The main difference would be the strike price of the options, which can make a huge difference in both taxes and income at a liquidity event. Assuming the company is growing over time, you absolutely want option 1. The strike price is determined by a 409a evaluations.

Example: assume the valuations each year are 0.10, 0.20, 0.30, 0.40, 0.50 and the sale price is $1 at year 5.

In option 1 your strike price will be $0.10 for all 100 options so should you choose to exercise you have to pay $10, netting you $90. You can choose to exercise these as they vest, paying $2.50 each year. If you choose to exercise on vest, your cost is the same, although you potentially will owe AMT.

This means that if you make enough money you essentially have to declare the difference between strike price and current value as income. This means you will have to potentially pay taxes on an extra $25 over the four years.

In option 2, exercising the options will require $5.00, $7.50, $10, $12.50 for a total of $35. This means you only make $65 in the sale.

And just to see if I understand correctly, if you exercise on vest, you have an extra $25 of taxable income over the four years, but then $25 less at year 5? There is no sense in which you have more taxable income; its distribution over time has merely changed.

Actually your taxable income in the second case is less because you made less money. :)

How can you make less money by exercising the same options, but at a different time?

The answer is that they're not the same options. Your respondents are assuming the strike price is FMV at the time the options are issued, which will be different at different times. There may be good reason for that assumption, if it's somehow prohibited to later issue options based on an earlier FMV, but it should have been called out because it's changing more things than just what you'd intended to ask about.

when you declare your income you subtract your cost basis from the sale price. In 1 you paid $10 and sold for $100 = $90 profit you have to pay taxes on. In 2 you paid $35 and sold for $100 = $65 profit. It isn't the time at which you exercise that makes the difference, it is the higher strike price.

EDIT: to be clear, 1 and 2 refer to the original differences in the first post. If we are comparing different exercise time with the same strike price, then the taxes are nominally the same (Because the income tax % you pay depends on your income, you might be able to save money by exercising in a year when your income is low).

Why can't the options have a strike price of 0.10 in option 2?

(I assume I should look up "409a", the magic keyword to answer my questions?)

Yes once upon a time companies could set whatever they wanted for the strike price but not anymore. I think there might still be a way to do it with complex bookkeeping but AFAIK everyone just uses the 409a value.

I'm not following.

The normal way it works: you get 1/48th of your allocation every month you work there, EXCEPT that you don't get the first 12 months worth until you stay for a whole year --- the first 12 months are "all or nothing".

Why is it phrased as 1/48 of my (say) 48000 optipns/shares vest rather than a fixed amount of 1000 options/shares are awarded every month?

Alternatively, why aren't salary offers phrased as "you will get $640,000, which vests at 1/48 per month"? (Usually you'll hear "your salary is $160,000 per year and we do payroll monthly.)

Because when the four years are up, you don't automatically keep getting more options.

I don't understand. The alternative, as I detailed above, is "you get 1000 options per month for the next four years", which is also time-limited.

It's much easier on the accountants and the share spreadsheets to just assign you 48000 shares and make up funny 'vesting' rules than to update the spreadsheet every month to add 1000 shares for you. It's literally just ease of bookkeeping.

When the accounting and law professions catch up with the tech I think we'll see this all being much simpler, as with government and driving licenses and all the other pointless bureaucracy. But judging by how slowly bureaucracy moves, don't hold your breath.

When a company issues an employee an option at below its fair market value, it has literally created income for the employee, not in a funny accounting sense but in reality.

Replacing vesting with options artificially discounted to the FMV of the company at hire might not be different fundamentally from vesting, but it seems like there's lots of ways to abuse the capability of issuing discounted options.

When an option vests today with a fair market value from four years ago, the company has "literally created income" for the employee. But for whatever reason, this isn't a taxable event. I was inquiring as to the reason for this difference in treatment.

Options at the money are also incredibly valuable, and even more so when they're for a startup (hence their usage in compensation). It's instructive to look at the prices for at-the-money options on, say, GOOG 1--2 years out to see how much they're worth on the open market (easily 10% of the current stock price).

The strike price for options you receive two years from now will likely be much higher than the strike today.

Why can't I be told what the strike price will be for the options for the next four years?

Because it depends on the valuation of the company, and nobody can see the future.

Can't the strike price be set in the employment contract right now?

Possibly among other issues, because if you grant options to an employee that are below the fair market value of the company, you've just created immediately taxable income for the employee.

I think this hits the target.

As far as I understand, granting an option now with a currently "fair" strike price which "vests" in the future (but only if the person is still employed), does not create a taxable event at the time of vesting. However, granting an option in the future at the exact same strike price at the exact same time, creates a taxable event.

So my understanding is that option vesting is "simply" tax-preferred.

No. Options have to be priced at the time the grant is made, and that price needs to be the then-current fair market value of the company.