Should I Exercise my Options?

Startup Stock Options by + on November 12, 2007 at 3:07 pm

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.

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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.
  • http://www.mattishness.com mathew johnson

    dave, you should be a vc :)

  • Anonymous

    Dave, regarding the “Tax Advantages” section: An ISO must be held for 1 year from exercise date AND 2 years from grant date in order to receive capital gains treatment. An NSO that is held for 1 year from exercise date receives capital gains treatment, too. In both cases, if the option was pre-exercised (i.e., exercised before vested), within 30 days of the exercise date the holder must file with the IRS the appropriate 83b election paperwork in order to qualify for capital gains treatment. It is my understanding that the 30 day filing deadline is strictly enforced.

  • eddie

    If you have “early exercise” options, filing an 83b is not only important to get cap gains — if you early exercise and buy stock subject to buyback where the buyback price is less than fair market value, but you don’t file an 83b, you could also be subject to the disastrous tax consequence of being charged with ordinary income on the spread between the exercise price and the fair market value of the shares on the date the buyback restrictions lapse. So for instance, say you early exercised 1000 options at $1 a share in year one, but didn’t file an 83b election. Those shares are worth $5 a share at the end of year 1, $10 at the end of year 2, $20 at the end of year 3 and $50 at the end of year 4. For year 1, you will be taxed on 250 shares x $4, for year 2 you will be taxed on 250 shares x $9, year 3 you will be taxed on 250 x $19 and year 4 you will be taxed on 250 x $49. Ugly — especially if you don’t have liquid shares to sell to pay the tax bill.

  • http://jon.es Terry Jones

    Hi Dave

    Here are couple of quick comments.

    Under “Tax advantages”, you say “NSOs don’t provide the same opportunity”. There’s no reason you can’t exercise (vested) NSOs aiming for a tax break. The difference is that with an NSO, exercise is a taxable event whereas with ISOs it’s not. But if you believe there is going to be a large increase in stock value and your options have a very low strike price, exercising may be a great move – you pay tax on an arguably very small spread, you hold the stock for >1 year, and pay long term capital gains tax on the spread when you sell the stock.

    Also, you say that “unless there is a buyer for your stock, it has no value”. That’s very definitely not the case. The stock may have no buyer for various reasons (not for sale, not allowed to be sold), but that doesn’t mean it has no value. When issuing ISOs the board needs to determine FMV. That can be done using last purchase (investment) price, or via some other arguably more accurate method.

    The key in both the above is “arguably”. You don’t really want to have to argue with the IRS about the FMV of illiquid stock at the time you exercised options or issued ISOs to an employee. That’s a very gray area, and of course an argument you’re unlikely to win.

    Finally, you leave out the 83b election, under which unvested stock can be exercised early, and the tax paid immediately. That’s a complex subject but can be a very attractive option when FMV is very low. I don’t even know if 83b election is still possible – it’s about 5 years since I knew this stuff well. Along with 83b is the complicated AMT. These are things people being granted options should be aware of – especially as 83b election has to be done promptly.

    Regards,
    Terry

  • http://www.naffziger.net Dave Naffziger

    Terry,

    Great points. They are a great addition to the conversation. I think I should pen a separate post on the 83b election as its a critical part of any startup (particularly for founding members).

    While options do have an FMV, and the company is required to determine it, I’d argue that the are still essentially ‘valueless’ to the option holder as it is next to impossible to find a market for the stock. Not always true of course, but it definitely applies to the vast majority of startups.

    Dave

  • http://jon.es Terry Jones

    Hi Dave

    > Great points, thanks for taking the time to make them. They are a great
    > addition to the conversation.

    And thanks to you for blogging in the first place.

    > I think I should pen a separate post on the 83b election as its a
    > critical part of any startup (particularly for founding members).

    Yes. It’s complicated though, at least once you run into the AMT. BTW, I think for a very early stage company (with very low FMV) and very low strike price options, NSO plus 83b can be a better choice than an ISO.

    Anyway, you definitely need to IANAL-preface any posting on that one…

    > While options do have a FMV, and the company is required to determine the
    > FMV, I’d argue that the are still essentially ‘valueless’ to the option
    > holder as it is next to impossible to find a market for your stock. Not
    > always true of course, but it definitely applies to the vast majority of
    > startups.

    I still disagree, but I guess it’s just a POV. You’re really saying that the value bound up in the option is currently illiquid and will be for some time. But illiquid != valueless. If there were really no value, employees would be happy to give their stock options away, or not have them at all :-)

    Regards,
    Terry

  • KJK

    > 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.

    I’m terribly new at this, but in the case of the former the answer is to exercise early?

  • http://www.naffziger.net Dave Naffziger

    KJK,

    As always it depends. Basically, you only get the benefit of long term capital gains if you hold the stock for a year. So, if an acquisition is imminent it typically makes sense to wait until the acquisition comes about and exercise your options as part of the exit (this reduces downside risk in the event the acquisition doesn’t happen.

    Dave

  • Confused

    Dave, if grant price of an NSO equals its fair market value at grant date then the spread is $0 and if I nderstand it correctly taxes to be paid with an 83b election within 30 days of grant date is also $0. Right? So under this condition one should definately make the election. right?

  • Confused

    Per IRS Publication 525 (http://www.irs.gov/pub/irs-pdf/p525.pdf, see page 13, second caution):

    “You cannot make this choice for a non-statutory stock option.”

    ‘this choice’ refers to “Choosing to include in income for year of transfer” (or the 83b election, right?)

    So it appears 83b does not apply to NSO.

  • http://venturehacks.com/articles/advisors-part-2 Venture Hacks — Everything you ever wanted to know about advisors: Part 2.

    [...] advisors want options they can exercise immediately—that’s [...]

  • Cemartinez415

    my company is being acquired at 2.50 cents less per share than it is now. Should we cashless sell or will a cashless hold be an option?

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