The Essentials to Early Exercise of Stock Options

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The most exciting (and uncertain) time to be in a company is the beginning. With little in the way of pay and much in the way of work, companies have to get creative when it comes to compensating their employees. This is why those who join early with a startup often receive a lot of stock options. We have already explored stock options, the tax consequences surrounding their exercise, and the possibilities of making an 83b election in previous blogs. However, it’s worth taking a deeper dive into the early exercise of options.

Normally, stock options are subject to a vesting schedule. This schedule is typically defined by time. So, while a person may be granted options when they start working, the vesting takes place over a period of years. As the options vest, the employee has a choice to exercise the option (buy it) or defer. Upon exercise, the difference between the price that the employee pays and the fair market value (FMV) is recognized as either regular income or AMT Preference (see previous blogs). It’s also important to note, the holding period for capital gains begins once exercise occurs.

Here’s the problem: the longer you wait to exercise the more problematic the tax consequences become. It could be, by the final year of vesting, there are significant differences between the purchase price and the FMV (as defined by the latest 409a valuation). This can lead to prohibitive tax consequences not upon selling the stock, but upon purchase. Wouldn’t it be great, if you could exercise in the beginning when the tax impact was low? 

 

When to Exercise Your Stock Options

For many in high-tech, it’s a very real possibility called ‘early exercise.’ When an employee early exercises their options early, they are purchasing the shares before they technically vest. You can then use your 83b election to have the paper gain included in your taxable income. For Non-Qualified Stock Options (NSOs) that means the difference in what you paid versus the FMV is going to be included in your W-2. For ISOs, the difference is going to show up as an Alternative Minimum Tax (AMT) preference item.

Since early exercise typically occurs when the shares are granted, the difference between the strike price and the FMV is usually small or zero. This means that the taxpayer won’t have an AMT difference or any additional wages to report on their return. However, the taxpayer still has to come up with the coin to purchase the options. If you’re not willing to part with the money and stand a decent chance on losing it, an earl exercise might not be right for you.

The cornerstone of the 83b election is that the shares must be subject to substantial risk of forfeiture. Meaning, it can’t be guaranteed that you’ll receive the shares, or a particular value later on. In real terms, if you make the 83b election and leave the company several months later, the company will typically buy back the unvested shares at cost. However, you will not be able to get a refund of any tax that you paid the Treasury as a result of the election. 

 

Outcomes of Early Exercise 

While early exercise typically occurs at the time of grant, it doesn’t have to. It can occur any time before vesting. This means that a person could take wait-and-see approach, to a certain extent. For instance, if a person received 100,000 shares upon hiring with a four-year vesting schedule, they may decide to forgo an early exercise in year one. On their first anniversary, the first 25% would vest, but they could early exercise the remaining options.

This comes with consequences. If the company shows a lot more promise in year two, it’s likely that their valuation has gone up significantly, and the nominal delta that which has to be included in income isn’t so nominal anymore. The longer an employee waits, the more severe the tax implications, unless you run into a dumpster fire of a year like 2020 when valuations went down for many small companies. If your strategy hinges on a global pandemic, it’s probably not sound.

Whatever your choices are, talking them through with an experienced financial advisor with a focus on tax can make all the difference. For more information about your stock options, subscribe to our blog today. 

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