Dave Naffziger’s Blog

Several companies I have been directly and indirectly involved with are going through the sale process at the moment. One will be a positive outcome, while the other (JB) will be a disappointing outcome. Anyway, options have been on my mind recently.

This post depends heavily on understanding the difference between ISOs and NSOs.

Exercising Stock Options

Stock options can be exercised as soon as they have vested. This always means an out-of-pocket expense by the employee to purchase the options. They are typically exercised when the company is sold or goes public. However there are situations where an employee would exercise the option before there is a buyer:

• The option would expire. The most common reason that an option would expire is because you are leaving the company. ISOs must be exercised 90 days after the employee has left the company and many NSO agreements have similar clauses. Options also expire if they haven’t been exercised within the term of the agreement (typically 10 years).
• Tax advantages. ISOs may be treated as long-term capital gains if the stock is held for a year. If you are certain the company has an exit in the near future it can be advantageous to exercise an ISO option early and start the holding period for the stock. NSOs don’t provide the same opportunity.
• There is a buyer for the stock. ISO options can’t be transferred, so if there is a buyer for the common stock the employee may have an opportunity to exercise the option and sell the stock. This is becoming increasingly common at successful still-private companies within Silicon Valley. Investors want the founders to be focused on growing the company not on a near-term exit, so investors will purchase some common stock from the founders. Although this is becoming increasingly common, it doesn’t impact many people and is only used in rare circumstances.

Early Exercise Plans are option plans where the options are granted in full at the start of the period, and vesting is handled by an expiring right to repurchase exercised shares. These are almost always ISO plans. The goal is to provide employees with the opportunity to purchase their stock early so that they can hold it for the year necessary for short-term capital gains treatment.

Early Exercise Plans also have a downside if the fair market value of the grant exceeds $100K. The IRS allows an individual to receive $100K of ISO options a year. Any amount above $100K gets treated as an NSO. You could be granted $400K in options under a standard 4yr vesting plan and all the options would be treated as ISOs because you’d technically receive 1/4 of the grant each year. If that same plan was an early exercise plan, you’d really only have $100K in ISOs - the rest would be treated by the IRS as NSOs.

I’ve also seen situations where the company will give a loan (typically to key executives) to allow them to exercise their options early. In some instances this loan may be forgiven by the company. I believe this is more common at established companies than startups but it does happen from time to time.

Should you exercise your options?

Obviously, if your company is about to get acquired (or go under), the decision is much more straightforward. I’m going to assume that your startup’s fate hasn’t been determined.

The first thing you should recognize is that unless there is a buyer for your stock, it has no value. Go read Dick Costolo’s great post on evaluating employee options.

Here is a super-simplified timeline / decision hierarchy:

1. Investors decide if they should convert their preferred shares to common.
2. Common stock holders decide if they should exercise their options.
3. The proceeds are first distributed to the preferred shareholders up to their liquidation preferences. For example, if they invested $5M with a 2x liquidation preference, the preferred shareholders would receive the first $10M of any liquidation if they chose not to convert to common stock.
4. The remaining proceeds are then distributed ratably to the common shareholders (unless the preferred stock is ‘participating preferred’. In this case, the preferred share holders are treated ratably like the common shareholders).

Simplified, investors typically get their money first and common shareholders (you) get paid based on what’s left.

There are several questions that you’ll need to address to help guide your decision:

• What % of the company do my options represent? If you don’t already know the number of authorized shares, find out. Your percentage of ownership is determined by dividing your options by the number of authorized shares (Keep in mind that ‘authorized’ is substantially different from ‘issued’ or ‘outstanding’ shares).
• What do the investor preferences look like? If your company has taken multiple rounds of financing, this can be very hard to answer. Management should be able/willing to tell you two numbers:
  • The exit value where common stockholders get nothing, and
  • The exit value that would trigger the preferred shareholders to convert their preferred stock to common stock.
• Can I expect further dilution? (Will the company need to raise more money). If the company will need to raise more capital, dilution will be forthcoming. If the company has lost momentum (or did a very expensive prior round), and needs to raise more capital, expect lots of dilution.

Gauging Future Dilution is hard. Whenever a company raises money, the capitalization table can be entirely renegotiated. This rarely happens at a company with strong momentum that is raising money had a higher valuation than the prior round.

If a company is struggling, the capitalization table can be completely changed. The new investors have tremendous leverage (presumably because others don’t want to invest) and may value the company at a very low amount, effectively washing out prior shareholders. They’ll want to make sure current employees are appropriately incentivized, but former employees are at the bottom of their priority list.

I find it useful to generate several scenarios to see what my financial outcome would look like if the company had an exit. You’ll have to make some assessment of the likelihood of those scenarios and hopefully you’ll at least have enough data to figure out if it makes sense to exercise your options.