You just started a new job, got a new laptop and after some negotiations, a shiny stock option package. One thing you could do is forget about your stock options and be surprised (really surprised) when the time comes to exercise them. You could also make the more responsible choice and evaluate, upfront, the different options you have in terms of exercise timing. This post will try to help you with just that.
When to Exercise Your Stock Options? Three Options.
1. Wait For An Exit
Your first option is to wait as long as possible and exercise only when there’s an exit (an acquisition or an IPO for example) or when an exit is imminent. To do so, you must stay with the company all the way through that exit. If you’ve made it all the way, the rest is simple. If the company goes public in an IPO you can sell your stocks after you exercise your options since they can now be sold freely on an exchange. If the company is acquired for cash, you just get cash from the acquirer (we’ll discuss a stock-for-stock acquisition in later posts because that can get complicated). In both cases, even if you have to come out of pocket to exercise your shares, you can get cash shortly thereafter.
The Pros and Cons of Waiting
The benefit of waiting for an exit is clear – you remove uncertainty from the equation and ensure that you don’t pay for something now (exercise options) that’s may be worthless in the future (if the company goes under). This eliminates the possibility of a complete loss. However, the downside to this option in comparison to the additional options we will discuss, is that typically you end up paying more taxes since essentially all of your gains will be taxed at the ordinary income rate (vs. the lower capital gain rate), and that can be a pretty brutal rate of 30-40% in a high-income-exit year between federal and state tax. We’ll have a more detailed tax post in the next few weeks if you want to learn more about why that would be the case.
An additional downside or consideration to keep in mind is the fact that you have to stay with the company all the way through an exit. As companies are staying private longer, this could take many many years even if the company is doing great. If you are forced to leave or have better career options and choose to do so, you have limited time to exercise your options. At that point, the cost of exercising your options (strike price + tax) may be too high.
2. Exercise Upon Termination
This takes us to the second option – exercise upon termination. Most companies will require that you exercise your vested options within 30-90 days from the day you leave the company. During this time frame you will need to come up with the money required to exercise your options – the strike price times the number of options you have vested. You may also need to pay taxes on the difference between your strike price and the current value of the stock the day you left. What’s ironic is that the more successful the company you worked for is, the higher the tax bill you may have to pay. If the company has experienced hyper-growth and you’ve worked there for a while, your tax bill may even exceed the exercise cost of the options. If your granted options are NSO, they will be taxed as ordinary income. If they are ISOs and you work in tech, it is possible that will you have to pay Alternative Minimum Tax (read more here). In both cases, if the company did well you can expect the tax bill to be significant. (Note: the new 2018 tax bill may allow you to defer such taxes for up to five years, but it does not remove your liability to pay them).
3. Exercise Early
The third and last option is to exercise early. This means exercising your options while you still work for the company and preferably as early as you get them. Some companies allow this early exercise, which means you can exercise your options before they even start vesting. If you leave before they all vest, you get the money for the unvested portion back from the company. The best point in time to come to a decision about option three is when you join the company, and that’s what sets it apart from options one and two.
The Pros and Cons of Exercising Early.
If you exercise early, the difference between your strike price and the current value of the stock is zero. You will still need to bear the exercise cost but you won’t have to pay taxes upon exercising. In top performing companies this can make a huge difference and turn the cost of exercising from unreasonable for any individual, to doable. Upon exit, this will also result in favorable tax treatment since your stocks would have been (probably) held by you for long enough that the gains will be subject to long term capital gain tax (lower than ordinary income rates). The downside is that you are taking higher risk. There is no way for you to know if these stocks will ever become liquid. By waiting, you gain more information about the company’s probability to succeed. When exercising early you are making a decision with less information in your hands.
At the end of the day, this is about tradeoffs. Take higher risk and potentially pocket more money, or wait until more information becomes available or even until the company exits, and pay more in taxes while lowering your chances of a loss.
So should you exercise early?
We really don’t like using this answer, but… it depends. If you currently strongly believe your company will exit and you can afford the risk of exercising early, it just might be the right thing to do. If the cost of exercising is too burdensome or you just don’t feel like you have enough information, then wait, or contact us to see if we can help you take some of the risk out of the equation.