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When to Exercise Stock Option As A Startup Employee?

If you’ve joined an early- or growth-stage venture-backed startup in the past decade, you’re probably wondering when to exercise stock options, and what is the best time for given your situation. Your compensation package probably included equity, usually in the form of stock options, and that’s great! Options can turn into shares, and shares are a potential ticket to life-changing earnings if your company takes off.

But those gains can come at a price, and often a prohibitive one, in the form of exercise costs and taxes. Naturally, then, the questions every startup employee will face are the same: Should I exercise my options immediately? During my tenure? When I leave the company? After we go public? And what are the trade-offs of each choice?

Before we get into the details, let’s start with the basics of stock options.

What Are Stock Options?

Stock options are a common type of equity compensation for employees of early- and growth-stage startups. An option is just what it sounds like: It gives you the right to “exercise” — that is, to choose to purchase a share of the company’s stock — at a pre-determined price (called the “strike price”). That price is typically fixed when you join the company, and it is usually equal to the startup’s current 409a valuation (the fair-market value as determined by a valuation specialist).

Therefore, if you’re in this type of situation, knowing when to exercise stock options could save you hundreds of issues.

Why do startups give options as compensation?

Because they are a great way to align the employee’s incentives with the company — an employee who owns a piece of the company is invested in the company’s upside and will be motivated to help the company succeed. (This could be said of other types of equity compensation as well, including shares of stock and restricted stock units (RSUs), which are typically given out at different stages in a company’s lifecycle. We’ll focus here on options, which are more common among earlier-stage startups.)

Are all options the same?

In some ways, but not in others. All options give you the right to purchase shares at the strike price. But there are two different common types of employee stock options — incentive stock options (ISOs) and non-qualified stock options (NSOs) — and they are treated differently for tax purposes. We’ll get into those differences as we proceed.

How and when can you exercise your options?

Each situation is different. So now that you know the key concepts, you might be asking yourself: when should I exercise my stock options? Luckily, we can help you out!

Some companies allow employees to exercise their options only once those options have vested — once the employee has completed a certain period of service to the company. You can think of vesting as unlocking your options over time. For example, if you are granted 10,000 options when you start your job and those options are set to be unlocked on a typical schedule — vesting over four years, with a one-year “cliff” — then you would be allowed to exercise 1/4 of the options on the one-year anniversary of your employment, and the remaining options in equal installments over the last three years of your vesting period.

Other companies allow employees to “early exercise” their options — to exercise even before their options have vested. In this scenario, the employee may convert options to shares before the options have vested, and they’ll then take ownership of the resulting shares of stock on that same vesting schedule (and if they leave the company before vesting is complete, the company will have the right to take them back).

What is the Cost to Exercise Options?

In general, there are two direct costs associated with exercising options: (1) the cost of converting the options to share, which is paid to the company, and (2) taxes paid to the government.

Exercise costs

The first cost is straightforward: You have to pay the company for the shares you are being given. Say you are granted 10,000 options when you start your job at a strike price of $1.00. If, after one year, you would like to exercise all of those shares, you may do so at that strike price, even if the company and the shares have become much more valuable. In that case, you’d be purchasing 10,000 shares at $1.00 each, for a total exercise cost of $10,000. (Incidentally, you would be paying that amount to the company, since you are buying those shares from the company.) If you waited longer to exercise — say, another couple of years — your exercise costs will go up if the company’s valuation has gone up.

Taxes

The second cost is more opaque, and it is the source of most of the questions we field about option exercise: Taxes. Wait, you might be thinking: When I exercise my shares, I’m not actually receiving any money. Why would I be taxed? This is a good question, and the answer is why exercising valuable options can create all sorts of liquidity issues. In short, although you technically won’t owe regular old income tax on your options, exercising can — indeed, usually will — cause you to be subject to income tax (in the case of NSOs) or the Alternative Minimum Tax (in the case of ISOs).

How are option exercise taxes calculated?

When you exercise your options, you are buying shares that are worth something. This is called the Fair Market Value (FMV), and it changes over time (hopefully increasing!). Even if the FMV increases over time — say, to $10.00 — you are still entitled to buy the options at the strike price when they were granted (in our example, $1.00 per share). That’s great — you’re paying less for the shares than they’re worth. But the IRS is always looking for its cut, and the government will tax you on any value that you get from your employer. In this case, that’s the difference between the FMV of the shares at exercise and the strike price you pay the company for the shares.

Let’s return quickly to our example. Say you received 10,000 shares at a grant price of $1.00 apiece, and you exercise them all at a price of $10.00. You pay $10,000 for the shares, and you’re receiving shares worth $100,000. To the IRS, then, you have a gain of $90,000 — an imaginary gain, to be sure, but still a taxable gain in the IRS’s eyes.

How much you will be taxed depends on whether you have ISOs or NSOs. For ISOs, it will be the Alternative Minimum Tax. For NSOs, it will be the ordinary income tax rate. What, exactly, these taxes will be is outside the scope of this article, but suffice it to say that the bill can be substantial — often as much as 35-50% of the difference between what you paid for the shares at exercise and their value, or between $30,000 and $45,000 in our example. (Like the costs of exercise, these taxes would likely go up if you waited longer to exercise, since the value of the shares, and your paper gains, would be higher if the startup becomes more valuable.)

Are there any other taxes associated with stock options and the resulting shares?

Unsurprisingly, yes: You will be taxed on any appreciation when you sell the shares. Returning to our example, you exercised at $1.00. Say the company is acquired or goes public at $100.00 per share. If you sold at that price, you would pay at that point on your gains — the $99.00 that the shares have appreciated since they were granted (though you will receive a credit for any taxes that you paid at exercise).

