Do I exercise my options early if I have the choice?
February 5, 2009 7:03 AM   Subscribe

Did you work for a startup and exercise your options early?

I work for a young company. A good one with a bright future. I have the option to exercise my options early. I plan to stay there for a while, and am in no rush to do this. Just curious. I've googled this, searched all previous info on AM, but really can't quite figure out the "if x then y, if not x then z" scenario that would help one decide if exercising early is the right choice.

Did you? Did you not? Why, and did it work out how you planned?

(Sorry for the anon, but my coworkers read a.mefi and this is my personal concern, not theirs.)
posted by anonymous to Work & Money (11 answers total) 3 users marked this as a favorite
 
Best bet is to talk to an accountant; my recollection was that early-exercise avoided long term capital gains taxes, but this is really only relevant if your company goes public. Since we're in the middle of the worst IPO season in years, I'd be extremely leery of counting on a public offering to happen with enough of a time window to make the tax savings worthwhile. Also, be aware that you will likely be locked out for the first chunk of time after the IPO event.

Your options may have additional value if there is a "change of control" event, but in that case it's extremely hard to predict what that would be.

If there is a significant amount of money involved here, I'd seek professional advice, etiher through a financial planner or accountant.
posted by jenkinsEar at 7:12 AM on February 5, 2009


jenkinEar is right. Consult a CPA. Long term capital gains taxes are actually lower than short term capital gains taxes, but there's lots of factors that come into play like AMT.

A CPA will be able to walk you through all of the various scenarios and you can decide which makes sense for your situation.
posted by dejah420 at 8:08 AM on February 5, 2009


IANACPA, but I've dealt with and thought about employee stock options.

I assume you're talking about exercising the options and holding on to the stock in a pre IPO company.

The only real benefit for this is to avoid short term capital gains tax (not long term as jenkinsEar says) on the increase in price between now and the time you would have exercised them anyways. This can be significant if you're in a high tax bracket. There's another possible benefit in that you become an actual shareholder in the company, but I don't know what the significance of that would be in a private company.

The problem with this is if the company does not IPO, you're stuck with an asset that might be pretty hard to sell, reducing it's value. Check the paperwork with the options, the board might be willing to buy the stock back at the last established price.

This only makes sense if you have enough cash to pay to exercise the options and to pay the tax that you will owe based on the difference in current price and your exercise price.

If you do exercise early, keep good records. You're probably on a vesting schedule and figuring out which of 5 different cost bases, the stock you sold has is a pain.

I would say if exercising will take a big bite out of your available cash, the hold off until an IPO or buyout is at least imminent.
posted by jefftang at 8:13 AM on February 5, 2009


I early excercised and it worked out great. But my company offered this as an option right before the IPO so there was no doubt it would go public. Plus the strike plus was really low, so it wasn't a big outlay.
The one thing to watch out for if it does an IPO and you early excercise is watch out for the AMT (ie talk to a tax person). You can do what's called a form 11b. I won't get into all the details as it may not apply, but make sure you have this angle covered/understood.
posted by alkupe at 9:03 AM on February 5, 2009


I am not a/your financial advisor.

There's no reason, IMO, to exercise stock options before you have an opportunity to sell, either because your company is public or someone has taken a significant financial stake- neither of which seem to be the case here. I'm assuming that this is also not a life-changing amount of money (yes, yes, your company could always hit 200 on the NASDAQ, but let's be realistic), or you wouldn't be asking here.

What you'd be doing, as jefftang noted, is buying something that you'd have a very hard time selling. Any tax benefits you might gain need to be weighed against this giant risk.

Also, if you have Non-Qualified Stock Options, there are additional tax liabilities that you need to be aware of. I can't recall the details off the top of my head, but I think you treat the spread between your strike price and fair value at the time of exercise as immediate capital gains. So, in a nutshell, if your strike price is $.10 and the accountants say your share is currently worth $1, you'll immediately have to pay capital gains tax on $.90. This is why many people advocate a "cashless exercise" for NQSO's, where you exercise and sell at the same time, so you have the cash on hand to cover your tax liability.
posted by mkultra at 9:11 AM on February 5, 2009


I'm assuming you're talking about an 83(b) election. Here's how I consider these (note, I am not a tax guy):

if ( value of stock - purchase price ) * number of share to purchase < 10% ann. income

and (purchase price * number of shares to purchase) < 5% ann income.

and you think this is a good way to spend ~ 5% of ann. income

then go for it.

