Private company stock options
August 27, 2018 5:43 AM   Subscribe

Help me understand whether it is worth exercising private company stock options.

I have a small amount of unexercised stock options through my employer, a small venture-backed startup. It would cost me a few thousand dollars to exercise these. According to the 409a fair market value, they are worth a few thousand dollars more than the cost to exercise. But this is a private company and there is no active market in its stock. To my knowledge, there are no plans for an acquisition or IPO in the short term.

If I were to quit or be fired (I'm not planning on either), I'd have 30 days to exercise the options. Would it make sense to do so? What are my chances of getting something like the 409a valuation for my shares? What are my chances of selling them at all? To whom would I sell them and how would I find that buyer?

Some articles I've read say that sometimes a company will buy back the shares. But it seems like they'd have little incentive to do so if I'm no longer at the company. Does it make sense to exercise the shares now and try to get the company to buy them back while I'm still working there?

I'm generally a risk-averse person and my instinct would be to let the options expire and walk away. But if there is a relatively painless way to turn these into a little money, I'd feel dumb if I didn't do that.
posted by anonymous to Work & Money (13 answers total) 1 user marked this as a favorite
Not a tax lawyer thus not yours but do take care that once exercised you own the value and may owe tax on that value. It may be worth an actual tax lawyers opinion.
posted by sammyo at 6:04 AM on August 27, 2018 [2 favorites]

It's not a very satisfying answer, but, it depends on what you want and on your company's particular financial situation and future. Some people like to exercise their options and own their shares because it gives them a greater sense of ownership in the company (and it certainly brings with it the security that if you are terminated, voluntarily or involuntarily, you aren't losing your stake.) But liquidity for your stock outside of a public offering or an acquisition is likely to be very low. Because companies are often opting to stay private for longer these days, there are some cases of secondary transactions where you may be able to sell shares (during fundraising rounds, etc.), but I don't really know how realistic a scenario that is for you. I would expect your shares to stay pretty illiquid in the near term if you were to exercise and purchase.

The tax implications that sammyo refers to may also be significant and are worth investigating.
posted by Kosh at 6:06 AM on August 27, 2018

As mentioned above, if there is no open market for the shares then this isn't really a financial decision so much as an emotional one. Unless you have an explicit buy-back scheme, you really have no way of converting shares into cash - so assume that you will make no money back any time soon, and there's a good chance that any shares you hold will end up worthless.

In short then, you've got to ask yourself which matters to you most. The shares are your stake in the company - what does that stake mean to you? If it represents a sense of ownership that you feel like you've earned, then you may feel better not sacrificing it. If it represents a low but possible potential to generate a large return on investment, then you may also feel like it's worth keeping. How much do you want to gamble on your company's future? Are those factors worth the potential loss of the cash paid upfront to exercise the shares?

Also, don't underestimate the tax implications and research this thoroughly - as noted, you could owe tax on the shares despite having no ability to sell them.

For what it's worth, I worked for a start-up for a number of years, and decided to exercise my share options on leaving. Based on the valuation of the company in the latest funding round, my shares are theoretically worth three times the exercise price. But with no market for shares that value is entirely theoretical and really shouldn't be taken too seriously. What it comes down to for me is that I'm prepared to lose my initial outlay because maintaining a stake in the company I helped build is more important to me than cash lost. Also, due to the nature of the share option scheme, I only pay tax on the eventual sale of the shares, so I was free from a tax point of view.
posted by iivix at 7:01 AM on August 27, 2018

One reason to exercise now might be that the tax implications of exercising the options may get worse in the future; the valuation of the company will probably go up. So exercising now and paying taxes on the smaller value gain may be worth considering.

All startups end. If you run out of money and it shuts down the shares are generally worth nothing. If you get acquired or ipo you can convert the options at that point and pay nothing out of pocket (assuming they’re not underwater). But if you leave the company or the options expire then you have to decide if you want to buy or walk away.
posted by jeffamaphone at 7:10 AM on August 27, 2018

Exercise of ISOs are used in AMT calculations. So if you are close to or are within the AMT range, the "bonus" gain over the exercise price (409a value minus exercise cost) is used to calculate the AMT owed.

In that situation, you essentially pay taxes on a fictional gain with quite-real money. You can look at this as an extra cost of owning the shares, if you want.
posted by Dashy at 7:57 AM on August 27, 2018

One reason to exercise now might be that the tax implications of exercising the options may get worse in the future; the valuation of the company will probably go up. So exercising now and paying taxes on the smaller value gain may be worth considering.

