This page is based on personal experience, and is based on what I know of American tax law. I am not a lawyer, however, and can not claim that this information is currently accurate. Use it at your own risk.

Terms to know

incentive stock options (ISOs)

Options which get special tax treatment: they create no tax event when exercised, but are taxed when the stock is sold. if the stock is held for more than a year, they are taxed at the long-term capital gains rate, rather than the normal income rate.

When exercised, ISOs can subject the owner to the Alternative Minimum Tax, which can be substantial.

You can get paid in stock or in options. If you get paid in stock, you actually receive shares of a companys stock. If you get paid in options, you receive the right to buy the stock later, at a set price. If the stock is selling on the open market for more than the strike price, you can exercise the option, buy the stock for the strike price, and then sell it immediately for the market price, pocketing the difference as profit. The lower the strike price, the more profit you make.

Options are often issued with a strike price equal to or 10% lower than the market value of the stock at the time the options are issued. That means that the maximum profit the option holder can realize is movement in the stock price after the time options are issued.

Cash flow & liquidity

With stock, there are no cash flow concerns. Once you own the stock, you own it. With options, however, you need to come up with the money to exercise the options. This isnt always easy. If you have 10,000 options with a strike price of $5, it will require $50,000 to exercise those options and buy the underlying stock.

But why is that a problem? I hear you ask. After all, youd only exercise options if the stock were selling for more than the option strike price. Cant you then just sell enough of the stock to cover the $50,000? Ah, if only it were that easy

Liquidity

You cant sell stock in a non-public company. So unless your company is publicly traded, the stock you get (either directly or by exercising options) is just pieces of paper, unless the shareholders agreement gives you permission to sell it to third parties. Rarelyand never in a venture backed by professional investorswill you be given that ability.

As I write this (8/99), there is also a holding period on shares of stock in non-public companies. The holding period can range from 6 months to 3 years. Even if the company goes public during that time, the holder of pre-public shares cant sell until their holding period expires. The intent of this is to prevent monkey business in which insiders are allowed to purchase pre-public shares immediately before an IPO and then turn right around and sell them. In fact, there is currently a strong movement in congress to eliminate the holding period.

[Authors editorial opinion: eliminating the holding period will probably encourage all kinds of game playing and profit-taking. Philosophically a believer in businesses being value-creators, rather than transient-paper-profit creators, I favor keeping the holding period. Yet as someone who may someday be in a position to benefit from its elimination, I find my principles put sorely to the test.]

Tax implications

To make matters worse, taxes can cause a cash flow issue in all of this. Heres a summary of how the taxes work: