So you’ve just been granted stock options. Your first question might be: How do they work? (We can help with that). Or it might be: When should I exercise them?
Stock options don’t have to be an all-or-nothing decision. When you decide to exercise is entirely up to you. There isn’t a “right” time, and what’s right for one person may not be right for another. By considering your equity in the context of your overarching financial picture, you’ll have a better idea of the timing and tax moves that make sense for your life.
So when should you exercise? The short answer is that earlier is usually better. You’ll generally have lower taxes and better upside with an early exercise, but that's also not always the case. Let’s say you could pay only $20K to exercise early (which, in general, is low, given the average is $500K). But do you have $20K to spare to exercise? Are you ok with that money being tied up for years, or even losing it? You have to understand the risk.
The ideal situation is that you maximize future gains while minimizing tax liability. But to do so, you need to put together a plan before your company IPOs. If you wait until the IPO, you’ll likely miss out on significant tax advantages with your equity.
Let’s dive into some common timing strategies, each with their own pros and cons, to help you understand the options you have, for your options.
Option #1. Exercise early.
Pros: Cost is probably minimal. Tax is probably minimal. Future gains are likely maximized.
Cons: Not all companies allow unvested options to be early exercised. Early-stage companies are risky because your company might not exit. You’re making a bet on a company that may not have product-market fit yet.
Some companies allow early exercising, which means you’re allowed to exercise stock options that you haven’t vested yet. If your company allows you to do that, there are some key advantages, but you should also be aware of the risks.
Exercising your options early typically means you’ll pay lower taxes and get better upside. You’ll want to factor in your company’s 409A — the closer it is to your strike price, the fewer taxes you’re likely to pay. If the 409A is equal to your strike price, you may pay no taxes at all, because your phantom gain is zero. That’s exactly what happens when you’re first granted your stock options, because your strike price is based on the 409A valuation at the time. Then, if you exercise before the 409A valuation goes up, it’s effectively tax-free.
Another consideration is how long you think you’ll be at your current company. If the IPO is looking to be 10 years out, but you don’t think you’ll be there in 10 years, it’s probably worth your time and money to exercise earlier. By exercising early, you become an owner of the stock and can benefit from any future upside, even if you are no longer an employee.
If an early exercise sounds like it might work for your goals, start by verifying that your company even offers this option; not all do. If you are able to exercise early, make it official by filing an 83(b) election with the IRS within 30 days. (If you forget to file it, you may still be taxed when your options vest in the future.)
Option #2. Exercise as your options vest.
Pros: You have a plan. You’re putting money into your exercise plan, so you’re not going to be caught off guard if you unexpectedly leave the company, and will own at least some of your equity. You’re able to adjust your exercise schedule based on the confidence you’re gaining or losing in your company as you go.
Cons: Depending on how periodic it is, such as every month, you could complicate your tax situation. If the 409A changes as your options are vesting (which is likely), your total costs of exercising may become more expensive than you had planned.
If your company doesn’t allow for early exercising, but you still want to take advantage of exercising as soon as you can, you might consider exercising as your options vest. Options usually vest monthly, after a one-year cliff (meaning, nothing vests for the first year), so you could exercise every month or quarter, or at whatever interval makes sense to you.
This may not have a material impact if the 409A doesn’t get updated. But be aware that if the 409A does get updated at least once a year, so this strategy could impact your tax liability if you’re not paying attention to these details.
Or, instead of exercising as they vest each month, you might just decide to exercise a portion several times a year to make sure you’re fully aware of costs and taxes, to avoid any surprises.
Option #3. Exercise a certain portion every year.
Pros: It’s a periodic plan. You’re in control of how much you want to put toward your options. You won’t be caught in a situation where you don’t own anything in a worse-case scenario. You might be more aware of tax implications.
Cons: In a growing company, it will likely cost you more each passing year to exercise. It may take longer to fully exercise all of your options this route if the company keeps growing, due to increasing costs.
Most current employees are likely to have ISOs, which are subject to AMT, but that AMT only triggers at a certain threshold. So, you can exercise a portion each year that is under that threshold to avoid AMT. By having an exercise plan, you can mitigate unnecessary taxes, gain control of your equity, and pull levers in your capability to maximize upside potential. For example, you might exercise each year up to your AMT crossover point (the gap between your current income and amount that would trigger AMT). This can help you avoid triggering AMT. You can find your AMT crossover point with our calculator here.
Even if you don't want to base your decision on completely avoiding AMT, you can have a plan to exercise a portion at a certain time of year, like the beginning of the year to have a clearer understanding of it could impact your yearly taxes, or at the end of the year so you can see what the impact will be (having a better idea of what your yearly taxes will look like).
Option #4: Exercise at least once a year before the 409A is updated.
Pros: You have more control over the cost, since 409As, in general, tend to increase over time. You’ll also have more time to evaluate your company’s prospects over time, while also being more mindful of the tax implications
Cons: The 409A may be updated without you knowing about it, which could result in you getting caught off guard with a higher tax bill. 409As may also be updated multiple times a year, which could throw off your plan. It’s possible the 409A could decrease, meaning you missed out on tax savings.
409As legally have to be updated once a year by a third-party administrator. They’re also updated during any other material event, the most common being a funding round.
Ideally, you want to exercise before the 409A is updated, since valuations tend to increase over time. However, if you exercise after, this also gives you a chance to monitor the company and evaluate what the new valuation means. (E.g., if it’s gone up, outside investors are valuing the company more, or it’s secured additional funding.)
