An “early exercisable” stock option is an option that can be exercised by the holder before it has vested. This type of stock option allows the employee, consultant, advisor, or other service provider (collectively referred to as “employee” henceforth) to immediately exercise all or a portion of the option, including the unvested portion of the award. For example, let’s say you received an early exercisable stock grant with a four-year vesting schedule. The moment you receive that grant, you could exercise the entire stock option, even the unvested portion.
When the option is exercised early, the employee receives common stock. However, that common stock remains subject to the same vesting schedule attached to the stock option, making it restricted stock. Like restricted stock, if the employee ends their relationship with the company before fully vesting the shares, the company will buy back the unvested shares.
Advantages of Early Exercise for Employees
Exercising stock options early can benefit employees in the following ways:
- Favorable Tax Treatment: If exercised immediately or soon after the grant date, employees should owe little or no taxes upon exercise. If they file their 83(b) election within 30 days, they can also report the value of the stock at that date, which is often more tax efficient. Click here for more details on the 83(b) election.
- Starting the Clock on Capital Gains: You should definitely consult your tax advisors on this point. But, generally, long-term capital gains are taxed at a lower rate than short-term capital gains. To qualify for long-term capital gains, the stock must be held for at least one year in most cases before selling it. The capital gains holding period starts when an option is exercised. In a typical four-year vesting schedule, an employee would be able to start the clock four years earlier than they would if they exercised when they were fully vested. It’s best to consult with a tax advisor on this.
- Potential to Increase Overall Return on Investment: Due to the first two points above, employees will lose less of the overall proceeds from the sale of stock to taxation, thus increasing the total amount of money they take home.
- Reduced Risk of Losing the Option Due to Expiration: Many options never get exercised simply because employees never get around to it before expiration. By exercising early, employees do not have to worry about that outcome.
Disadvantage of Early Exercise for Employees
Early exercise of stock options has a significant disadvantage: employees must pay their own money upfront to purchase shares, which carries risk. Although everyone hopes that the share price of the company will continue to rise, the stock value of many startups declines and can reach zero.
WeWork serves as a high-profile example of a company whose stock price collapsed. At its peak, it was valued at over $47 billion. However, investor confidence in the business model and leadership rapidly declined, despite an attempted initial public offering (IPO) in August 2019. Concerns about financials and leadership led to the postponement of the IPO. As its valuation continued to decrease, the employees holding stock suffered the most. If an employee exercised their stock at WeWork’s highest valuation, they would have spent a significant amount of their own capital and lost every cent of it.
Common Mistakes to Avoid When Exercising Early Stock Options
Exercising stock options early can be beneficial for employees, but it’s important to avoid common mistakes.
One of the biggest mistakes is exercising too early without considering potential downsides and risks. For example, employees may exercise their options early because they want to own shares in the company or because they believe the company’s valuation will increase in the future. However, as mentioned above, if the company doesn’t perform as expected or if there are unforeseen circumstances that affect its value, employees who exercised too early may lose money.
Another mistake to avoid is failing to plan for taxes. Exercising early may qualify employees for long-term capital gains tax rates instead of short-term ones. However, they should understand how taxes will impact their investment and plan accordingly.
Employees should also be aware of any restrictions on selling shares after exercising their options. Some companies may require that employees hold onto their shares for a certain period before selling them. This can limit liquidity and prevent employees from realizing gains quickly.
Lastly, employees should carefully consider their financial situation before investing large sums of money into exercising their options. Understanding one’s overall financial goals and risk tolerance is essential before making any investment decisions.
By avoiding these common mistakes and carefully weighing the pros and cons of exercising stock options early, employees can make informed decisions about how to best manage their investments in startup companies.
Strategies for Managing Risk When Exercising Early Exercisable Stock Options
Exercising early exercisable stock options can be a high-risk, high-reward strategy. To minimize financial exposure while still benefiting from potential increases in valuation, you may consider the following strategies:
- Exercise a Portion. You may choose to exercise only a portion of your options early, such as 25%, and wait to exercise the remaining options at later dates if the company continues to perform well.
- Immediate Sale. Another strategy is to sell shares immediately after exercising them to lock in gains and reduce exposure to future risks. However, carefully considering the tax implications of selling shares and planning accordingly is important. It’s also important to be aware of any restrictions on selling your shares after exercising your options, as these can limit liquidity and prevent you from realizing gains quickly.
- Diversification. Finally, diversifying your investment portfolio by investing in assets outside of your company’s stock can mitigate risks associated with investing heavily in a single company’s stock.
Using these strategies can help manage risks associated with early exercise stock options while still benefiting from potential gains in valuation. However, carefully evaluating your financial situation and risk tolerance before making any decisions about exercising early exercisable stock options is important. Seeking advice from financial professionals can also ensure informed decisions about managing investments in startup companies.
A Tale of Two Employees Exercising Early
Early exercise of stock options can be a helpful tool for employees, but it can also be risky. Some employees have made significant gains by exercising early, while others have suffered losses.
For instance, Joe worked at a fast-growing startup and exercised his options early when the strike price was $5 per share and the current market price was $10 per share. Over the next few years, the company’s valuation increased significantly, and Joe could sell his shares for $50 each. By exercising his options early, Joe purchased shares at a lower price and realized a significant return on his investment.
However, some employees have also lost money by exercising their options too early. Sarah worked at a promising startup that ultimately failed to meet its growth targets. Sarah exercised her options early when the strike price was $10 per share and the current market price was $12 per share. However, over time, the company’s value decreased significantly due to market conditions and internal issues. When Sarah tried to sell her shares later on, she found that they were worth only $5 each—less than what she had paid for them.
These examples illustrate both the potential benefits and risks of early exercise of stock options. Although some employees may experience significant gains by exercising their options early and benefiting from future increases in valuation, others may face losses if the company does not perform as expected or if unforeseen circumstances arise.
Therefore, employees should carefully evaluate their financial situation and risk tolerance before making any decisions regarding early exercise of their stock options. Seeking advice from financial professionals can also help ensure that employees make informed decisions about how best to manage their investments in startup companies.
Impact of Early Exercise Stock Options on a Company’s Capitalization Table
Early exercise of stock options can significantly impact a company’s capitalization table. When employees choose to exercise their options early, they buy shares of the company sooner than they would with traditional options. This increases the number of outstanding shares and dilutes the ownership percentage of existing shareholders.
For example, let’s consider a startup with 1 million authorized shares and 500,000 outstanding shares. If an employee with early exercisable stock options buys 50,000 shares before they fully vest, the total number of outstanding shares will increase to 550,000. As a result, the ownership percentage of existing shareholders will be diluted from 50% to about 45%.
Although the difference may not seem significant, it can have important implications for the company’s future financing rounds. If the company decides to issue new equity or take on debt financing in the future, potential investors will examine the capitalization table to determine how much of the company is already owned by existing shareholders.
Therefore, companies should carefully consider how early exercisable stock options will affect their capitalization table before including them in an employee compensation package. This will help them maintain control over their ownership structure and be better positioned for future financing rounds.