Part 3: FAQs on the Menu of Startup Stock Option Exercise Strategies
Wondering when to exercise stock options at a startup? Here's the menu of startup stock option exercise strategies including early exercise of stock options and extended post-termination exercise periods. Plan ahead to protect your equity stake. Photo by Kaboompics.com.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
When to exercise stock options?
Thanks for the great feedback on this post: The Menu of Stock Option Exercise Strategies. I’m delighted that people are using it to plan their startup stock option exercise strategies at the offer negotiation stage to save themselves from the unhappy surprises associated with startup stock options.
I’ve had some great questions on the menu and wrote this Q&A in response. Enjoy!
Why don’t you talk more about Incentive Stock Options (ISOs)? The recruiter told me not to worry about my startup stock option exercise at hire because the options are ISOs.
Founders, recruiters, human resources employees and hiring managers often use the “ISO status” of startup stock options to obscure this issue and falsely reassure hires to get them to sign offer letters without a viable option exercise strategy in place.
There are some benefits to Incentive Stock Options. These are relevant if you are following the exercise as you vest strategy or the exercise at termination of employment strategy. The basic difference is that gains on exercise of ISOs are taxed at AMT rates and exemption amounts rather than the ordinary income rates that apply to NSOs. However, this ISO benefit does not change the fundamental risk associated with startup stock options: If the FMV increases dramatically during your employment, the tax cost to exercise can make exercise impossible even with ISOs! More here on this $1M problem.
Why do I need to plan for this at the offer letter stage? Wouldn’t the company want to “help” me avoid forfeiting my vested startup stock options by extending the post-termination exercise period if I leave the company?
The post-termination exercise deadline is not often changed after hire. If an individual does not have (or press) the negotiating power before they join to inspire the company to extend that deadline, in the vast majority of cases they will not have that power at the time of termination or resignation.
My clients often hear founders declare at hire that their companies could not possibly extend the post-termination exercise deadline in the original option contract. In the next breath, those founders promise that their companies would “of course” extend it in the event of a termination or resignation. This is not, in my experience, a realistic promise.
Why? The “company” in this context is the venture capitalists who likely control its board of directors or the law firms who protect their interests. The post-termination exercise deadline is, from their perspective, a feature not a bug. When companies make offers, they assume that only a small fraction of vested options will be exercised (in large part because of these early termination features). Since this is part of the venture capitalists’ economic calculus and method of maximizing returns for their investors, they’re not in the business of helping people out of it.
Why do I need to plan for this at the offer letter stage? The company promised they will let me sell some of my equity stake each year through a tender offer.
You will almost certainly not get a written commitment from a company for a right to pre-IPO sales. Access to an employer-sponsored tender offer will depend entirely on a company’s decision to arrange it, investor interest to fund it, and a company’s decision to let any individual take part in it.
When tender offers are available, they are almost always limited to some small percentage of vested holdings. Given this limited liquidity, most people who have the opportunity to sell a portion of their shares in a tender offer do not use the funds to exercise the remainder of their options. They could, but they do not.
Why? Once those funds are in the bank, these individuals immediately start to think of the funds as “my money.” It seems to them too risky to take funds that they want to use today to buy a house or diversify their portfolio and invest those funds in the exercise price and associated tax bill to exercise their remaining options.
This is a personal choice, not right or wrong. I’m offering it here to show what I have seen as a common phenomenon. Individuals are faced with the problem of a huge expense in front of them to exercise their vested options and pay the taxes associated with the exercise. What happens in practice is that if they do successfully cash out some of their shares, they keep the money and are left with the remainder of their options still subject to forfeiture. Then they encounter this forfeiture problem when they either (1) are subject to option early expiration at termination of employment termination or (2) the approach of the end of the original, non-extendable, 10 year term of the option.
Why do I need to plan for this? I’ve heard there are “services” who will help me sell my equity stake on the secondary market or offer me a non-recourse loan to exercise when I get in this situation down the road.
This method is rarely available. Why? A lot of reasons. Here’s a few:
Investor interest is limited to a few choice companies.
Information asymmetry.
Company transfer restrictions (which also apply to loans in most cases).
For those who are able to access these sources of pre-IPO liquidity, in spite of these and other challenges, they only operate as a “service” for those who have time and other good choices on their side. Those who are caught without time and other good choices will see offers of deal terms that are obviously made with that vulnerability in mind. Calling this market an option exercise strategy would be like calling a payday loan a monthly budget.
Happy strategizing!
