Should I exercise my LaunchDarkly options?

Sadly, some employees do not realize the massive implications of exercising stock options ahead of an exit event before it’s too late. 

How can it be “too late”?

As hyper-growth startups stock price goes up, exercising options can become more expensive and unaffordable.  Employees are often heads-down building the company and may miss the opportunities to capture their equity.  Even if you think a LaunchDarkly exit event is finally coming soon, it may not be too late for you!

Exercising your options early is not always an obvious decision, however.  It’s also not the only decision.  Employees have the ability to complete a cashless exercise, sometimes called a same-day sale, but that is only possible after your company has exited (and you’re able to sell your shares).

With startup options the big decision you need to make is:

1. Will you wait for the exit and do a cashless exercise?
2. Or will you exercise your options pre-IPO?

Keep in mind: You also don’t have to go at making this decision alone. There’s lots of knowledgeable advisors out there including at Secfi that can walk you through all equity decisions you might be facing. We’d be more than happy to chat and discuss the solutions on the table for you.

Let’s dive into each of these.

Exercising LaunchDarkly stock options after the exit

Employees will often default into this situation because they were not aware of the alternatives, did not grasp the concept of exercising, or never made a plan. Additionally, employees often make this decision because they do not have the funds to exercise their options (+ taxes) or they do not want the risk that the company may not be successful.

There are some advantages to a cashless exercise, though:

1. It’s simple. There’s no action needed on your part prior to the IPO.
2. You avoid the need for cash. Exercising options is expensive, especially when you factor in the tax cost. A cashless exercise can cover that expense without it coming out of pocket.
3. It’s potentially low risk. You’re not putting your savings on the line. Although it’s often better from a tax perspective to exercise before your company IPOs, you have no guarantee that an IPO will ever happen (and that you’ll be able to sell your shares). Since a cashless exercise happens post-exit,it can alleviate the risk.

On the flip side, cashless exercise isn’t always the best option for two reasons:

1. You’ll be taxed at the highest rate.  This is the absolute biggest downside for a cashless exercise, as the money you make will be taxed at ordinary income rates. These can be as high as 52.65% (for federal + state taxes). If you exercise before your company exits and sell your shares at least 1 year later, you’ll get the lower long-term capital gains rate.
2. You have to stick around at the company until the exit. At the majority of startups, when you leave, you have to exercise your stock options (or they expire). So if you leave before an IPO or acquisition, you won’t be able to wait for a cashless exercise

Exercising LaunchDarkly stock options before the exit

Employees who have made a plan and understand the nuances to exercising their options may often find themselves in a more favorable financial position when their company goes public.

1. Potential Tax Savings at Exercise.  Employees who exercise early are often able purchase their options at a lower FMV - strike price spread.  This can mean less taxes owed today!
2. Potential Tax Savings at Exit.*  LaunchDarkly employees who have exercised their options (now held as shares) ahead of time and held for at least a year, will be able to take advantage of selling at the long-term capital gains rate (very favorable compared to ordinary income rates).
3. Flexibility at Exit.  While others may feel forced to complete a cashless exercise as soon as possible, those who have held their shares for an extended period prior to the exit can stick to their gameplan.

Why exercising early can be difficult

1. The need for cash. The cost to exercise and cover the taxes can be significant.  Employees may not be able to afford to or may not want to come  out-of-pocket that amount.
2. Increased risk.  Employees may be putting large amounts of money on the line while waiting for the IPO.  They may also find their investment portfolio concentrated (e.g. “putting all their eggs in one basket”).

A case study: you have vested LaunchDarkly options today and are planning for a potential exit.

Let’s look at an example to see how this could play out in real life.

For the scenario below, let’s assume you’re an early engineer at LaunchDarkly

• Living in New Jersy
• Married filing taxes jointly
• 65,000 stock options (ISOs) at $5/share (strike price)
• LaunchDarkly 409A is $40/share

Disregarding taxes, the cost to exercise your options is $325,000.

Today

• Exercise cost: $325,000 ( 65,000 x $5 )
• Tax bill: $825,189
• Total cost of exercise: $1,150,189

You decide that’s too expensive, and choose to wait until the IPO.

Wait til IPO 

Let’s assume the company exits in six months, but you’re subject to a standard six month lockup period.  When the lockup expires, LaunchDarkly is trading at $70/share so you want to finally complete your cashless exercise.

• Exercise cost: $325,000 ( 65,000 x $5 )
• Tax bill: $2,180,000
• Total cost of exercise: $2,505,000

When you compare the all-in exercise costs and taxes upon exit, that’s over $600,000 in additional taxes that you’re paying to the government (and not going into your pocket!).  

Making your decision

You may be thinking “Well, I cannot afford to exercise now, so I’m forced to wait until the exit anyway.”

First, exercising is not an all-or-nothing decision.  You can create a game plan to strategically and tax-efficiently acquire your shares in smaller batches over time.

Sadly, many people do not realize there are alternative solutions out there like non-recourse financing that can potentially put you in a much better financial position exercising now (with someone else’s funds) rather than waiting until the IPO!

It may not make sense for everyone, but it’s certainly worth the conversation to see if it makes sense for you. Schedule here to review a custom proposal with a member of our Equity Strategy team.

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*Please ensure you consultant a tax professional for you individual circumstances.