or later? That boils down to the risk associated with a particular company. We maintain a lot of data on companies. The person I’m talking to usually works there, so they know a lot about the company as well. We give them our perspective and the data from the secondary markets. How much demand is there? The crowd knows quite a lot about companies. They don’t know specifics, but just by virtue of transacting, you have to assume that’s because the executives gave a tip to their friends at the country club or whatever, and so there’s action.

VentureBeat: There’s a wisdom of the crowd in reading the market.

Chou: That’s right. Sometimes it’s foolishness. It’s just someone speculating based on something they misunderstood. But generally speaking–those are on-offs. When you can see significant broader-based demand for stocks, that usually means something is going well. We share stuff like that, things you might not know. If you’re there and you’re well-connected to the water cooler, you can pick up on things, but we pay attention to that as our primary business. We help with that.

People who let us exercise for them, they benefit a lot. Once they leave the company–that’s why they hired us in the first place. Several years go by and their information about the company goes downhill fast. In fact, a lot of their main friends may have left at the same time they left. They don’t have anyone to call back. On the other hand, we continue to answer phone calls from people at these companies who leave later, every year. We constantly get updates, in addition to tracking.

VentureBeat: How do you deal with some of the relatively unknown companies out there? Or is that the majority of the companies you deal with?

Chou: Yes, the vast majority of these companies we’ve never heard of. We’re using a database. Every single conversation is logged. Not recorded, but logged, notes from the conversation. My database has tens of thousands of companies in it. If you work at a particular company can you call me to do your deal, we’d talk about it for a bit, performing diligence. I would capture those notes and other information about the company at that point in time. By maintaining that, that puts us in a position to say yes or no when you come in.

We’re also tracking lots and lots of stuff that we do on our own, well before you call, even for companies that have never called us. We track who joins a company and who quits. We learn a lot about the health of a company over the years based on that activity. For example, one of the easiest things to know that’s not good is when a founder quits. Especially the CEO. If a CEO is fired or quits, that’s usually bad. People might ask, “Doesn’t that happen all the time?” But it happens all the time because most companies fail. That’s why you hear about it. It’s not a good thing. The Facebooks, the Googles, all these heroic companies, the founders were still there all the way. Even Steve Jobs, as poorly as he behaved as a young man, he wasn’t fired as CEO until much later, and even then it wasn’t helpful for the company. The company did much better when he got back.

We have extensive data on what we call signals that matter. That’s our thing, maintaining an extensive database on those signals that matter, keeping track of thousands of companies that most people have never heard of, so that when you call me from a weird company that isn’t famous, like Stripe or Uber, I can still say yes or no very quickly and give you a price.

VentureBeat: Should employees think of ESO as a secondary market?

Chou: We’re not really here to sell. If you’re working for a famous company that can be sold right now, you can go straight to the secondary market. Hire a broker or participate in one of those marketplaces and unload your stuff. You don’t need us. But the vast majority of people don’t work for a company famous enough to be bought in that way. You need to exercise and hold.

Even if you do work for a famous company, your goal may be to exercise and hold because you believe that most of the value creation is still in front of you. You don’t want to sell. But the cost of exercising and holding is huge because of the taxes. That’s also a good reason to come to us. We become a business partner with you. My capital, your options, and we split it. All the downside risk is mine. We can wait many years with you. Along the way, we continue to capture information about the company that you don’t have. We can share that with you.

Brokers look for stuff and contact us all the time. “Hey, a few years back, did you deal with someone from this company? We have lots of interest.” I can share their insights with the shareholder. Maybe they’re in the middle of a cash crunch. They want to remodel their house or the kids are going to college. Maybe they do want to sell some of their stock. That’s another helpful service that isn’t as easy to get if you’re on your own.

VentureBeat: Are there good resources that you would recommend to people so they can study up on this subject?

Chou: They can just call us. We’ll walk them through it. We have a website that has a lot of FAQs and primers on various topics. We have calculators for taxes, AMT and stuff like that. We even have a calculator for comparing job offers. Does what you have compare favorably to what people have gotten from similar companies? It puts you in a percentile. That has no immediate benefit to us, but we stuck it out there to get some attention. Later on if you leave the company and you want to monetize your shares, hopefully you come back to us because you remember that.

Our website has quite a few primers on topics. The tax savings space especially, right now there are about 17 different tricks for saving money on stock options. That’s all free. You can just read that. A lot of those methods require our participation, though, like getting a third-party transactor to do a disqualifying disposition. You need a transactor. We’re here for that. But you can still read about it and find someone else to work with if you want to.

A lot of people these days are nervous about their companies. Not necessarily nervous about them dying, but nervous about how long it will take to go public in this market, and what price they might achieve. Instacart finally went public, but it’s 80% down from the VC price. We used to have this mindset that the VC price was the floor for what the IPO might eventually reach, but that’s not true. Even Uber went down from the VC price. They went public at the same price as the VCs, went straight down, and took six years to finally go up over the last VC price.

