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Risk is top-of-mind in all of our investment decisions — whether we’re working with an investment advisor, picking stocks ourselves, or deciding to invest in a mutual fund. We naturally think about investing with a “risk vs. reward” framework, so why don’t we think about equity the same way?
Stock options are just as much an investment as your 401(k) or brokerage account and should be treated as such.
Just like you would with a brokerage account, you should evaluate your investment — your company — and decide if it’s worth investing in. Do you believe in it? How long do you plan to stay?
There is no “right time” to exercise your stock options, but there is a right time for you to evaluate your life goals, timing decisions, and the amount of risk you’re willing to take on. Here’s how to evaluate risk and reward in the context of your exercise decision and personal goals.
Remember Economics 101? Opportunity cost is what you give up when you make a specific choice. For example, exercising early can be beneficial from a tax standpoint.
But that doesn’t mean you should rush into doing it, because you need to consider what you’re giving up to be able to afford to exercise — the chance to own a home? A new car?
The decision on when and how to exercise your stock options is not black and white. It’s important to understand what you can and can’t afford — and how that could change over time.
Consider near-term goals such as career flexibility, home ownership, and the ability to invest in more liquid public equities that have diversification benefits. This last point is especially important in managing concentration risk (i.e., the “don’t put all your eggs in one basket” concept) as your company’s value grows.
Questions to ask yourself — or discuss with an advisor — include:
Once you have a good understanding of your career plans, upcoming life events, excess cash-flow, etc., you can start to evaluate different scenarios and the risk/reward trade offs with each.
There are a number of strategies you can employ to mitigate risk as you determine when and how to exercise your stock options. If you’re trying to figure out how much it makes sense to exercise, you can start by using an AMT crossover calculator to figure out the maximum you can exercise without triggering additional taxes.
Since ISOs come with some favorable tax benefits, it's important to know how you can take advantage of them and have an exercise plan that factors in both timing and personal implications.
For example:
If you recently moved to a low- or no income tax state, now may be a good time to consider exercising your options. Since taxes are imposed based on your state of residence as your options vested, be sure to consult a tax advisor to ensure you fully understand the tax implications prior to exercising your options.
One unique aspect of AMT is you are eligible to recoup the amount paid in subsequent years when you do not trigger AMT. This is one of the key benefits that ISOs provide. By claiming the AMT credit, you can recover the AMT you paid in prior years.
Another important strategy is to make sure your ISOs don’t convert to NSOs if at all possible. Why? The short answer is because ISOs are much more tax advantaged.
With ISOs, you’re taxed under the alternative minimum tax system (AMT) — but, if leaving your company, you only have 90 days to exercise. If your company offers an extension exercise window, your stock options will automatically convert to NSOs, which are taxed under the ordinary income tax system.
Taking the extension could make sense if you can’t reasonably afford your ISOs within 90 days. Plus, there are further strategies to explore with NSOs, like spreading your exercising across multiple tax years.
Make sure you don’t fall into the trap of thinking exercising has to be an “all-or-nothing” decision.
That analysis paralysis has led to many less-than-favorable outcomes for people. You can exercise all at once, little by little, or wait until your company IPOs.
For example, if you’re in a termination window, some people may forfeit it all if they can’t afford it all. But you could exercise just a portion, based on what you can afford, or based on a strategy to let the rest convert to NSOs (if you have the extended window).
The point is that there are nuances to exercising equity, and what you should do will be based on your personal situation.
You’ll try to manage risks, but there will always be unforeseen risks (and that should be something you take into account). We’ve seen companies implode, and it was for reasons no one could have foreseen. But there are just as many employees that have seen the opposite — they may have left the company early on (and didn’t think their equity was worth it) only to see it have a massive exit years later.
It’s important to be aware that there are risks you can sort of control, such as taxes and making sure you’re not surprised come tax season, and risks you can’t control, such as your company experiencing a PR nightmare or deciding not to IPO for another five years.
The goal of having an exercise strategy and plan is to control what you can, and to be prepared for what you can’t. But not having a plan is going to be the worst of both worlds.
When you’re leaving, the risk/reward situation changes. If you’re laid off and have 90 days to exercise, you may not want to exercise right away, if you don’t know when you’ll get your next job.
Or maybe you're a manager and get offered a director or VP role. You still believe in your company, you’re just leaving for a better career opportunity. In that case, you may want to exercise within the 90-day window — either because you have to or you want to take advantage of ISOs if you have an extended window.
Even if you’re leaving a job, are ready to move on, and don’t want anything to do with the company, you should still take a step back and consider what choices you have when it comes to your equity. Too often, startup employees abandon massive amounts of money — we’re talking billions — in employee stock options. Investing in a company you work with is hard to separate from an emotional one, for better or worse.
If you abandon some or all of your stock options, and the company ends up exiting successfully down the road, you lose out on the upside of those options.
For Tesla employees who abandoned shares in 2008, fewer than two years before the company IPOed, that lost upside equates to $14 billion today.
Your decision to exercise your stock options is a personal decision and should be coordinated with your other investments, financial goals, tax situation, and current circumstances.
While chatting with co-workers in the lunchroom or via Slack about the company's growth trajectory and a potential IPO can be exciting, this should not be the basis for making an investment decision for exercising your stock options. Instead, it’s just another data point to consider.
Joining a high-growth startup can be an incredible wealth creator, but it isn’t a guarantee your company will reach that coveted IPO event. By working with an advisor who specializes in working with individuals throughout the startup community, they can help uncover unknown risks, identify tax-advantaged opportunities, and ultimately help you implement a plan for your equity that aligns with your broader financial picture.
It’s impossible to overstate the importance of evaluating risk in your exercise decisions. To make good choices with your equity, you have to take a 30,000-foot view of your life, goals, values, risk tolerance, and timelines.
If you’re interested in speaking to an advisor about how we can help you create a holistic financial plan and leverage your equity as a tool within that plan, we’d love to hear from you. Drop us a line if you’re interested in a free consultation.
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Secfi Wealth is a brand name for investment advisory products and services, including financial planning and investment management, offered by Secfi Advisory Limited exclusively to Clients under an in-force Agreement. Secfi Advisory Limited is an SEC-registered investment adviser and is a separately managed, wholly-owned subsidiary of Secfi, Inc.