(IANATL, and this subject is a little tricky.) There's going to have to be a realization event to turn those shares into $$$ regardless, though, which means you are going to be paying taxes on the total gain sooner or later regardless. The only way this makes a difference, then, is if the gain is somehow taxed differently before and after exercise (or maybe if you die; I haven't looked into if there's a special basis treatment for inherited ISO shares--probably not?).

If this is an ISO, a qualifying disposition (basically a sale more than one year after exercise and two years after grant) is taxed as a long-term capital gain on the difference between the strike price and the market price at sale. That means that the market price at exercise is basically irrelevant (except for the weird AMT issue flagged above). The IRS doesn't tax the gain differently depending on whether it occurred before or after you exercised the option.

For a nonqualifying disposition, the difference between the strike price and the market price at exercise is taxed as ordinary income, and the difference between the market price at exercise and at disposition is either a long or a short term capital gain. For most people, then, you will want the market price at exercise to be as low as possible, because most people pay higher taxes on their ordinary income than on their capital gain income.

NSOs are basically treated like nonqualifying dispositions of ISOs.

The ISO tax treatment is a BS giveaway, but what can you do?
posted by praemunire at 8:25 AM on August 27, 2018

The ISO tax treatment is a BS giveaway, but what can you do?

Not exactly, as far as the IRS is concerned. The difference is who pays the tax.

For a NSO, the employee pays the tax and the company gets an expense deduction. For an ISO, if held for at least one year, the employee gets the advantage of the long term capital gains tax. But in that case the company doesn't get an expense deduction and pays more corporate income tax. They sort of balance out.

For an ISO, it to the advantage of the employee, but the disadvantage of the company, tax-wise. It's comes down to a decision of how the company prefers to compensate their employees. To the IRS, it's sort of a wash.
posted by JackFlash at 9:13 AM on August 27, 2018

Not to the shareholders, though!
posted by praemunire at 9:32 AM on August 27, 2018

It's still pretty much a wash. The company first decides how much total it is willing to spend on compensation, including taxes. It can then choose to give fewer ISO shares and pay more corporate income tax or choose to give more NSO shares and pay less corporate income tax. After all taxes are paid, it's close to the same for both company and employee and the IRS.
posted by JackFlash at 9:44 AM on August 27, 2018

No, because in actual practice compensation doesn't work that way ("here is a maximum amount, how shall we split up the components, it's all economically the same"). The decision is being made by a self-interested agent who has certain incentives and operates under certain constraints that don't apply equally to all forms of comp.

But I guess we are getting way off topic, so I'll leave it at that.
posted by praemunire at 9:50 AM on August 27, 2018

Not going to talk about taxes. Effectively you're being offered a low price on a wager regarding the companies future. You have to decide if that wager is worth taking, there's no hard and fast rules. Depending on the company, there are secondary markets where you can sell private shares (usually the company has right of first refusal).
posted by so fucking future at 11:58 AM on August 27, 2018

Some things you could do to get more information:

- find out if your company put transfer restrictions on your stock options (limiting your ability to sell them). If so, it might be hard / impossible for you to sell the shares.
- find out how much it will actually cost to exercise, including taxes, like everyone mentioned above. This is really confusing but your coworkers might have exercised and might know.
- if you feel comfortable, ask your company's execs why they chose to make options expire 30 days after quitting. That's a pretty employee-unfriendly policy (even though it's relatively standard) and it might be worth asking if they'd consider changing it. For example see this article about Pinterest changing their policies. There's a guide to helping employees keep their stock options which some more companies have been using.

If after all that you do want to exercise and you think the value of the company will increase, it might make sense to exercise now because it means you'll owe less taxes than in the hypothetical future where the company is worth more.
posted by oranger at 9:13 PM on August 27, 2018

If you’re risk averse just stay clear of the whole thing. It’s called "The Stock Option Lottery" for a reason.

To give you a depressingly typical example, I was an early employee at a company that was later sold for $170,000,000. The stock the founders and executives had options on was priced nicely and they all made out. The common stock, which is what all the other employees had options on, was valued at: $0.00 . So everything can go swimmingly, the company can thrive and get sold, and you may still be out the money.

This isn’t to knock stock options entirely, but if you’re truly risk averse then put your money in an index fund instead.
posted by Tell Me No Lies at 9:44 PM on August 27, 2018

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