Exercising stock options pre-IPO means evaluating risks and rewards.
- What will happen to the stock over time?
- Will the Company continue to do well?
- When could an IPO happen?
- How long might the stock remain illiquid/unable to be sold?
Once you evaluate your risk, then it’s about understanding the ramifications of exercising the stock options.
What are stock options?
There are two types of stock options: Incentive Stock Options (“ISOs”) and Non-Qualified stock Options (“NQSOs”). Each is considered valuable as the company continues to grow. If the Company does well, the value of your options will increase and (hopefully) so will your personal net worth. However, it is important to consider the tax ramifications.
Incentive stock options (“ISOs”) are stock options available under a company stock plan. Qualified ISOs receive favorable long-term capital gain tax rates upon sale instead of ordinary income rates. In order to qualify, they must be held one year from the date of exercise and two years from the date of grant. Otherwise, they are considered non-qualified stock options (“NQSOs”).
In the year you exercise ISOs, you may be subject to the alternative minimum tax (“AMT”).
If you have NQSOs, exercising shares may trigger regular income tax. The difference between the ‘market value’ and exercise price is compensation and generally shows up on your W-2 in the year exercised.
What happens when you exercise pre-IPO options?
When you exercise pre-IPO options, you are purchasing the shares at the exercise price in order to own the shares outright.
The year you exercise pre-IPO options, you will pay the exercise price and pay any taxes due from the exercise. Depending on the price, you are potentially paying taxes now to avoid more taxes in the future.
This generally works if the company continues to grow well and the shares increase in value. The downside is that not all companies continue to do well and sometimes it can take years before you can sell them.
What is the best time to exercise stock options?
It is important to decide how much cash out of pocket you are willing to put towards purchasing shares and paying the taxes. You have no idea when you will be able to sell – so ‘betting’ on your ability to pay is a no-go.
It is also a good idea to consider the risk of the company. Are they at Series B and struggling to meet growth expectations? Or are they at Series F with institutional investors and continuing to scale well/be profitable?
In other words, how much cash out of pocket are you willing to lose?
Once you are comfortable with the potential loss, you can determine other types of timing.
When you join: If you join a very early stage company, there may be a chance to file an 83(b) election with little cash out of pocket. This may help to start your time period for claiming capital gains treatment or the qualified small business stock exclusion (‘QSBS’). Read more about the qualified small business stock exclusion here. The downside is, you know very little about the company at this point. If you decide to terminate before your vesting period is done, you may lose out on some shares you already paid for. An 83(b) election should be used with care.
Down-turn in the market: If the downturn in the stock market lasts a while, tech startup valuations come due. The new 409A valuation may end up lower based on expectations in the market. If it looks like they will weather the storm and do well, this could be an opportunity to purchase the shares at a lower tax due.
Before the next fundraise: If a fundraise is expected, you may wish to purchase some shares before it closes in order to minimize taxes. Generally, upon a closing of a funding round, the share price must be reset based on the value the new investors assigned to the company.
Note: Beware the cap table lock period. This is the time when fundraising commitments are being incorporated into the cap table to know where everyone stands. If you wait too far into the fundraise, you may not be able to exercise shares during this time.
At S-1 filing: When the company has committed to the process of IPO, this may seem the least risky time to exercise shares. The risk is in what price/value it will be on the stock market and taxes, but it is at least becoming more liquid.
Again, beware the taxes!
For example, let’s say you were granted 100 ISOs on May 1st, 2021 and then you exercised them May 1st, 2022. You ended up paying AMT on those 100 ISOs in 2022 because the stock price went up significantly over that time.
Then, the company IPOs at year end, and you are able to sell some in January 2023. The ISOs sold will be considered NQSOs because they were not held 1 year from purchase date / 2 years from grant date.
So in 2023, you will pay taxes on them as W-2 income, but there will be no way to get back the AMT you paid on your 2022 tax return. This is when you hear about people who ended up paying 70%+ in taxes on their shares. Please involve a tax advisor!
This is why it is important to hold the ISOs for the required time period. If you sell them before the 2 year grant/1 year purchase date, you could end up paying AMT in one year and regular taxes the following year. Ouch.
A basic discussion of AMT and exercising stock options is HERE.
At Termination: Your ISO shares generally expire within 60 to 90 days following termination (check your plan document). If you do not exercise them, they may turn into NQSOs eligible for a future exercise, or completely expire. For our thoughts at termination, check out our post on What to do with stock options at termination.
At SeedSafe, we tend to look at ISOs over each year to understand what is best to do in the current environment.
When should I exercise ISOs this year?
As you save more money and are able to take a little bit of risk, then we recommend looking at exercising ISOs during each year. Think of it as dollar-cost averaging into your stock.
Spring: Consider an initial round of ISO exercises at a conservative level. The goal here is to maximize the AMT exemption based on $X to be used towards stock and income expected for the year. Once maximized, then you can consider the trade off in exercising more (depending on stock price & other factors).
The hard part for tech professionals is that your stock compensation doesn’t stay static during the year. What may look like $200,000 in stock compensation for the year could drop to $50,000 or go up to $400,000 and completely change the math on what an ISO exercise will do to your tax bill. This is why it is important to look at the risks and run a few scenarios to decide what risk you want to take.
Winter: This is a great time to do a wrap-up on how the year went financially and to decide if it makes sense to exercise some more shares. This is the time when calculating the tax bill will be easiest. More knowns means fewer surprises For other year end tax tips on stock, check out our article on Year End Tax Planning for Stock.
If you’d like a thinking partner in considering the risks and rewards of stock options, please schedule some time with us. We love helping tech professionals think through what the stock can do for them and what their trade-offs are in exercising or not.
The above discussion is for informational purposes only. Recommendations are of a general nature, not based on knowledge of any individual’s specific needs or circumstances, and there is no intent to provide individual investment advisory, supervisory or management services. You should consult a legal or tax professional regarding your individual situation.
