So, you were hired at a startup. The company is growing fast, and people tell you how the equity can make you rich. Just look at all the wealth created by mega-IPOs like Uber and Lyft.
Not everyone at a startup has enough equity to become a millionaire, and not every IPO is as large as Uber or Lyft, but your equity can still be a very impactful source of wealth if things go well. On the flip side, if things go poorly, your equity may be worth nothing at the end of the day.
Given the two sides of the coin and the fact that equity must be earned via employee tenure and purchased through a stock option exercise, it begs the question: when does it make sense to pay up and exercise my stock options?
Ultimately, you should have confidence in the company’s future before exercising. If you are confident in the company, there are several reasons to exercise your options at various times.
Whether you are approaching an expiration date, considering early exercise, or looking to reduce your tax burden, understanding these elements will help you make a well-informed choice.
Reasons to Exercise Stock Options
Expiration is Imminent
When you leave a startup, you typically have 90 days to exercise; otherwise, your options will expire. The possibility that your hard-earned equity could cease to exist is a great reason to consider exercising your options. For ISOs, that 90-day window is required. If you have NSOs or get an NSO Extension, your expiration date can be extended beyond 90 days.
If you remain employed at the company, your options should not typically expire until 10 years after they were granted. However, if you are ever exploring a career change, it is essential to consider exercising your options, as you will eventually trigger your expiration if you decide to leave. Your stock options or “golden handcuffs” can be used as leverage when negotiating salary or stock at the new job.
Even if you don’t expect to leave any time soon, there are still reasons to exercise, even if expiration is not yet on the table.
Exercising Early
Some companies offer the ability to exercise unvested stock options early, which can result in significant tax savings. Early exercise can allow you to take advantage of paying zero or minimal taxes at the time of exercise and start the clock on long-term capital gains for options that have yet to vest. However, it’s essential to understand the implications if you do not vest these options, as most companies will buy back the shares at cost.
If you do the early exercise route, we recommend Filing an 83(b) election with the IRS within 30 days of your exercise. This will save you money on taxes as you vest.
Reducing Taxes
Minimizing tax impact is a common reason to exercise stock options. Strategies such as triggering long-term capital gains, exercising a Qualified Small Business Stock, exercising before a significant rise in valuation, and managing Alternative Minimum Tax (AMT) liability are crucial considerations.
Proper planning can result in substantial tax savings, but it is not always worth risking the cash to save on a tax bill. You must weigh potential tax savings versus the risk of losing your exercise money.
Factors to Consider Before Exercising
Belief in the Company
Your decision to exercise should be grounded in your confidence in the company’s future success. At a startup, this means believing the company will eventually exit through an IPO or M&A. To make money from your investment, this exit also must be at a higher value than your strike price.
Alternatively, you can get liquid while the company is still private via a secondary sale or tender offer. This pre-IPO liquidity is typically only available to hot companies on track for a future exit event. Ideally, you invest in the company because you believe a profitable exit is in the cards. Any pre-IPO opportunities to sell should be treated as a bonus, not a given.
Financial Risk
Evaluate how much you can afford to invest in exercising your options. This includes considering the cost of the possibilities, potential taxes, and the risk of losing the investment if the company does not perform as expected. It is also worth considering opportunity cost: are you better off buying Apple stock? Or paying down your mortgage?
When you exercise, you must pay the strike price per share. If the company’s Fair Market Value has risen since your grant date, you may also owe taxes on the exercise. ISOs are taxed via Alternative Minimum Tax, aka AMT, and NSOs are taxed as regular income withheld by the company during exercise.
Determine if the exercise makes sense for you and how much you can afford to exercise. It is worth exploring financing options like ESO Fund to cover costs if they are too steep. Ensure you have a clear plan for managing the financial risk.
Conclusion
Exercising stock options can be a valuable wealth-building opportunity but doesn’t come without risks. Making informed decisions based on your belief in the company, understanding costs, and financial planning is essential. By following this guide, you can confidently navigate the complexities of exercising stock options.
