Stock options are a form of compensation that many startups and other companies offer their employees and other key players in the company. A stock option is a contract in which the company issuing the stock grants the right to purchase a certain number of shares at a set price, regardless of the current market price at the time of purchase. When you exercise a stock option, you purchase shares at the price stipulated in your options contract. This price is commonly referred to as the strike price, exercise price, or grant price.
Most often, employees are not allowed to exercise their options immediately but rather must wait until they have worked with the company for a certain period of time, hit another specified milestone, or a combination of these. The guidelines under which this occurs is called a vesting schedule. Often, options are scheduled to vest over a period of time, so even after vesting begins, only a portion of the options allotted in the contract are available for exercise right away.
The time at which the first set of options vests is called the vesting cliff. After this cliff is reached, additional options often continue to vest over a period of years. As options vest, an employee has the right, but not the obligation, to buy up to the specified number of shares at the strike price. This right continues until the option’s expiration date or until you leave the company and the post-termination exercise window closes. For incentive stock options (ISOs), this window is commonly 90 days.
Some companies allow employees to exercise their stock options early—before they vest. In this case, an employee is able to purchase shares of stock at the strike price as soon as options are granted. However, these shares will vest according to the vesting schedule outlined in the options contract. So, if you early exercise options, you’ll own shares in your company, but you won’t be able to sell them until after they vest. There are both potential benefits and drawbacks of doing this.
The main benefit of exercising stock options early is the potential for tax savings. When you exercise a stock option, you can choose to pay the taxes early on the unvested shares by filing a timely 83(b) election rather than waiting until after the shares vest. Why would you want to pay your taxes early, you may wonder?
The difference between the strike price of an incentive stock option (ISO) and the stock’s fair market value at the time of exercise is counted as a preference item for the alternative minimum tax (AMT), a calculation designed to limit the ability of high-income taxpayers to take advantage of certain tax benefits. If your stock options are nonqualified (NSOs), then this difference is included in the income reported on your W-2. When you exercise a stock option early, its fair market value is likely to be low and may even be equal to the strike price. Whether your options are ISOs or NSOs, the result is that little or no income is included in your tax calculation.
The primary drawback of this tactic is the uncertainty involved. In order to file an 83(b) election, your shares must carry a substantial risk of forfeiture. You’ll have no guarantee of receiving the shares or any particular value in exchange for them in the future. While most companies will buy back unvested shares at cost if an employee leaves the company, there is no way to recover any taxes that have already been paid on them.
Because of the risks involved with early exercise, it’s important not to bet more on it than you can afford to lose. It’s also important to understand that even after your stock vests and your company is publicly traded, you may not be able to sell your shares anytime you want. It’s common for employees to be subject to a lockup period and trading windows, which restrict trades by people who hold nonpublic material information about a company.
When you decide to exercise your stock options, you have to decide how you will fund the purchase. If you early exercise, you must pay for them out of your own funds, since you won’t be able to sell any shares yet. You may, however, be able to access loans for this purpose. You may also want to use your own funds to purchase stock options if you intend to hold all of your shares in anticipation of rising value.
If, on the other hand, you exercise your stock options when you’re able to sell, you have a couple of other choices. If your company is public or extending a tender offer, you may be able to exercise and sell shares simultaneously. In this case, you can choose to either sell just enough shares to cover the strike price or sell all of the shares and pocket the gains.
No matter when or how you choose to exercise your stock options, it’s critical that you understand the tax consequences associated with options exercise. Different types of stock options are subject to different rules, so it’s important to work with a tax professional who is well versed in stock options and the IPO process.