Why would anyone exercise their stock options early?
Exercising employee stock options
Editor’s note: A version of this question originally appeared on Reddit.
I’ve seen a lot of people ask about what to do with their incentive stock options (ISOs), and the general consensus seems to be, exercise as many shares as you can, as soon as you can.
After doing some research and noodling on it for a few days, I’ve arrived at a different conclusion. From my vantage point, late exercise seems preferable to early exercise if the shares are publicly traded or close to an IPO. Tell me what you think?
Early exercise: Exercise as many shares as you can, as early as you can
Benefits
- Temporarily reduce tax burden at exercise
- Starts the clock early for long-term capital gains, which mitigates the impact of unforeseen liquidity events
Costs
- Time premium of capital required to exercise (money could have otherwise been invested)
- Risk (No liquidity event, value falls below strike price)
Late exercise: Exercise everything as soon as you leave your company. Alternatively, exercise shares in January/February each year, hold onto the shares and sell them 13 months later in March, so you can cover alternative minimum taxes (AMT) and take advantage of long-term capital gains
Benefits
- Minimize time premium and risk by exercising if fair market value/stock price is profitable
- Generate liquidity to cover taxes
Costs
- Requires advance planning to exercise in Q1 each year
- If shares can’t be immediately sold at a profit, potentially large cost in terms of liquidity and time premium from AMT
- Risk that value falls below the strike price, or an unforeseen liquidity event forces an unplanned sale, triggering the short-term capital gains tax
Is this an accurate summary of my two options? Is there something that I’m missing?
- Anonymous
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Dear Anonymous,
You’ve done your research — this is a really well thought-out breakdown of the benefits and costs around exercising employee stock options.
The fact is, exercising stock options early is not always the best option for everyone. For some people, I’d absolutely recommend waiting to exercise. Creating blanket rules for the startup community, like “exercise as many shares as you can, as soon as you can,” can be dangerous advice, because everyone’s risk profile is different.
That said, let’s unpack the question a bit further, and highlight a couple hidden risks that I didn’t see listed in your breakdown.
Let’s create a realistic profile of a senior manager working at a late-stage startup, and call her Liz.
Liz’s company says they plan to go public in the next two years, and may raise one more round of funding before then. So far, she’s vested 35,000 ISOs that have a strike price of $2 per share, and a current 409A valuation (also known as fair market value) of $5 per share.
If Liz exercises her stock options today, she’ll pay $70,000 in exercise costs (35,000 shares x $2 per share) and may avoid paying alternative minimum taxes, because the spread between her strike price and fair market value is still fairly close.
You’re right in that Liz is taking a risk in deciding to exercise her stock options now. She’s tying up $70,000 in an illiquid investment that might not experience an exit event.
However, by exercising early, she’s also mitigating risk. You’ve highlighted two big benefits of exercising now — the possibility of lower upfront taxes, and starting the clock on long-term capital gains.
I wanted to highlight a couple other benefits to exercising early. As soon as Liz exercises her stock options, she becomes a shareholder in the company, with the flexibility to sell her shares when she chooses.
People who wait to exercise can find that the eventual cost to exercise becomes so expensive that their only option is to wait until an exit event occurs, so they can perform a cashless exercise. There’s risk to Liz waiting until an exit — she might have to stay in her job for longer than she’d like, artificially stalling her career while she waits to break her golden handcuffs.
And while cashless exercises carry the lowest possible financial risk (you don’t risk any actual capital, and can anticipate your gains), they also carry the highest possible tax rate.
Exercising your stock options early means that if your company goes public, you’ll get more control over the timing of your stock sale. Once your company’s lockup period ends, you can decide to sell (potentially at the long-term capital gains rate) or hold onto your shares.
People who instead perform a post-IPO cashless exercise might find they don’t have the same luxury of timing, and end up giving up valuable equity shortly after an IPO, just so they can cover the cost to exercise.
Additionally — and this really only applies to employees working at very early-stage companies — if they exercise early enough, they could qualify for the QSBS tax exemption, allowing them to avoid paying taxes on millions of dollars in an eventual exit.
In your breakdown, you also describe exercising your stock options in January or March, waiting for 13 months and selling the resulting shares the following year, to take advantage of long-term capital gains, while earning enough to cover AMT.
Depending on the company, that could be a risky move — it only works if there’s a liquid market for your shares next year (hard to do if the startup is still private) and you open yourself up to the risk that shares are worth less next year than they are this year.
Thousands of startup employees collectively owed millions of dollars in taxes when the first dot-com bubble popped in the early 2000s, because they exercised their stock options and held onto them as their employer’s share price plummeted.
At Secfi, we encourage all startup employees to get educated on stock options, and use that information to build a plan for their stock options. Feel free to reach out if you’d like to learn how Secfi can help.
- Vieje Piauwasdy, Director of Equity Strategy, Secfi
Do you have a question about your stock options? Email us at ask@secfi.com