Like any investment, exercising employee stock options involves risk. In fact, there’s risk on both sides of the decision — you take on risk when you decide to exercise, but you could be taking on even greater risk if you decide not to exercise.
Before exercising your stock options, you’ll want to understand and consider those risks to make an informed decision about when, how (and if) you plan to exercise. Of course, each person weighs risks differently, and some of the following risks will apply to you, while others might not.
We’ll lay out the five most common risks here, with the caveat that it’s always best to consult with a financial professional before making a decision about what to do with your stock options.
Risk #1: Abandoning your stock options
Startup employees abandon billions of dollars worth stock options every year. In 2008, for example, Tesla employees gave up 2.8 million shares of stock just 2 years before the company went public — at an average exercise price of only 73 cents per share. Today, those shares would be worth tens of billions of dollars.
Of course, hindsight is 20/20 and we’ve all heard stories about people that missed out on lucrative investments. When it comes to stock options, there are typically two main reasons employees leave their equity behind:
- It was a conscious decision: They didn’t think their company would succeed, the risk was too high, or they didn’t want to pay the cost of exercising.
- They were forced to abandon it: They weren’t aware they had to pay for their stock options or couldn’t afford their options.
Many employees find themselves in either position when they are leaving their company. Often, it’s because they don’t build a plan for their stock options before they leave their job. Most companies only offer 90 days for employees to exercise their stock options, which isn’t much time to make a major financial decision. Even more so when you’re unaware of that deadline.
Unfortunately, many people abandon their equity because they just can’t afford the cost of exercising in a short amount of time — even if they’re bullish on their company’s future.
Risk #2: Not understanding the tax implications of exercising
You may know how much it costs to exercise your vested stock options. But do you know what the tax implications are? Many people don’t, which makes sense, because most of us aren’t financial or tax experts. Compounding the problem, most startups still don’t do a good job explaining to their employees how stock options work.
Some people exercise their options and end up being hit with a surprise tax bill they can’t afford. In fact, this was the position Secfi’s co-founders found themselves in after selling their previous startup, and what led them to help other startup employees better understand their equity.
Taxes typically make up the biggest cost of exercising stock options. In 2021, taxes accounted for 73 percent of the average exercise cost among Secfi’s customers. Plus, you are responsible for calculating and paying taxes, not your company. Even if your equity management platform estimates your tax liability, it’s still your responsibility to make sure that amount is correct and to pay the tax.
You should always make sure that you both know your tax liability, and that you can pay for it. Getting hit with a surprise bill when you file your taxes is not a situation anyone wants to find themselves in.
Check out Secfi’s free Stock Option Tax Calculator to get an accurate estimate of your stock options-related taxes.
Risk #3: Your company fails
This is the risk that most startup employees are worried about: “What if my company doesn’t make it?”
Taking a bet on your company is always a risk, and it’s true that many fail. While it’s more common for earlier stage companies to go under, there are plenty of well-positioned, later-stage companies that don’t exit.
Of course, going out of business is just one way to “fail.” Your company could be acquired, and the terms of the acquisition could not be beneficial for employees. There are many different types of acquisitions and each will impact your equity differently. An acquisition can be an opportunity to cash in on your equity, but it really depends on the terms of the deal being made.
Your company could also go public but at a lower price than what you paid to exercise. Of course, you can always hold onto your stock (and it may not be a bad strategy — though your financial planner can help you) but it’s possible your company may never reach, or exceed, the price point you paid for your stock. This would put your stock underwater, though there could be tax strategies you could use to minimize your losses — a silver lining, though an admittedly less-than-ideal one.
An unknowable future shouldn’t necessarily discourage you from exercising, but it’s important to understand the risks of making an investment in your company.
Risk #4: Waiting too long — or waiting for an IPO — to exercise
Waiting too long to exercise your stock options — even after an IPO — carries risk. There are two main reasons for this.
First, many employees wait because the risk their company won’t exit is greater the younger the company is. By waiting to exercise, they hope to see the risk of company failure decrease, while the chance of a successful exit increase. Which, in general, is likely true. But waiting could also dramatically increase the cost to exercise because the more valuable your company becomes, the bigger your tax burden will likely be when buying your options.
If you’ve ever heard the term “golden handcuffs,” this is the scenario it’s referring to. Many startup employees wait until they view an exit as likely, only to realize that they can’t afford the cost of their stock options. So they feel that they must stay at their company, even if they want to leave, because they don't want to forfeit their equity.
The other reason waiting carries risk isn’t due to losing stock options, it’s losing the potential for more upside. Since the cost to exercise often increases over time, or employees just don’t want to risk exercising before an IPO, many just wait. After the company goes public, they can do what is called a cashless exercise. In this scenario, they are effectively exercising their stock options and selling them in a single transaction. It’s “cashless” because they don’t need to pay anything out of pocket.
Doing a cashless exercise also comes with the highest possible tax rate — up to 52% vs. 37%. That’s because you’ll be taxed at ordinary income tax rates between the strike price and the price you sell the shares for. If you exercise your options and hold them for at least one year (and in the case of ISOs, two years after being granted the options), you’ll be taxed at long-term capital gains rates when you sell, which have much more favorable rates.
Of course, there are plenty of reasons employees may choose to wait until an IPO to exercise, and they could still see favorable upside gains. But it’s important to know the risks of waiting.
Risk #5: Not having a plan that takes risk into account
Many of these risks can be summed up as “not having a plan for your stock options.” Many people find themselves in these situations because they didn’t understand their stock options, or they didn’t have a plan in place for their equity.
While any good plan should take into account minimizing tax liabilities and maximizing upside potential, those shouldn’t be the only factors that go into the decision to exercise.
Again, exercising always carries some risk, and managing those risks should be part of your decision.
Some people are more comfortable taking big risks, while others are more conservative. But a common risk those risk-takers make is exercising their stock options with the assumption that their company will definitely IPO, and at a sky-high price.
We’ve heard stories of employees exercising, knowing they had a sizable tax bill, but were certain they’d be able to pay it with proceeds from selling their public shares. Nobody can predict an IPO, and many companies delay IPOs for various reasons (and they’re not always bad reasons). Maybe there are too many IPOs happening and they want to wait for a better time, or they just don’t need the capital they’d raise from going public and decide to hold out a bit longer. Assuming something that is out of your control could spell disaster.
Similarly, employees have taken out risky loans, like home equity lines of credit (HELOC) because they’re convinced about their company’s trajectory and therefore assume the risk is minimal.
A good equity plan always needs to account for what you can control, and what you can’t. Just like any investment. Assuming you’ll be able to pay the sizable AMT tax bill with the proceeds from an IPO you are sure will happen this year can get you into trouble if your company’s timeline isn’t what you thought it would be.