Most early stage startups grant incentive stock options (ISOs) to their employees that will vest as they remain employed. ISOs are employee friendly because of their tax benefits, but there’s a catch: ISOs expire 90 days after your final day of employment. This means that if you leave the company or get fired you need to exercise your options by paying your strike price times the number of options you have vested. This typically isn’t cheap and can become even more expensive if the company has grown in value since you were hired because you may owe AMT (Alternative Minimum Tax) in addition to your exercise cost.
One way to alleviate some of this pain is for your company to give you an extension to exercise a.k.a. an NSO extension. This means your expiration date can be pushed out well beyond the original 90-day window, but it also means that your ISOs will convert to non-qualified stock options (NSOs). The primary downside to this conversion is that you will owe regular income tax (rather than AMT) when you eventually exercise the options. The main incentive behind taking this extension is that you hopefully will be able to wait until the company is public (or acquired) before exercising your options and locking up a significant amount of cash. At that point the shares will be liquid and can be sold to cover any exercise/tax costs. At the very least, an NSO extension can give you time to come up with the cash to exercise.
Some companies offer this to all employees. Others offer extensions only to executives. Some don’t offer them at all. It never hurts to ask about when you are preparing to leave. Often, when a company lays off employees they will offer NSO extensions to ease the pain of losing their job (see Compass during COVID-19 layoffs).
If offered, an NSO extension is a very employee friendly option, and in many cases it makes sense for the optionee to take advantage.
How do you know if you should take the extension or simply exercise your ISOs?
When deciding whether to flip your ISOs to NSOs, timing is everything. The first important piece of information is how long the extension will be. NSO extensions can be anywhere from 1 year to a maximum of 10 years from the original grant date. While 10 years is obviously the most favorable, it is up to the company and in most cases out of the optionee’s control (although once again it doesn't hurt to ask). The length of the extension combined with the stage of the company will be the two most important factors when deciding whether to take the extension.
If you believe the company will exit in time (for example, if you are at a late stage startup and are offered a 10 year extension), it is a no-brainer: take the extension.
If you doubt that the company will be mature enough to exit before the expiration date (for example a Series A company and a 2 year extension), you may be better off exercising the ISOs because you will have to exercise eventually (assuming you believe in the stock) and the tax burden could increase if the value of the stock continues to increase in the future.
In the case where you don’t believe the company will exit in time and you are skeptical about the company’s prospects, there is some value in taking the extension in that you can wait and see how the company does before spending your hard earned cash on an option exercise. However, this does mean you may be on the hook for an expensive NSO exercise down the line.
The exit date is unknown and estimation isn’t a perfect science, so there is always risk in taking the extension. If you decide to take an NSO extension, you must always consider that you may need to execute a more expensive exercise in the future (NSO tax rates are higher than AMT rates, not to mention the price will likely/hopefully go up).
This is where the size of the exercise comes into play. If the exercise is large and outside of your risk profile, then it could be very advantageous to take the extension and hope for an early exit – although you could get burned on the back end. On the other hand, if the exercise is small and potentially affordable, it could be advantageous to simply exercise the ISOs and avoid paying any taxes (especially if your ISO exercise results in less than $70,000 of taxable gain). If you do need to exercise, it may make sense to work with ESO Fund to cover the cost of the exercise and any associated taxes, and there is no risk or fees in seeing what we can offer.
Below are a few easy questions to ask yourself before deciding whether to take an NSO extension:
1. Are you still working at the company? I.e.does the 90 day ISO expiration window apply?
a. Yes, I am: Are you planning on leaving soon?
i. Yes: go to Question 2
ii. No, no plans to leave anytime soon: don’t take the extension, there is really no need to lock yourself into an NSO exercise.
b. No, I am no longer employed at the company: go to Question 2
2. Will your ISO exercise trigger AMT? (see this page on how to calculate AMT) This could also be phrased as "Will your ISO exercise trigger A LOT of AMT?"
a. Yes, it will: go to Question 3
i. If you can afford it, a savvy way to handle this situation is to exercise just enough ISOs to avoid AMT, then take the extension (or run back through these questions with the remaining options).
b. No, I will not owe AMT
i. If you can afford it and have confidence in the company’s future, exercise the ISOs. This is the cheapest possible exercise for you.
ii. If you can’t afford it, or even if you can, it may make sense to seek option exercise financing from ESO Fund. Taking the extension only adds to your eventual cost of exercise
iii. If you can't afford to exercise, but the extension will give you enough time to come up with the funds, take it (BE CAREFUL in this case because your NSO tax basis may go up if the company gains value while you are coming up with the funds).
3. Will this extension get you to the finish line? I.e., will the company exit before the extended expiration date?
a. Yes: Take the extension! If you believe this NSO extension is long enough that the company is basically guaranteed to exit, take it. BE CAREFUL with speculating here, you should be almost certain that the company will exit otherwise you may be on the hook for a large NSO tax bill in the future (i.e. S-1 filed already or a multiple year extension at a late stage company)
b. No: go to Question 4
4. Do you believe in the future value of the company? Stock Options can be a great wealth creator but shouldn’t be looked at in a vacuum. Just because you have the right to purchase shares of the company doesn’t mean you should. If you had enough money, would you view this option exercise as a smart investment? Keep in mind all the risks involved with private companies, chiefly that this stock could go to $0. If your company is large enough, they may qualify for Rule 701 disclosures, meaning you can receive financial information from the company prior to making your decision to exercise the options.
a. Yes: go to Question 5
b. No: Take the extension, this will give you more time to evaluate the company and allow the company to get back on track or prove that it is a worthy investment. Worst case you simply decide not to exercise on a later date.
5. Can you afford the exercise? You may have the total dollar amount necessary to cover the cost of exercise and AMT, but are there better things you could be doing with your money? Can you afford to take the risk?
a. Yes: Go ahead and exercise. If you believe the company will do well and can afford to take the risk, you are better off exercising ISOs and paying AMT in April of the following year.
b. No: Take the extension. Before finalizing this, you should investigate all financing options including working with ESO Fund to cover your ISO exercise. The NSO extension buys you time, but you will have to come up with the cash eventually, and it will be even more expensive the second time around. If you believe you will need help covering the exercise cost either way, you may be better off working with the ISOs and thus a lower cost basis (taxes included).
Run through these questions if you are having trouble deciding whether an NSO extension makes sense for you. You should be able to make a confident decision. In any case, it may be worthwhile to see if the ESO Fund can help cover the cost of your exercise before making a decision.