Step by Step Guide to Planning for Early Stock Option Exercise

Planning for Early Stock Option Exercise can be overwhelming and challenging. if you are one of the many employees of early-stage startups and private companies who receive equity compensation in the form of stock options and RSUs., this article will give you a starting point.

Planning for Early Stock Option Exercise

You probably want to understand how owning stock options will impact your long-term wealth.  The exact specifics of your equity compensation will vary widely from one company to another. There is also a vast range of possible outcomes regarding the value of your equity and the timing of your liquidity event. Your tax implications depend on when and how you exercise your stock options and how long you hold your vested stocks. Furthermore, many employees will struggle with the high concentration of your net worth in a single company.  Burdened with many questions and a few answers, tech workers often delay early stock option exercise until closer to an IPO or other liquidity event.

So, what do you do next? Here are some ideas that can help you navigate the complex world of equity compensation and early stock option exercise.

1. Know what you own

The best way to master your equity ownership is to take a step back and figure what you own. Reach out to your payroll department or stock option vendor and ask for more information about your stock option holdings.

In general, there are two types of employee stock options – Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). You will most likely own one or the other or some combination of the two. While they may look very similar on the surface, there are significant financial and tax differences between ISOs and NSOs.

ISOs, generally, offer a more favorable tax treatment. There are no taxes due upon your ISO’s exercise, but that can force you to pay an Alternative Minimum Tax.

In comparison, NSOs offer slightly little more flexibility but trigger an immediate taxable income at exercise. Both employers and other stakeholders can receive NSOs.

2. Keep track of key dates and figures

Keeping track of important dates and figures is the next step in mastering your stock options. In most cases, you must start from the moment you receive your job offer. In my article “Guide to understanding your job offer with stock options,” I discuss evaluating a job offer that includes a combination of salary and stock options. There are a handful of important dates and figures that you need to keep track of. Here is the alphabet of terms you have to remember – a number of shares, vesting dates, exercise dates, strike price, fair market value, and vested versus unvested shares.

Furthermore, as you continue working for the same firm, you may receive other stock option grants with different strike prices.  Create a spreadsheet or use the information provided by your option vendor to track all the numbers. It could be cumbersome, but it can help immensely when making early stock options exercise decisions.

3. 83b election

Some companies may allow you for IRC § 83(b) election.  This IRS rule permits companies to offer an early exercise of stock options. When making this election, you will pay income taxes on the fair value of your stock options. The early election is incredibly lucrative for founders and employers of early-stage startups with low fair market value.

The 83(b) election is rarely done due to the complexities in calculating the value of an early-stage startup’s options. If you can determine the value at the time of the grant and decide to pursue this road, you will owe taxes on your options’ fair market value at the grant date. But no income tax will be due at the time of vesting. Another disadvantage of this strategy is the risk of the employee stock price falling below the grant date level. In this scenario, it would have been advantageous to wait until the vesting period.

4. Navigate your taxes

Managing and planning your taxes is by far the most challenging step in the process of early stock option exercise. The biggest hurdle comes from the uncertainty about having enough cash to cover your tax expense. Further on, frequent changes in the company’s fair market value and inability to sell vested shares complicate the process of planning your taxes.

Given so many moving parts, you are probably wondering what your best course of action is. For one, once you reach this junction, it is time to ditch Turbo Tax (no offense, I used it for many years in the past) and seek expert advice. Despite all uncertainty about the future, we advise our clients to start making regular tax projections. Taking a snapshot of your current circumstances will allow you to take an objective view of your finances and make informed financial decisions.

5. Plan ahead for Early Stock Option Exercise

In my practice, I often speak with folks whose company is going public in a matter of days or weeks. A good number of them are considering exercising their stock options for the first time.

There is a strong appeal to do nothing until you approach a significant liquidity event. Waiting to exercise until the IPO eliminates a lot of financial and business uncertainty. However, the waiting strategy has a notable trade-off – paying higher taxes in the future and exposing yourself to material concentration risk.

The advice we give to all our clients is to plan ahead. Do not leave these critical financial decisions for the last minute. Even with the broad range of future outcomes, you could minimize your taxes and reduce your anxiety levels by taking small, measured steps.

What makes the Early Stock Option Exercise decisions so tricky is that no magic formula or one-size-fits-all solution works for everyone. While working with numerous clients, I realize that we all face different circumstances and challenges. If one approach works wells for your colleagues, it may not work very well for you. When we work with our clients, we try to strike the right balance between managing uncertainty and planning for the future.