What are Early Exercisable Stock Options?
What does it mean to exercise a stock option?
Exercising stock options simply means buying shares of the issuing company’s stock at a set price, also known as the strike price, at the time the options are granted. This price is usually the fair market value (FMV) of the shares. You’re not required to exercise your options, but if you do this means you own a piece of the company.
Normally you can only exercise vested options, and if the company is privately held, you’ll need to use your own money to purchase them (since there is no secondary market to perform a cashless exercise).
What happens when you early exercise stock options?
When
- Ideally the spread between the exercise price and FMV is zero
- You are a relatively new/early employee
- Company is unlikely to be acquired before desired holding period is met
- Your company is projected to go public or get purchased at an accurate valuation
- You have enough funds on hand you are willing to risk; to buy the shares and pay any associated tax and fees due without having to sell the shares
- You have a high level of confidence about the growth and success of the company and the likelihood of a future liquidity event
Benefits
People who wait to exercise can find that the eventual cost to do so becomes so expensive that their only option is to wait until an exit event occurs.
Some key benefits of early exercising include:
- The long-term capital gains holding period would start upon purchase
- If exercise takes place immediately or soon after the grant date, then it is not taxable, deferring all taxation until the option holder sells their shares
- Avoid any taxes upon vesting by filing a 83(b) election (You will pay all taxes up-front, which cannot be refunded, but avoids future short-term income taxes)
- Becomes a shareholder in the company with flexibility to choose when to sell shares
- It could pay off if your shares end up being worth a lot due to company success
Risks
- If the value of the common stock decreases, the option holder risks losing their out-of-pocket investment.
- Your money is tied up in an investment that might not experience an exit event; unknown longevity of company
- As the cost to exercise increases relative to the optionholder’s financial means, the decision to exercise the options early is likely to become more difficult for them.
How
Depending on your company’s stock option agreement, there may be a variety of ways you can exercise your options.
These are the most common methods:
- Cash exercise: Use your own money to buy and hold all of your shares.
- Cashless: If your company is public or provides an open offer, they may allow a holder to exercise and sell all options all in one transaction or sell enough shares to cover the purchase price and taxes and fees.
83(b) Election
It is important to consider the tax implications to exercising options. Filing a 83(b) election when exercising options can potentially save you a significant amount of tax in the future as this accelerates your income tax by giving the elector the opportunity to elect to pay taxes on their shares on the grant date rather than at the time that they vest. With the idea that the stock will increase in value over time, purchasing the shares before the value rises will reduce your tax liability because you would be paying on a lower valuation.
When you file a Section 83(b), you are requesting that the IRS treat your unvested shares as fully vested and that they tax this equity at the time it is granted at FMV. This election is only available and applicable on stock options with an early exercise option or as a restricted stock award (RSA). You must file an 83(b) election with the IRS within 30 days of the exercise.
If exercised at the time of grant the strike price is highly likely to equal the current FMV of the stock, which provides a favorable outcome in having a $0 spread between the FMV and strike price. At that point, timely filing of a 83(b) election is required in securing the transaction.
If an employee decides to exercise their grant options at a later date, they then must pay taxes on the difference between the stock’s fair market value (FMV) and the current FMV at time of exercise.
Deciding if it is Right for You
What if I get terminated before my options vest? Although you have exercised your options early, your standard vesting period holds. Therefore, any shares that have not vested before you leave or are terminated from a company are returned to you (the company refunds you the purchase price, but not the taxes). When deciding how many of your shares to early exercise, consider your expected length of employment with the company and only early exercise the number of shares you feel comfortable taking that risk with.
Both early exercising and the failure to do so each come with their own set of risks and rewards. As everyone’s risk profile is different, this method is not always the best option for everyone. Early exercising is a very common choice at early-stage companies and startups where the FMV is initially at its lowest and can offer significant tax savings in certain situations. The deciding factors mentioned are there to help you in your goal of mitigating your investment risk while growing your equity.
To learn more about what we do, or to request a quote, contact us at hello@finvisor.com or 415-416-6682. We’re here to help you navigate deferred revenue journal entries so you can make the most of your assets!
*This blog does not constitute solicitation or provision of legal advice and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction.*
- Last Modified
- June 19, 2023
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