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Part 2: The Menu of Startup Stock Option Exercise Strategies
Wondering when to exercise stock options at a startup? Here's the menu of startup stock option exercise strategies including early exercise of stock options and extended post-termination exercise periods. Plan ahead to protect your equity stake. Photo by Ali Pazani.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
When to Exercise Stock Options?
Before you accept a startup stock option offer, you will want to have a strategy in place for exercising the options. This will save you from the unhappy surprises associated with stock options, such as forfeiting vested options, golden handcuffs, or unnecessary tax expenses.
There’s not a one-size-fits-all strategy, but there is a menu of choices.
Strategy #1: Exercise Startup Stock Options at Liquidity
The default for most startup employees is to wait to exercise their stock options until the company is acquired or they can sell the shares (such as after an IPO). They simply exercise the options and sell the shares on the same day.
The benefit of this default is that they have no out-of-pocket expense to exercise or pay taxes on the option exercise until they are certain they will have a market to sell those shares. It’s a no-risk choice from that perspective.
One downside of this strategy is that a same-day exercise and sale would tax your gains at ordinary income tax rates.
Another downside of this strategy is a lack of career mobility. At most companies, options expire within 3 months of termination of employment. If you are waiting on an exit event to exercise your options, you may be stuck at the company until that exit event occurs.
If you leave the company voluntarily or are terminated by the company before an exit event, you may be forced into exercising your options prior to liquidity or forfeiting the options when they expire. In addition, options have a final expiration date - usually 10 years from the date of grant. This seems like a long time, but occasionally companies do not have an exit event in this timeframe. This forces the employee to exercise prior to liquidity or forfeit the options when the expire.
One variation of this strategy is to negotiate for an extended post-termination exercise period for the options. If you have, for instance, the full 10 year term of the option to exercise regardless of your termination date, you can use this strategy and still be free to leave the company without forfeiting your options. More on that here.
Strategy #2: Forfeit Vested Startup Stock Options by Not Exercising
Most startup employees do not exercise their options if they leave the company before an exit event because they do not want to invest the exercise price and tax cost and risk losing that investment. Therefore, forfeiture is probably the second most common option exercise choice for startup employees. Why?
All options have a final expiration date, which is usually 10 years from the date of grant. Most options also expire earlier at a termination of employment. The standard is that employees have 3 months after termination of employment to exercise their options. An expiration date is a forfeiture date. If the option that is not exercised before it expires is forfeited and the option holder can never purchase the shares underlying the option.
A private company employee facing an expiring option has to make their investment in the shares before there is a public market for those shares. I call this the $1M problem because I regularly get calls from startup option holders who need to come up with $1M to exercise their options and pay the tax cost of exercise. The exercise price of an option may be quite high in itself, especially for an employee who joins later in the startup’s growth. It is the tax cost of exercising, though, that prevents most startup employees from exercising their options.
Strategy #3: Exercise Startup Stock Options at Expiration, Before Liquidity
Not all startup employees forfeit their options if they leave the company before a liquidity event. Many invest the exercise price and pay the associated tax cost when they leave the company so they can acquire the shares they worked to vest.
The exercise of an option is a taxable event, so the option holder recognizes taxable income based on the difference between their exercise price and the FMV on the date of exercise. That might be taxed as AMT for ISOs or as ordinary income for NSOs. Either way, it can result in tax bills in the millions of dollars for the exercise of a valuable option. More on that here.
The tax on an option exercise is due whether or not there is a market to sell the shares to cover the tax bill. Some people call this “phantom income” or a “dry tax charge,” but it’s very real. I’ve heard horror stories about people losing their homes (and moving in with their in-laws) because they exercised their options and incurred this tax expense but did not have a market to sell the shares. In some cases, those shares later were cashed out at a high value in a company exit event which in the end made the risk of investing the exercise price and tax bill a very wise choice. Sometimes, though, the investment of the exercise price and tax bill is lost, since the shares can end up either being worth less than the exercise price or worth less than the taxable value of the shares at exercise.
To avoid this scenario, some startup hires negotiate for an extended post-termination exercise period for the options. This allows them to follow Strategy #1 - Exercise at Liquidity and also have career mobility to leave the company before an exit event and still take advantage of their options. More on that here.
Strategy #4: Early Exercise Stock Options (Prior to Vesting)
An “early exercise” is an exercise of unvested stock options. You pay the exercise price to the company and file an 83(b) election with the IRS. The shares are still subject to vesting, as the unvested shares can be repurchased from you if you leave the company prior to your vesting dates.