Not all companies communicate impending 409A updates proactively, and there is a blackout period that typically happens when it’s being updated when you won’t be able to exercise. For a funding round, for instance, they may not be in control of timing because a blackout period occurs once they accept a term sheet. And, it’s possible, they may not want news to leak about the fund raise. You may want to ask your equity admin or finance team when the yearly valuation usually occurs, or if they can communicate when a funding round may be happening, as well as when any blackout period happens prior. That way, you can make a decision ahead of time.
Option #5. Wait until your company IPOs (or has a liquidity event).
Pros: This is the lowest risk option. You’re waiting until you have a liquidity event to cash in on your options, so there’s a market to sell your shares and get real value out of them.
Cons: You’re probably minimizing the potential value of your gains, because your taxes are likely going to be the highest with this option. You’re sacrificing career flexibility if you’re planning to stick around until the company IPOs, and may be forced to forfeit them if your employment is terminated before then.
When your company IPOs, you now have the option to performa cashless exercise — where you can buy and sell your options in a single transaction. While this approach comes with low risk because you are selling your shares for a gain, you’re paying the highest possible taxes, eating into your gains. You’ll also lose some flexibility of, for example, having a strategy to slowly sell shares over time or waiting to sell until you’ve hit long-term capital gains.
If you have a tender offer, you can consider taking advantage of the opportunity to sell a certain number of shares at a fixed price during a specific time frame, before the company goes public. This can be a good way to convert your options to cash fairly quickly. Tender offers can be buybacks from the company or outside investors purchasing stock from employees. The most common time this occurs is following the close of a fundraising round.
It’s possible that only employees who have already vested stock options are eligible to participate in a tender offer and/or employees may only be allowed to sell a certain portion of their options. For example, the investor(s) may allocate a certain amount to buy back employee equity during a tender offer. An employee may wish to sell 50% of their equity, but are later told they can only sell 25% due to allocation limits. It’s important to understand the rules and limitations of a tender offer, especially before exercising. The risk of a tender is that you are selling those shares and won’t be able to sell them later if the company experiences a more favorable exit event.
Cashless might be a strategy to consider if your company provides tender offers during or following new fundraising rounds. We have had a few clients utilize a cashless exercise and sale strategy to get liquidity during a tender. If your company does not offer tenders, it’s important to note that cashless is only available after the IPO happens. But note that this situation is what often leads to “golden handcuffs,” where employees may be ready to make a career move but feel stuck because they want to exercise their equity yet are unable to afford it. (Note: With a tender, it’s more likely your company can support the cashless exercise. On a secondary, in which you find your own buyer, it’s much less likely your company would support it.)
Option #6. Exercise when you’re leaving.
Pros: You’re able to own the stock and benefit from any future upside of the company. You have a plan. When you’re leaving a company, you can make a more informed decision, because you have insight into the company and how it may perform in the future.
Cons: The cost could be more than you were expecting or you could have a t, a surprise tax bill. There’s usually a limited window of 90 days to come up with the cash to exercise. You’re losing the flexibility factor..
As long as you understand the risks of this plan, this strategy can work for you. The cost to exercise is not static, so it can be hard to predict what it will be whenever you decide to leave. You must also understand what your Post-Termination Exercise Window is. Typically, you only have 90 days to exercise when you leave, although your company may offer you an extension. If they do, the most important thing to remember is that there is still a 90-day window before your ISOs convert to NSOs (which aren’t as advantageous from a tax standpoint).
But the advantage of this strategy is that you can make an informed decision about exercising, because you’ve been working at the company and have insight. And the reason you are deciding to leave could also inform that decision — if it’s just a career move or due to concerns about the company. But, sometimes the decision to leave is not in your control — due to layoffs or for sudden personal reasons — so, again, this strategy could catch you off guard.
Option #7. Take an extended exercise window.
Pros: Gain flexibility over the decision to exercise. You don’t lose it, so you’re not forfeiting anything yet.
Cons: You may not understand the conversion of ISOs into NSOs and the resulting tax implications. You no longer have an insider knowledge of what’s going on with the company, so your decision to exercise may be less informed.
Extended exercise windows are not offered at every company, though they are becoming more common. Taking the window means that you don’t have to make a decision within 90 days, especially if you are leaving involuntarily. It allows you to have more time to consider what you want to do with your stock options instead of making a decision because you have to within a certain time frame.
But there are some disadvantages to this strategy. For one, ISOs, which are taxed more favorably, are converted to NSOs after 90 days. Of course, if it’s between the conversion and forfeiting them, the conversion is likely the better choice. You’ll also no longer have first-hand knowledge about the company and its trajectory.
While you may forfeit the tax advantages of ISOs when your options convert to NSOs, the longer timeline can minimize your risk and still allow you to financially benefit if the company does exit during this period. Since your options have become NSOs, income taxes will apply upon exercising your options, therefore you may be forced to do a cashless exercise and sale. If there is a high uncertainty about your company’s future exit prospects, this strategy may be a good option for you to consider.
Without an early exercise, you may not completely minimize taxes or maximize value. But our goal is to find the right fit for you and help you navigate risk, tax implications, and upside gain.
Bottom line: you don’t have to exercise all at once. Just exercise what you can afford and what you think is worth it. A financial advisor can help you figure out an exercise plan that works within your financial goals and boundaries to still minimize taxes and maximize gains. We’re here to help you evaluate your timing options, how they fit into your broader goals, and how to go about exercising in whatever way works best for you.
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