Most resources on stock options explain what they are and how they work. But I couldn’t find anything that discussed the financial and tax implications of exercising options in detail.
Additionally, most guides are US-focused. This post focuses on the consequences for folks based in Germany, which may be similar to those on other European countries.
Many excellent guides explain the ins and outs of equity compensation. My favorite resource is the Holloway Guide to Equity Compensation. The guide explains all the fundamentals you should be aware of:
- The differences between stock options and RSUs
- How stock options and RSUs are granted
- How stock options and RSUs are valued
That guide explains how equity-based compensation works in US companies and how it affects US-based employees.
If you work for a US company and live in Europe, you may still receive the same equity vehicles (i.e., stock options, RSUs), but you will pay different taxes according to local regulations.
If you work for a non-US company, the equity vehicles may be different. Local versions of stock options and RSUs may exist, which are more tax-efficient for the company and the employees.
Index Ventures has written a great guide on Stock Options for European entrepreneurs, which has country-specific details.
Stock options 101
A stock option gives you the right to buy a share of the company at a given price. This price is called the strike price. Let’s imagine you are a new employee at $Corp:
- They grant you 100 stock options
- The strike price is €20
If you choose, you can buy 100 shares of $Corp for €2,000. Notice that since these are stock options, you have to purchase the shares. We call the act of buying the shares exercising your stock options.
Stock options may be lucrative IF later you can sell their shares for an amount which is higher than what you paid to buy them. Notice that this is a big if. Startups fail all the time. Investment is risky. Yadda yadda yadda! You know the drill. Oh, and by the way, this article isn’t investment advice.
Naive profits calculation
Let’s say you exercised and bought 100 shares of $Corp at a strike price of €20. Now the shares have a price of €50 and you decide to sell. What is your profit? A naive approach would be to say that the profit is €3,000 (€50 * 100 – €20 * 100). But that is wrong. It is wrong because it does not account for taxes, which have a significant impact on stock options’ returns.
There are three share prices which are essential to determine stock options returns:
- Strike price: the price at which you have to buy the shares
- Fair market value: the price when you exercise. The share price may have increased or decreased since your stock options were granted. For private companies, this may be determined through a 409a valuation.
- Sale price – the price of the shares when you sell the shares
In regards to stock options, you may pay taxes on three different occasions:
- O1 – When you receive the stock options according to your vesting schedule
- O2 – When you exercise the stock options
- O3 – When you sell the shares
The specifics of the taxes you have to pay on each occasion varies according to each country. Oh, and by the way, this article isn’t tax-advice either.
Stock options taxes in Germany
Below I explain how stock options taxes look in Germany.
O1 – When you receive
You don’t pay taxes on stock options when you receive them.
O2 – When you exercise
You pay income taxes when you exercise your stock options. The gain arising from the difference between the fair market value and the strike price is added to your taxable income.
For a fair market value of €30 at exercise time, you would have a gain of €1,000 (€30 * 100 – €20 * 100). This gain is added to your taxable income. For a marginal tax rate of 42%, you would pay €420 in taxes.
When the fair market value is lower than the strike price, you don’t pay income taxes.
O3 – When you sell
You pay capital gains taxes when you sell your shares. The gain arising from the difference between the sale price and the fair market value (at exercise time) is subject to capital gains taxes.
For a sale price of €50 and a fair market value of €30, you would have a gain of €2,000 (€50*100 – €30*100). This gain is subject to capital gains. Germany has a capital gains allowance of €801 and a capital gains tax rate of 26.375% (without church tax). So you would pay €316 in taxes.
How to correctly calculate profits
Now we can put it all together. To calculate the profits you need this information:
- Strike price: €20
- Units: 100
- Fair market value at exercise time: €30
- Sale price: €50
- Marginal tax rate: 42%
- Capital gains tax allowance €801
- Capital gains tax rate: 26.375%
Your profits are €2,264 ( final value at sale – capital gains tax – income tax – exercise amount = €5,000 – €316 – €420 – €2,000). This result is substantially lower than when taxes are not considered.
Income taxes vs. Capital gains taxes
The key aspect of stock options taxation is the balance between income and capital gains taxes. The fair market value at exercise time determines the split between these two taxes. The table below shows the amount paid in both taxes as well as profits for different fair market values at exercise time.
The table shows that when the fair market value increases, the income taxes increase, and the total return/profits decrease. This is expected because income tax rates tend to be higher than capital gains tax rates for high-income earners.
Often people will exercise their stock options at the same time they sell them. In the table, you can see this scenario under the row with a fair market value of €50 and a sale price of €50. In that scenario, all the gains are taxed as income, and you can still see a total return of 53.37% (!). This return is OK despite being substantially lower than if you were to exercise at a fair market value of €20, 116.92%.
Another interesting observation is that the fair market value needs to be substantially higher than the sale price for you to observe a negative return. In this example, that threshold is somewhere between €90 and €100.
Other investment considerations
Does this mean you should buy stock options at the lowest possible fair market value? No. It depends on your financial goals.
I’ve only really explained how to assess profits at different price points. If I were deciding on the topic, I would at least also consider the following aspects:
- Do you have the cash to buy the stock options? Remember, these are options, and you have to purchase the shares.
- Can you tolerate the possibility that these shares will be worth 0? This process requires you to
estimateguess a sale price. That is a big ask. Equity is risky. Startup equity is super risky. Plan accordingly.
- How long will you have to wait to see your returns? €1,000 tomorrow is not worth the same as €1,000 in ten years. And I’m not even talking about inflation. A fair comparison would probably take into account the present value of money though I may be geeking out a bit since interest rates are low in the Eurozone.
- How liquid are the shares? Shares of private companies are illiquid assets. You’ll have a harder time exchanging them for cash in an emergency. You can’t eat your private company equity, can you?
All those critical considerations are outside of the scope of this post.
I built a spreadsheet to estimate income taxes, capital gains taxes, profit, and total returns of stock options. That is what I used for this post. The spreadsheet works for Germany and should work for other countries with a similar tax system with minor adjustments. Let me know if you’d find this interesting. Depending on the interest, I could put it for sale for ~10€ + VAT. I’m happy to send it for free to folks that got the Complete Edition of my book (which has an unrelated topic ?).
Let me know what you think and if I missed something.
I can send you my posts straight to your e-mail inbox if you sign up for my newsletter.