Disclaimers: I am not an attorney, I am not a tax professional, I am not in any way officially qualified to give advice on financial matters of any kind. I am simply an employee of a company that provides some compensation in the form of ISO stock options, and I’ve done some research to better understand how stock options work and how they may eventually be of value to me. My intent here is simply to share some of what I’ve learned. Please be advised that I could be wrong, or could have left something important out. I hope that others will do their own research, and seek out help from people more qualified than I am, in order to make a plan that works best for them. I am also focusing here primarily on Incentive Stock Options (ISOs) as that is what is what is given out at my company, and most commonly given to employees at early stage startups.
Looking for an intro to stock options? See my post on ISO Stock Option Basics.
What does early exercise of stock options mean?
Exercising your options early means you exercise your options before the shares are liquid: pre-IPO, pre-acquisition, etc.
Whether or not you exercise your options early is a complex topic, and I recommend that anyone with a significant number of options in a successful company do their own research, consult tax and financial professionals, and make a plan for if and when they will exercise options.
In general, unless it will cost you a ton of money to exercise your options, or unless you stand to gain a significant amount of money from your shares, it’s usually best to wait on exercising.
Below are some considerations as you make this plan for yourself.
Why you might NOT want to exercise now
Exercising costs money and comes with risk
Exercising stock options is no different than buying shares in a company. You pay a price for the shares (the strike price), and the company gives you shares in exchange for that money. The value of those shares can go up or down over time. If you buy the shares at $1.00 per share and they go to $10.00 per share, you gain $9.00 per share! But if you buy the shares at $1.00 per share and they go down to $0.50 per share, you lose $0.50 per share.
When you exercise, you are essentially saying that you believe the value of the shares is either currently worth more money than the strike price, or will be worth more money than the strike price in the future.
You most likely can’t do anything with the shares
Unlike public companies, stock options are usually given out at private companies, which means there is no market for the shares. Although you can theoretically sell your shares, in practice it is often impossible to go forward with that. Most private companies have the right of first refusal – meaning if you want to sell your shares, the company has the right to buy them before you can sell them to anyone else. This right of first refusal can easily be used to drag out the sales process so long that selling becomes impractical.
In general, private companies don’t want their shares being sold to just anybody. They want them with their employees and their investors (the people that are truly invested in the success of the company), not random people that now the company has to be beholden to.
This essentially means that in all practical senses, even if you own shares, you cannot do anything with them today. Only at some unknown date in the future could you decide to sell the shares.
Moreover, your company controls if and when that date comes, as well as how you can sell your shares. There are numerous ways that this can happen (IPO, acquisition, company buyback of shares, allowing employees to sell shares to investors, etc), but the company decides when and if those things happen, and they set the rules for what employees can do in those circumstances.
So, when you exercise stock options, you have to accept that you are paying cash right now for something that a) might not pay off at all, or b) will only payoff when the company enables it.
The Alternative Minimum Tax could bite you
Incentive Stock Options (ISOs) are generally NOT taxed when you exercise them. However, that is not always the case.
When you file your taxes each year, there are 2 calculations done: the normal calculation, and a separate calculation called the Alternative Minimum Tax (AMT). In the end, you end up paying the larger of the two calculations, which for most people in most years is the normal calculation, and AMT doesn’t pay a role.
But, unlike the normal tax calculation, the AMT DOES include the gains from the exercise of ISO stock in its calculation. The gains are calculated by #shares exercised * (current fair market value – strike price). In essence, what that means is the following: if you exercise 1,000 shares at an exercise price of $1.00, and the current fair market value of the shares is $10.00, the AMT includes $9,000 in gains in your income calculation.
Now, $9,000 extra in your AMT calculation is not likely to affect your tax bill in a significant way. But what if the fair market value of those shares was $100.00 instead of just $10.00? Now you have $99,000 in gains that count towards AMT. That most likely will cause your AMT bill to be substantially higher than your normal bill, and you could face a seriously hefty tax bill come April of the next year.
So, if you exercise too many options at once, you can run into a situation where you owe way more in taxes than normal. Talk to a tax professional before exercising your options!
Why you might WANT to exercise now
Ok, the risks above seem pretty legit. Should I just wait and exercise when something like an IPO or acquisition happens?
You can, you absolutely can. However, there are 2 reasons you might consider exercising a portion of your options early, or even right now.
- You can get a better tax rate when you eventually sell your shares if you have owned your shares for longer than 1 year.
- If you might leave your company before exercising your shares, you can find yourself in a situation where it is difficult or perhaps impossible for you to exercise all of your options within the 90 day window after leaving.
