It is a difficult question...
ESO is here to help.
Exercising employee stock options is like buying stock in a company for a discounted price. With this mindset, it only makes sense to exercise if you think the company will succeed. In a private company this means you believe the company will exit at some point either via an Initial Public Offering (IPO) or a Merger/Acquisition (M&A). In a public company this simply means you have confidence in the future of the company.
There are 3 primary reasons to exercise your employee stock options:
- Your expiration date is approaching.
This is simple: given that you have confidence in the company, it is almost always better to exercise than let your hard-earned options drop off the table for nothing. If you can't afford to take this risk on your expiring stock options, a non-recourse loan with the Employee Stock Option Fund allows you to keep your money in the short term, while maintaining the long-term upside potential of your options, all without taking on any personal risk. Another alternative would be asking the company for an NSO extension.
- You are leaving the company or want the flexibility to leave soon. (Unlock Golden Handcuffs)
If you have already left the company, then you need to know how long you have before your options expire (For ISOs it is 90 days, otherwise the company decides). In this case your incentive to exercise is clear: to prevent the options from expiring and losing ALL value. If you haven't left the company, but either plan to leave or want the flexibility to look around (or fear you may lose your job) it can be appealing to exercise because it will lower the stress once you do leave.
- You want to reduce your tax impact and trigger long-term capital gains.
If you have high confidence in the future of the company, you can exercise early to trigger taxes on long term capital gains. It may seem appealing to wait until the last-minute to exercise your options so you don't have to risk your own hard-earned cash up front. While this may be true, it fails to factor in that you pay taxes based on the spread between your exercise price and the current Fair Market Value of the stock. If you wait, by the time you exercise the tax implications may have gone up considerably. When considering this tactic, you should understand the implied tax savings. According to TurboTax, in 2017 short term capital gains taxation ranged from 10-39.5% and long-term capital gains is typically 0%, 15%, or 20%. If you are subject to AMT, the rate can be as high as 28%. You will need to weigh the savings of triggering long-term capital gains based on how much you think the price of the company will rise. Beyond triggering long-term capital gains, there are many other ways to reduce stock option taxes.
Depending on the circumstances, here are 3 other reasons to exercise your stock options:
- You were recently granted options and would like to Early Exercise in order to take advantage of a lower tax basis.
Some, but not all, companies will allow for an early exercise of un-vested options. In many cases it can be advantageous to exercise your stock options early (provided you have the cash, and assuming you believe in the company given you accepted a job there). The first benefit of exercising early is that you will likely have zero (or very little) tax liability at the time of exercise. The second is that you will get a head start on the clock to long-term capital gains for options that you haven't even vested. Additionally, the lower long-term capital gains rate will be applied to all (or most) of your gains on the stock, rather than paying income tax (for NSOs) or AMT (for ISOs) on some phantom gains if you were to exercise once your options vest. The most important thing to understand is what happens if you never vest options that were exercised early. This will likely be outlined in either your Stock Option Grant or Plan (or both). The vast majority of companies will simply repurchase any un-vested shares at cost (exercise price). This means you won't stand to lose any money, but exercising options only to get the money back for no gain a number of years later isn;t exactly ideal. A good rule of thumb for early exercise is to exercise as many options as you are confident you will vest based on how long you plan to stay with the company. You should look to file an 83(b) election with the IRS within 30 days of the exercise in order to prevent taxes being owed upon vesting.
- You recently vested ISOs and can exercise without paying AMT.
In 2020 the AMT exemption level is $72,900 for individuals and $113,400 for married filing jointly. If you recently vested ISOs that have a taxable gain below the exemption amount, you can exercise them without having to pay any taxes. This can be very advantageous if you company is earlier stage and primed for explosive growth in value, but makes less since if an exit is imminent (i.e. you don't plane to leave anytime soon and can simply wait until post liquidity to exercise). Read more on exercising just enough ISOs each year to avoid AMT.
- Your company is still early stage and you qualify for QSBS.
If you purchase your stock directly from a C corporation with less than $50 million in capitalization and hold for 5-years or longer you will qualify for Qualified Small Business Stock exemptions. Read more on QSBS.
Okay, the time is right to exercise my options: Now what?
Once you decide it makes sense to exercise your stock options, here are three steps you need to take prior to exercising:
Step 1: Do you believe this is a good investment?
This means 1) do you think the company will be successful in exiting through an IPO or an M&A? and 2) do you think that the value of the common stock will increase higher than your strike price? Just because you worked there and have the right to exercise options doesn't necessarily mean you are not better off simply buying an S&P500 fund or shares of a publicly traded company. Keep in mind, even following an IPO, you typically must wait out a 6 month lockup period on the public markets, and the stock could go up or down during that period. If your company is large enough, they may be required to provide Rule 701 Disclosures to option holders. These disclosures include financial information that can help you make an informed decision on whether or not to exercise the options.
If you believe in the future of the company, proceed to step 2.
Step 2: How much will the exercise cost you (taxes included)?
The cost of the exercise itself is simple: the total number of options * exercise (strike) price = cost of exercise. How much you owe in stock option taxes will depend on whether you have ISOs or NSOs. For Incentive Stock Options (ISOs) you will pay AMT Tax when you file taxes in April of the following year (here is some info on How to Calculate AMT Tax). For Non-Qualified Stock Options (NSOs or NQSOs) you will pay income tax that will be withheld by the company at the time of exercise. If you have an equity portal like Carta you may find your NSO tax number there, but often times you must reach out to someone at the company to confirm your tax liability.
Once you have figured out the cost of the exercise, proceed to step 3.
Step 3: How do I plan to pay for this exercise?
The main question is "How much can I afford to exercise?" There are two definitions of "afford" to consider. 1) Do I physically have enough money to pay for this exercise and the associated taxes? and if the answer is yes, 2) Can I afford to risk the money required to exercise? Exercising private company shares always leaves the possibility of losing your entire investment on the table. Ideally, since you are confident in the company and have done as much research as you can, you have minimized the chance of losing your money. but it still exists (COVID-19 has shown that even in the best of times, things can change dramatically). If you can afford to exercise the whole grant, great! Exercise away! If not, looking into options like the ESO Fund to cover the cost of exercise can be a great option. NOTE: even if you can afford to exercise 100% of your options, it still may be advantageous to work with ESO for free leverage and diversification.
In summary, a stock option exercise at a startup can be a great creator of wealth, but it does not come without any risks. It is important to understand when and if it makes sense to exercise.
For more information on how to monetize your private company equity, please contact us at the Employee Stock Option Fund.