Early exercise of stock options is a popular tax planning maneuver, as it starts your capital gains and, perhaps, Qualified Small Business Stock (“QSBS”) holding periods. This sets you up for the lowest possible tax rates when you sell your shares. It may also help you avoid the tax cost of exercise. If you early exercise immediately after grant, while your exercise price is still equal to the FMV of the shares, you have a $0 tax cost to exercise.
Early exercise stock options are not available at every company, but it is worth considering if it is available to you. It may also make sense to negotiate for the right to early exercise as part of your offer negotiation if it is not offered to you. I have also had clients who ask for this right to be added to their options well after they join the company, especially if the company valuation is about to explode and they want to early exercise before the tax cost would make any exercise impossible.
The downside of early exercise of stock options is investment risk, as you have to pay the exercise price (and, perhaps, some taxes at exercise) out of pocket before you have any visibility into whether the value of the shares will go up. Early exercise is very common and an easy choice at early stage companies where the FMV and, therefore, the exercise price is low. It’s a less obvious choice when the company is at a later stage and the exercise price of stock options is significant.
Strategy #5: Regularly Exercise Startup Stock Options as They Vest
The final strategy is to exercise startup stock options regularly as they vest. This is the least popular but (in many cases) the most favorable strategy.
It’s unpopular because it requires both attention and money, which are both in high demand for startup employees. It’s favorable because it provides for some of the same benefits of early exercise; it starts your tax holding period and allows you to avoid the golden handcuffs that come with unexercised options as the tax cost to exercise increases over time.
The downside of this strategy is, of course, the investment risk of paying the exercise price and tax cost of exercise. There is no guarantee that startup stock will ever become more valuable than your exercise price, or that you will be made whole for the taxes paid to exercise.
How does it work? First, you would need to stay apprised of the current FMV of the company’s common stock and upcoming corporate events that might increase the FMV of the common stock. Since the FMV of the common shares on the date of your exercise will determine the tax cost to exercise, you will need to know this in order to make a thoughtful exercise decision.
Second, you would regularly consider whether or not to exercise your vested options. Most people approach this by meeting with their tax advisor or financial advisor on a regular basis to calculate the expense of exercising their vested stock options. This would be done annually or more frequently if the company is anticipating an event that would increase its FMV. If you have ISOs, this would include an analysis of how many options you can exercise tax-free by staying under the AMT exemption amount. If you have ISOs or NSOs, it would include an analysis of the total tax cost to exercise as well as the financial costs/benefits of exercising.
Finally, you would pay the exercise price and associated tax cost (if any) to exercise the vested options.
Conclusion
I hope this menu inspires you to choose a strategy before you accept a startup stock option offer. It’s worth the time and attention to understand your choices and come up with a thoughtful plan of action before you invest years of your time to earn startup stock options.
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Early Exercise of Startup Stock Options
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.
Planning for your startup stock options? Consider an early exercise of stock options to protect your equity stake from taxes and forfeiture.
Most people learn the hard way about the complexity of exercising stock options at a startup. If you can spare a few minutes of attention, this post will teach you about early exercise - the easy street of startup stock option exercise strategies.
Early Exercise Stock Options
An “early exercise” is an exercise of unvested stock options. You pay the exercise price to the company and file an 83(b) election with the IRS before the options vest.
Early exercise makes you the owner of the shares in the eyes of the company. The shares are still subject to the options’ original vesting schedule, though, as the unvested shares can be repurchased from you if you leave the company prior to your vesting milestones. The repurchase price for unvested shares is usually the lower of your exercise price or the fair market value (“FMV”) on the date of termination.
Early exercise with an 83(b) election also makes you the owner of the shares in the eyes of the IRS. That means you start your capital gains and, perhaps, Qualified Small Business Stock (“QSBS”) holding periods, which sets you up for the lowest possible tax rates when you sell your shares.
Tax Benefits of Early Exercise of Stock Options
If you early exercise while your exercise price is equal to the FMV of the common shares, the exercise itself is not taxable and therefore defers all taxation until you sell the shares and have cash gains to use to pay the taxes.
This may seem like overkill on planning, but the tax bill for a later option exercise can snowball surprisingly quickly and make it impossible to exercise vested stock options. More on this here: Startup Stock Options - Early Expiration - The $1M Problem. Early exercise can, therefore, act as a forfeiture-avoidance strategy as it can defer taxes until sale of stock and, therefore, save people from prohibitive pre-liquidity tax bills for exercise.
When to Early Exercise Stock Options
Since options are granted with an exercise price equal to the FMV on the date of grant, it’s a safe bet to early exercise immediately after grant to be sure you can do so without a tax cost.