Better Tax Rate Upon Selling Your Shares
Whenever you sell stock, you get taxed. That’s true of any stock. The rate at which you get taxed depends on how long you’ve owned the stock.
- If you’ve owned the stock for more than 1 year, you get taxed at the long term capital gains tax rate. Depending on your tax bracket, those rates are either 0%, 15%, or 20% currently.
- If you’ve owned the stock for less than 1 year, you get taxed at the short term capital gains rate, which is just your ordinary income tax rate, and is typically a much higher percentage than your long term capital gains rate.
Remember that vesting stock options does not mean you own the stock. You do not own the stock until you exercise your options. So the clock doesn’t start counting for long term capital gains until you exercise your options.
Example
Let’s pretend you have vested 1,000 shares in stock options, and the strike price of those options is $1.00 each. And now let’s say a company comes along and acquires your company, paying $10.00 per share. Assuming you sell all of your shares, that’s a gross gain of 1,000 * $9.00 = $9,000 for you.
If you exercised your shares more than 1 year prior to the acquisition, you would owe either 0% ($0.00), 15% ($1,350), or 20% ($1,800) in taxes.
But if you owned those shares for less than 1 year, you could find yourself paying 24% ($2,160), 32% ($2,880), or an even percentage in taxes, depending on your tax bracket.
As you can see, the difference in how much you are taxed can be quite large depending on how long you’ve owned your shares and what your total gain is.
Of course, keep in mind that forking over money today for something that only maybe will pay off in the future just because you might get a better tax break in the future is likely not something you want to bet big on. It’s certainly a possibility to exercise a small portion of your options as a way of hedging your bet.
Leaving your company can be difficult, painful, or both
You may not be thinking about leaving your company right now, but most likely at some point in your life you will no longer work where you currently work. When that day comes, you have 90 days to exercise any stock options that you are vested in but have not yet exercised. This creates a couple issues.
Issue #1 – Do you have enough cash on hand to buy all of those options?
Options cost money, remember? If you have 1,000 options that have a $1.00 strike price, you now have 90 days to fork over $1,000 otherwise your options vanish into thin air.
Do the math on the options you have been granted, and make sure you understand how much it would cost you to exercise all of them at once.
Issue #2 – The Alternative Minimum Tax could bite you
Wait, wasn’t this listed in the reasons NOT to exercise?
Yep, the alternative minimum tax is such a pain that it is both a reason for and against exercising your options early. And amazingly, it’s for exactly the same reason!
In the reason not to exercise section, it states “if you exercise too many options at once, you can run into a situation where you owe way more in taxes than normal”.
Most of the time you have total control over this. However, when you leave your company, you only have 90 days to exercise all of your options, otherwise they are lost forever.
Imagine deciding to leave your company (or worse, being fired or let go), and then realizing that in order to exercise your stock options that you worked so incredibly hard to earn, you’ll have to fork over thousands or tens of thousands of dollars in taxes, all because you had to exercise “too many options at once”! And that’s in addition to whatever it costs to actually exercise your options (see Issue 1).
So why does exercising now vs later matter? Because the fair market value of your company’s shares could go up from what it is today. Remember, the gains calculation for AMT is #shares * (current fair market value – strike price). So as the fair market value goes up, so do the calculated gains and associated taxes.
Do you expect your company to be successful in the future? If so, most likely the fair market value of your shares will go up over time. Each time the FMV goes up, the AMT gains you would realize when exercising also go up, sometimes significantly.
Keep in mind that because this is all about taxes, the year that you exercise in makes a big difference, as your gains are only calculated in the year that you exercise. If you have 1,000 shares, and you exercise all of them in 2020, vs 500 in 2020 and 500 in 2021, or perhaps you spread it out over more years, that can make a big difference. Spreading out your exercising over multiple years is a great way to avoid major AMT hits. However, you also have to consider that the fair market value of our shares will likely change (up or down!) over the course of those years as well. It’s a very tricky balance.
Don’t wait to make a plan. Don’t find yourself in a situation where you have to exercise your options but cannot afford the tax bill. Talk with a tax expert and make a plan that makes sense for you and your family.
Final Thoughts
Exercising your options early is risky, and not something you want to do without a strong plan and advice from financial experts. I certainly advise talking to a tax professional, and would even recommend talking to multiple tax professionals, as not all CPAs really understand the ins and outs of stock options.
There are certainly situations where it makes sense to exercise early, but ultimately this is a decision that is up you (and anyone else that shares financial responsibilities with you). Your company likely cannot give you advise, and you should be skeptical of them if they try to give that type of advice. The options are yours once you vest them, and that comes with the responsibility of knowing what if anything you want to do with them.