Should I Exercise My Right to Stock Option Exercising

Working in startups, your pay is always split somehow between salary and “stock options.” If you don’t know what that means — basically an option gives you the option to purchase a share of stock at a low “strike price” of the company. If the company does well, the price of the stock goes up, and if it does really well the nitty gritty details that can make the purchasing of the said stock through the option become less painful to think about. Trouble is, most companies, even good companies, aren’t Facebook or even LinkedIn. So exercising options early could mean to big losses down the line.

There are some tax reasons to exercise options early. From my understanding, if you have ISOs (which I do), you can buy the stock options up front, before they’re vested, and wait a year to sell them at capital gains tax rates. That is, if in a year, or after a year, they’re worth more than they were when you bought them. And that only really makes sense if your company goes public — the odds of a startup going public are very, very small. More likely, even if your successful,  you get acquired. And as I experienced at my last startup — an acquisition, even when the founders do well, might not result in a great turnout for the rest of the employees.

So most of my instincts are telling me it would be silly to exercise the options now. Why not wait? Well, my company is likely raising additional funding soon, which means the value of the option will go up. While I’ll still be able to buy the option for the lower strike price, I’ll have to pay tax on the difference between the strike price and the value when I buy the option, which could be quite a lot, especially given that I’d be PAYING for the option and owe money on it. And there’s still a decent chance that eventually it will be worth $0.

Now, I could exercise a portion of my options – take a little risk, and wait on the rest – but it’s not clear this makes sense either. There is a whole issue with AMT that I don’t understand (anyone want to explain this to me?) that you can avoid if you exercise early, so says the Internets. I’m not sure at what point you hit the AMT issue in terms of your yearly gross income.

Besides all of that, the reality is that I don’t really have the $20k I’d need to purchase all of my stock options right now. Well, I do have it — I have $130k in random investment accounts — but I don’t know if it makes sense to pull my funds from any of them to exercise my options. It’s a huge risk. It might be better from a tax perspective if, in a year or a few years we get acquired, but who knows if that will happen. I do believe in this company (which is rare) so that says a lot. Still, I’m relatively risk-adverse when it comes to money. Hmm. What do you think I should do?

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5 thoughts on “Should I Exercise My Right to Stock Option Exercising”

  1. The thing you didn't talk about is expiry: When is the expiry date? If the options don't expire, or expire a long time down the road, then don't exercise them now. Usually it doesn't make sense to exercise options early .. if ever. Reason is that the option itself has value in addition to the value linked to the stock. Example: If the stock is worth $5 today and the option strike price is $4, then the option might be worth $1.5 or the $1 of value between the stock price and strike price, plus 50 cents for the option itself.

    Therefore, if you exercise the option you throw away that 50 cents in value. That 50 cents is higher if there is a long time to expiry, and gradually shrinks as the expiry comes due. The day before the option expires that 50 cents will have shrunk to zero. If you want to capture the appreciation in the stock then usually you just sell the option and never touch the stock. So if the stock later becomes worth $10 (doubles) then your $4 option will be worth $6 + the premium instead of $1 + the premium.

    Finally, in a private company you don't know what the value really is. They may not have properly audited books and the value may change so rapidly from the addition or loss of even one big customer or purchase of one big asset that it's hard to know if you are paying a good price for the stock. Therefore, keep the option as long as possible.

    1. As in any startup, I think, the options don't expire as long as I remain an employee at the company. If I am terminated or choose to leave, they expire 90 days after I leave.

      But if I purchase the options now I pay, say, 50 cents per option. Right now that means I pay no tax (I think?) because the current value of the option is 50 cents. If next week the value of the option increases to $5.00, I'll owe tax on $4.50 per share, even though my "purchase price" will still be based on the 50 cents. This is why it's better to purchase the option now vs. wait. Also, if I purchase now I start my "1 year" waiting period before I can sell the stock for long term capital gains tax, in case it's worth more in the future.

      However, it's quite possible that the company will one day be worth $0, or for whatever reason non-founding employees will be left without value to their common stock, in which case it makes no sense to exercise early.

      1. I don't know the US tax laws, but it doesn't make sense that you have to pay tax on an option you didn't exercise. Taxes in Canada (where I'm from) and the US are triggered when money or goods change hands. You may have had to pay tax on the option when you first got it as part of your pay, and/or you'll have to pay a capital gains tax when you sell it, or when you sell the stock that it gets you. But nothing in between.

        You'll have to check the details on the option. If they don't expire then I'm 100% sure it better not to exercise them in Canada, and 90% sure the laws are very similar in the US. You don't have to pay tax until you make a move. Have a look at http://www.irs.gov/taxtopics/tc427.html, it pretty much says the same thing. No tax payable until you sell or exercise something.

        Tax-wise, it is always best not to recognize income. I highly recommend simply holding the option, it is far more valuable than the underlying stock and it will cost you money to make the transformation.

        1. I don't pay tax unless i purchase the option and the option is worth more (on paper) when I buy the stock then the strike price. this is considered a profit "paid" to me (because i just made the profit on paper, even though i can't actualize it) and thus I have to pay tax on it that year. If you exercise when the strike price is the option price, you don't have to pay that tax up front, only when you sell the option later on.

  2. I think you got confused between ISO's and NSO's. ISO's do not pay taxes upfront. You pay taxes when you sell them. NSO's are required to pay taxes on the spread at the time of exercising the options, which is in your case, the value of your company stocks in the most recent funding.

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