The most common approach is to negotiate for the right to early exercise in the grant at the offer letter stage, and then join the company and wait a while before early exercising. This allows employees to get some visibility on the company’s possibility of success and their own fit within the company. So long as the early exercise is completed while the FMV is still equal to the strike price, the early exercise is tax free.
If you early exercise (or exercise vested options) after the FMV has increased above the exercise price (such as after a round of funding following your grant date) you will have taxable income on the difference between the FMV and the exercise price in the year of exercise. (The tax rates depend on whether you are early exercising NQSO or making an qualifying early exercise of ISOs.) This might seem unappealing, as you would of course prefer to defer all taxes until sale of stock. However, some people choose to early exercise even if they have to recognize income on that early exercise in order to be taxed at exercise on the current FMV rather than paying higher taxes on a later exercise based on a higher FMV.
Investment Risk of Early Exercise Options
The downside of early exercising startup stock options is investment risk, as you have to pay the exercise price (and, perhaps, some taxes at exercise) out of pocket before you have any visibility into whether the value of the shares will go up in the future. That’s why early exercise is very common and an easy choice at early stage companies where the FMV and, therefore, the exercise price is low. For instance, a first employee might be able to exercise 1% of the company for, say, $5,000. It’s a less obvious choice when the company is at a later stage and the exercise price of stock options is significant. For instance, some startup stock options packages have a $1M+ exercise price.
Some key hires of later stage startups with higher option exercise prices negotiate for the right to early exercise (or exercise vested options) with a promissory note instead of cash. Instead of paying their significant exercise price with cash, they deliver a promissory note to the company. This is a promise to pay the exercise price at some date in the future. There is some complexity to this to address with your advisor if you are considering this path.
Negotiating the Right to Early Exercise Options
Early exercise is not available at every company. Therefore, if you want to early exercise you will need to negotiate for this right during your offer letter negotiation or after you join the company.
For example, some early Uber employees negotiated to add the right to early exercise to their existing stock option grants. This allowed them to early exercise their unvested options (and exercise their vested options) before the FMV of the shares skyrocketed, so that the tax bill for the exercise was only in the tens of thousands of dollars.
Despite the out-of-pocket cost for the exercise price and taxes, this was a wise exercise choice for a few reasons. First, if they had waited and exercised after the FMV skyrocketed they would have had to pay far more in taxes to exercise - in some cases more than $1M. More on that issue here. Second, if they had failed to early exercise and ended up leaving the company prior to the company’s IPO, they would have had to come up with those astronomical tax payments before they had a market to sell the stock. This is because the company had only a 30-day post-termination exercise deadline and an absolute prohibition on sales of stock prior to IPO. Third, many of these employees purchased their shares while the company was QSBS eligible and then held the shares for the 5-year QSBS holding period. This qualified them for 0% federal tax rates on up to $10M in gains on the sale of their shares.
ISOs v. NSOs and Early Exercise Stock Options
If you are early exercising stock options, it is more favorable to have the options granted as NQSO rather than ISOs. If you early exercise ISOs, you have to hold the shares for two years before sale for long-term capital gains tax rates on your gains. If you early exercise NSOs, you only have to hold the shares for one year for capital gains treatment. Therefore, if you are planning to early exercise immediately after the grant, you will want to ask the company to make the grant as a NQSO rather than an ISO.
If you are not planning to early exercise, you may not want to include the right to early exercise in your documents. That’s because of the $100K limitation on ISOs. ISOs are a tax-favored stock option that are subject to certain limits under the tax code. Only $100K in exercise price of stock options can become exercisable in any given year and qualify as ISOs. So if you have a $400K exercise price grant that is intended to be ISOs, all $400K of the options will be ISOs if you do not include the right to early exercise. If you do include the right to early exercise, all $400K will become exercisable in the first year and so only $100K of the options will be ISOs. The remainder will be NSOs which are less tax favored.
Don’t Forget the Section 83(b) Election
If you early exercise unvested stock options, you file a Section 83(b) election with the IRS within 30 days of the exercise. The consequences of a missed 83(b) election can be very, very unappealing. If you don’t have the attention necessary to follow through on that, don’t early exercise.
When to Exercise Stock Options
As you can see, early exercise of stock options is not the best choice in every situation. To learn about the best structures for a variety of cases, see Examples of Good Startup Equity Design by Company Stage. For a comprehensive analysis of when to exercise stock options, see this three-part series:
Part 2: The Menu of Startup Stock Option Exercise Strategies
Part 3: FAQ on the Menu of Startup Stock Option Exercise Strategies
Attorney Mary Russell counsels individuals on startup equity, including:
You are welcome to contact her at (650) 326-3412 or at info@stockoptioncounsel.com.