In 2021 the VC price paid by so many of these unicorn companies was really high, way higher than their public counterparts. They may never be achieved again. Klaviyo is a good company. They went down from their IPO. Not down as in dead. The stock is still high. But the last round of VCs aren’t necessarily going to make money. So people like to talk about what they could get for their shares outright, and we’re happy to discuss that with them and share free quotes on the cost of going long.

If they have a smaller liquidity need that doesn’t involve selling the whole position–say you just want to remodel your house. Maybe we can provide that. A lot of people don’t realize that AMT is refundable. They come to me with a deal and say, “I quit this job because the cost of exercising in the worst case was $25,000. That’s a meaningful number, but I could cover it.” But the time they got around to doing it, the company was so successful that with the AMT, it’s $1 million. That’s not such an easy number to write. But when I provide the $1 million for you, which includes the $975,000 in AMT, they don’t realize that the AMT is refundable in credits each year.

If you’re looking for some cash and the long-term protection of a stock, do that deal. That $975,000 is going to be refunded to you in dribs and drabs each tax year depending on your situation. All of it will eventually be refunded to you when the stock is sold, whatever you haven’t recovered already. It’s coming back one way or the other. That’s a partial liquidity solution. The money, as it’s refunded to you, you can use it for anything you want. It’s yours once and for all.

VentureBeat: How does this turn into a good business for you when we have a situation where 95% of startups fail, and then occasionally you see home runs? How does your business come out ahead?

Chou: That goes for all of venture capital. The fundamental challenge is that it’s not easy to choose. But we do have the math where the winners pay a lot and the losers, you only lose 1X. You put $100,000 into a project, the most you stand to lose is $100,000. You might make a million. We have to play the game of portfolio math to make it work out. That’s true for every venture capital investor out there, even if you’re Silicon Valley Bank. They don’t charge as much, but that just means their batting average has to be a little tighter. They might charge 12% interest, plus they charge coverage of a couple of percent. They still do the same math. They’re not going to make 10X by lending like that, but that just means they don’t have to hit the same batting average. They set up their due diligence to eliminate whatever failure rate they can stomach.

We do the same thing, the portfolio math. We can stomach quite a lot. The basis of our business is the fact that our counterpart, the employee that has the stock options, if they were to do this on their own, they have a portfolio of one. Even with a pretty decent company–say there’s only a 25% probability of failure. Or not a total failure, but a partial loss. Maybe 10% is the probability of total failure. Since the cost of investment is one or two times your annual salary, that just causes heartburn. Now, for a venture capital fund like mine, we’re managing $500 million. A couple hundred dollars for a deal is small for us. And we have the portfolio math. I’m counting on the fact that the good ones will pay two to five times or more. When you just have the one, you can’t handle the possibility, even if it’s relatively minor. If you lose a year’s salary, that’s painful. Whereas for us, it comes out of a giant fund. We’re not going to lose sleep and hassle you over a loss of a few hundred thousand dollars.

VentureBeat: If you leave a company and you exercise, what risk is there to you that you might be diluted by subsequent fundraising?

Chou: Unless that’s the last round of funding, you’re going to get diluted. The IPO itself dilutes you. They’re going to sell more shares. Dilution is overrated as a concern. What really matters is whether the stock value goes up. You should welcome new rounds of financing, because even though it dilutes you, it gives the company capital. It’s ammunition to do whatever it is they want to do. Marking, hire more engineers, build stuff. That makes the probability of success higher, and so your shares go up.

VentureBeat: So it’s not necessarily a total negative.

Chou: Dilution is a fact of life. Selling more shares is a fact of life. Tesla, to this day, is going to issue more shares. Hopefully they’re not all part of the CEO’s compensation package. Of course, shareholders have a vote if they believe his participation is super valuable. Or using that money to buy another company. If you buy another company with your stock, you’re going to dilute yourself. But you bought another company. That’s useful to you. A combined company is now more valuable. Your shares continue to go up.

That’s all that really matters. Are the shares going up in value? If you’re going to obsess over dilution because you’re afraid of owning 0.1% less, you have a broken framework. The percentage you own is really meaningless. All that matters is where the stock is going. I’d rather have 0.1% of something really hot than 10% of the typical startup.

VentureBeat: Who usually has good information about what you should do? Do you want to go to an accountant, a lawyer, a tax guy, or someone like you?

Chou: Accountants only give you the mechanics of how taxes work. They don’t help you with strategic stuff like whether to invest or not. We can talk about that. Even if you don’t use me for a consultation – if you simply use me for a quote – whether you get a quote or not is a signal. You should interpret that as quality, especially if you call multiple people like me and get those signals. Getting a quote is definitely a signal of quality. And then the price I’m willing to pay is another sign of quality, a measure. That will help you make the decision.