The first rule says "will the tax hit be minimal?" and the second says "is the out of pocket expense manageable."
posted by zippy at 11:17 AM on February 5, 2009


What are you looking at as the upside here? Possible tax savings? I ask because the downsides seem material:

- you exercise, you are buying stock that there is effectively no market for. So cash out for you, and now you have some stock.
- There are all sorts of things that could happen to your stock, no matter how bright your company's future. Many of these things could happen to your options, but you don't have to pay anything to keep your options. Additional equity investment results in further dilution, company fails leaving you with nothing, etc.

The only thing I can think of is besides the tax issue, is that if you somehow ended up with some unrestricted stock...and the early exercise lets you accelerate your vesting or something, that somehow, in an acquisition scenario, you avoid the acquiring company negatively changing your existing vesting schedule...but I think they could achieve the same thing with some sort of lockup, so...that might be moot.

An 83b election is another story, but just early exercise in a young, gonna-be-private-for-the-forseeable future...I just don't see what the win here is. I'm not saying there isn't one, but what is it? Also, it would probably help more-informed commentors if you could explain your options a bit more: ISOs, what..? These things have different tax treatments. The main reason you hear about people exercising options in a startup is because they _are_ leaving and they have ISOs with an expiry set at 90 days from leaving the company or something.
posted by jeb at 12:11 PM on February 5, 2009


Buy and hold or buy and sell?
Qualified or non-qualified?

If you plan to buy and sell then wait to the last minute or a stock price peak obviously.

If you plan to buy and hold and these are qualified options it becomes more difficult to decide. The tax is long term capital gains and comes due when you sell the stock, as long as you have held it for a year. Unfortunately, it frequently triggers AMT which for many people has an effective tax rate of 35% due to the way the deduction phases out. This is due when you exercise and you have to come up with the cash on your own. The AMT preference is the difference between the strike price and the trading price at the time of exercise so exercising early reduces your AMT. You theoretically get it back, but in practice you almost never do unless this is truly a one time event and your income is not too high.

Another thing to consider, in the near future there is a real prospect that the AMT will be reformed so that it is truly aimed at higher earners but also that the long term capital gains tax rate may rise.
posted by caddis at 12:29 PM on February 5, 2009


I worked for a young company -- a good one with a bright future. I exercised my options early so as to avoid AMT.

This year the company finally liquidated. It's been 7+ years, so I'm having trouble finding the paperwork of my early exercise so I can write off those worthless options.
posted by rr at 1:45 PM on February 5, 2009


btw, in the interst of being less cynical.

I am not a financial advisor, but most of them are borderline scam artists. These are opinion, probably completely wrong and not intended to be advice. Do whatever you want.

You need to get the specifics of the options type

Early exercise can be very overrated. AMT is not desirable if you have any kind of lock in but depends on the option type (ISO vs. NQO). Likewise, for most employees, we are going to be talking NQO: NQO option income in general is W2 regular income, not a capital gains. You CANNOT get capital gains taxation with NQOs -- people who talk about doing it via sell to cover or holding the shares are merging two entirely separate transactions, the original tax on income is still owed (and people _can_ and _do_ make incredibly bad decisions due to this: for example, doing a sell-to-cover and then holding shares that they then ride down, only to discover they owe a pile of taxes the next April that they now cannot cover).

IPOs are basically done for the time being, leaving acquisition as the main exit strategy. Acquisitions are going to be way down over the next few years. Unless you are a spin in or funded by a corporate entity, I would be very cynical about the opportunities for conversion of the options to something you can sell for the near future.

Be careful and defensive.
posted by rr at 2:04 PM on February 5, 2009


What RR is talking about _really_ screwed a lot of people in the 90s. People...they really make bad decisions.
posted by jeb at 3:16 PM on February 5, 2009


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