Here’s a diagram:

When to exercise stock options

How to Save on Taxes When Exercising Stock Options?

Recall how options are taxed: You’ll pay taxes on (1) your paper gains when you exercise; and (2) your actual capital gains when you sell. Fortunately, there are options for saving on both of these fronts.

Early exercise

The main way you can take control over these variables is by thinking critically about the timing of your exercise. In particular, if your company allows early exercise (before your shares vest), you can elect to exercise your options right when they’re granted. If you do that, then the fair-market value will equal your grant price, and you won’t have any gains, even on paper. No gains, no taxes. Plus, the earlier you exercise, the lower the value of your shares and the less exposure you will have to the Alternative Minimum Tax (assuming that the value of your shares will grow over time).

Capital Gains

The second way to reduce the taxes on your shares is to qualify for favorable tax treatment when you sell. What tax rate will you pay on your gains depends on what kind of options you have and, critically, how long you have held the shares, plus a few less common rules that we’ll talk about in a moment.

No matter which type of options you had, if you hold the shares for less than a year after exercising, your earnings will be treated as short-term capital gains, which are taxed at higher rates. If you hold for longer than a year (and, in the case of ISOs, sell at least two years after your grant date), the returns will be taxed at the more favorable long-term-capital-gains rate.

In this example, on a $1m sale of the startup equity, early exercising may be the difference between a Californian keeping $650,000 (or more with tax planning that we share further down) or $500,000 if they do not exercise their shares till the sale!

The Benefits of Exercising Early

To sum up, what are the benefits of exercising options early, and why would you do it?

  1. To minimize your paper gains and, therefore, your taxes at exercise;
  2. To start the clock for long-term capital gains treatment and/or QSBS eligibility (more on that below);
  3. An additional one we haven’t discussed: To avoid the “golden handcuffs” associated with the post-termination exercise (PTE) window. The PTE window is the period you have to exercise your options after leaving the company. The most common PTE window is 90 days, though some companies have extended theirs for as long as ten years. If your company is on the shorter end, and if you wait to exercise, you could find yourself in a position where the cost of exercise is simply prohibitive. If that happens, you might need to wait to exercise until you can sell your shares to cover the costs. If you leave the company, though, you might be forced to decide between exercising before that liquidity is available or forfeiting your shares at the end of the PTE window. For that reason, many people with options that are valuable on paper find themselves stuck staying in a job they would like to move on from so as not to trigger the PTE window.

Additional Tax Planning Benefits from Early Exercise

QSBS exemption

Another timing benefit that that may arise has to do with the Qualified Small Business Stock (QSBS) exemption. (For more on what QSBS is, how it works, and the requirements, please check out this article.) Briefly, the QSBS exemption is a special tax rule that allows owners of startup equity to pay 0% taxes on their first $10 million of capital gains, provided that the shares meet certain requirements. One of those requirements is to hold your shares for five years after exercise and before you sell. It’s hard to tell when you exercise if this benefit will apply, but it is impactful enough that it should not be ignored.

Tax-advantaged accounts

One final way you might reduce the taxes you pay on your gains when you sell is to place your shares in a tax-exempt account like an IRA or a Charitable Remainder Trust. These vehicles can allow you to significantly increase your returns — often by over 70% — by enabling you to defer your taxes, reinvest the savings, and capture additional compound growth over many years. To take advantage of these structures, you do need exercise your shares.

Risks When Exercising Stock Options Early

It comes down to liquidity and risk.

On the liquidity front, your options and the resulting shares might simply be too valuable for you to afford them. If the strike price is high (for example, because you joined a very successful company at a later stage), you might just not have the cash to pay the exercise price. And if you wait till the time when you exercise your stock options, or if your company doesn’t allow early exercise, you might find yourself in a position where your paper gains are so large that the resulting taxes will be too big to stomach.

It’s also important to consider the opportunity cost of locking up your initial investment for many years in shares that you aren’t allowed (or able) to sell. You are giving up the opportunity use that money for other purposes — as a down payment on a house, or to invest in other growing assets.

As for risk, this one is probably clear if you’ve thought for a moment about the value of your startup equity. When you exercise your stock options (if you decide to do it), you’ll be paying an up-front cost — the value of the options and, possibly, some taxes. Those costs are sunk; you can’t get them back. Sure, they’re a down payment on future gains, and exercising early can save you a lot of money in taxes. But if the company loses value — or, worse, fails — you will have paid a potentially substantial sum to buy shares that end up being worth nothing. This is the same risk you would experience when investing in other asset classes, it’s just more common in the start-up world.

Next Steps

So, when exercise options? The answer is going to depend on your personal financial situation, how much your options cost, how much the company is worth, and whether you think the company is likely to succeed long term, among many other factors.

A quick rubric for thinking through these questions to decide when to exercise stock options, might look like this:

  • If you join your company very early, exercising might be very cheap, and in that case there’s no real liquidity or risk concerns. Here, early exercising is an easier decision.
  • If you join in the growth stage, exercising will be more expensive and you may still be tying your money up for many years, and there’s still a significant risk on the startups exit value.
  • If you join a late-stage company (or receive refreshers, bonuses, or other additional shares at that stage), these factors cut in different directions. Exercising will be expensive and there may be significant taxes, but you may have a better idea of when the shares will become liquid — through a secondary, acquisition, or IPO. At the same time, the potential savings from exercising now, as opposed to waiting for an acquisition or IPO, might be smaller, since the shares aren’t likely to grow 100x between now and then.

These are just some of the many factors to consider as you think through the decision of when to exercise stock options and how to do it. We hope they have been helpful, and you should schedule a call with our team if you’d like to work through them together.

About Valur

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