Smart Money Tips

5 Employee Stock Option Exercise Strategies

  • Workers at startup companies and small enterprises about to IPO face tough decisions around their employee stock options
  • There are five primary ways to exercise ESOs to maximize their value, keep taxes in check, and manage a portfolio’s diversification
  • Understanding the rules and working with an experienced advisor can avoid pitfalls and maximize your net worth

The paradox of choice grips tech-industry workers who hold employee stock options (ESOs). It’s often tough to evaluate and determine the right course of action with this potentially lucrative form of equity compensation. Having a good perspective of your current situation, future goals, and a solid understanding of how stock options work are all critical. There are five primary ways you can go about exercising ESOs. Let’s go through the pros and cons of each to help you decide what might work best for you.

  1. Exercise at a liquidity event.

Many employees of tech startup companies end up waiting until the firm is acquired or goes public to exercise their stock options. That’s the ultimate carrot dangling in front of the horse – seeing the value of your options soar on that glorious day.

The upside is obvious – a very hefty payday with little leg work. Moreover, you don’t owe taxes until you exercise. The downside can be substantial, though, if you exercise and sell on the same day all your gains would be subject to ordinary income tax rates.

Another issue we commonly see is when workers hold out for an acquisition offer as they end up bypassing career moves that might ultimately be better for them (since most ESOs expire within three months of leaving a company). That can feel like donning a pair of golden handcuffs for years on end. It’s also possible that an IPO or other event does not happen within 10 years of receiving ESOs, as that is a common period of an option’s life. The result is being forced into exercising at perhaps an inopportune time or forfeiting the options altogether.

Here’s what you can do: Talk with your employer about extending or rolling out your options so they live beyond your termination date. That can give you a little more wiggle room so that you make the most of your ESOs.

  • Elect not to exercise vested options.

It’s common for tech-industry employees to forfeit their options when they leave a company before a liquidity event such as an IPO. It is a burdensome and even costly process to exercise options, purchase shares, sell stock, and pay all the taxes. It’s also risky – the value of the shares could drop sharply causing significant capital losses.

Another scenario is when the company does not enjoy an IPO date or buyout offer. In such an instance, the value of ESOs dwindles as the options’ expiration approaches – typically 10 years from the grant date or, if you leave a firm, three months after your departure.

You might face this dilemma: exercising before there is a secondary market for the shares. This is a big hurdle since you must then have cash on hand to purchase shares after exercising the options along with being able to pay taxes that come along with that process.

  • Exercise at or near expiration.

It is not an all-or-nothing event with options. You can capture some residual value before a liquidity event or in advance of leaving the company. Exercising the options, buying the stock, and setting aside cash for taxes are all planning tasks that can be done when working with an advisor well-versed in equity compensation.

It is critical to understand, however, that exercising ESOs is a taxable event. You typically face income tax liability on the difference between the exercise price and the fair market value (FMV) of the options on the exercise date. Complicating the matter is the risk of the Alternative Minimum Tax (AMT) for incentive stock options. Managing a large tax bill requires understanding all these potential impacts.

One of the biggest pitfalls people fall into is exercising options while not having a plan to pay the taxes due since exercising options in itself does not generate cash to the holder. The last thing you want to face is having to sell other securities and assets just to meet the taxes owed from exercising ESOs.

To avoid that dire situation, workers might aim to wait to exercise options until a liquidity event with the company. Once again, negotiating with your employer to have a longer option window can help.

  • Early exercise and the 83(b) election.

Here is where we get into somewhat complex financial planning. But it can be worth it. An early exercise is done with unvested ESOs. You choose to buy the stock at the exercise price and file what is known as an 83(b) election. Though your shares are still subject to vesting requirements, you can save on taxes and earn the most value from your options with this approach.

The reason an early exercise with an 83(b) election can be a savvy move is due to the tax treatment. It begins your holding period requirement so that you can pay more favorable capital gains tax rates sooner when you look to sell the stock. What’s more, the election can even lead to a cashless exercise.

Unfortunately, not all firms offer an early exercise option. Be sure to check with your HR department and plan documents. You can even ask your employer if you can have this choice during your job offer discussions prior to employment. Exercising early, effectively locking in a lower capital gains tax rate, can save enormous sums if, say, an IPO is highly likely soon after you join the company.

An 83(b) election with early exercise can be risky, too. Consider the scenario in which you exercise (which means you buy shares at the strike price), and then the stock drops sharply. The value of the shares is now worth a lot less after you have raised cash to buy the stock and pay taxes. You can suddenly become both cash-poor and stock-poor. Partnering with an experienced fiduciary advisor can help manage this risk.

In general, early exercise works best with early-stage startups where the FMV of the stock is low and your strike price is also low. It becomes riskier if the company is more mature and features a higher exercise price.

  • Recurring exercises.

Exercising ESOs as each set vests is not a popular strategy, but it can be the right one. The issue is that it’s a very hands-on approach, subject to both a lot of your time and even money (things you might not have a lot of). The reason it can work well, though, is because it features some of the same benefits as an early exercise – the clock starts ticking on your holding period requirement.

The risk is that you exercise periodically, purchasing shares at the exercise price and setting aside cash for taxes, only to see the stock fall in value. The worst-case scenario might be you end up owning a large number of shares all while the company’s value never increases, or even drops, over time.

Mechanically, you and your advisor must stay on top of the FMV of the stock and any events that could increase its value. The FMV of the stock on the exercise date determines your tax cost, so making the right decision as to when to exercise is critical.

Next, after keeping on top of the goings on with the company, you must decide whether to exercise vested options. We see people do this periodically, say each year, with their tax advisor or financial planner, but it’s also plausible that you would have to decide more frequently than annually if the company is growing rapidly. Careful attention to AMT tax impacts is key while an overall risk/reward scenario analysis with incentive stock options and non-qualified stock options should be performed.

After all of that has been factored in, the mechanics are then straightforward once: you pay the exercise price, acquire the shares, and set aside cash for taxes.

Summary of the 5 ESO Exercise Strategies

StrategyProsCons
Exercise at a liquidity eventLargest upside potential, no costs until exercisingSignificant tax risk, opportunity cost of other career paths, possibility of ESO forfeiture and expiration
Elect not to exercise vested ESOsSimplicity, avoids facing a large cash outlay and taxesMisses out on some residual value of the options
Exercise near expirationDelays having to raise cash to buy shares and pay taxes, allows for more time to wait for a liquidity eventESOs could be forfeited, holder faces a large cash need to buy the stock and pay taxes
Early exercise and the 83(b) electionLock-in favorable capital gains tax rates, better at the early stage of a companyThe need to raise cash to buy stock and pay taxes, the risk that the stock’s value declines significantly
Recurring exercisesAllows for less taxes owed over time, greater career mobilityRequires time, effort, and cash

The Bottom Line

Workers at tech startups and even more mature firms nearing a possible liquidity event, such as an acquisition or IPO, face many choices with their ESOs. Knowing all the risks and benefits is critical to the health of your long-term financial plan and net worth. Teaming with an advisor experienced in equity compensation can go a long way toward maximizing the value of your ESOs, minimizing taxes owed, and managing risks.