What is entailed in exercising employee stock options?

Young companies often offer employees stock options. These options are not stock in and of itself, but rather, they grant the employee the right to purchase a specified number of shares at a set price (as outlined in the grant).

The price at which the employee can exercise the option and receive shares is called the exercise price, and it is typically the current fair market value of a share of the company at the time the grant is created. The idea behind stock options is that the price of the shares will rise substantially over the given exercise price over time, allowing the employee to gain a great deal of equity at a discount (which is a major advantage over the market).

It is important to remember that the grant only gives the employee the right to purchase or exercise his/her options - exercise is therefore not a requirement.

There are many aspects that must be considered before deciding to exercise stock options. A few of these include the future prospects of the company (i.e. how the shares will appreciate in value) and the applicable taxes upon exercise/sale of the options. Taxes can have a significant impact on the plausibility of an employee being able to exercise his/her stock options and must be considered carefully.

Early exercise of stock options

Typically, an employee must wait for his/her options to vest before being able to exercise. However, in certain grant contracts, there is a clause which permits the employee to exercise “early,” or before the options have vested. In these situations, the employee is typically able to exercise the options immediately upon receiving the grant. While you can exercise them early in this situation, it is important to note that the options will still vest according to the schedule detailed in the grant contract.

Impact of early exercise

If stock options still need to vest, why would you exercise early?

Early exercise may be beneficial for the employee for both types of options, ISOs and NSOs. For ISOs, early exercise can help the holder qualify for the favorable tax treatment that ISOs receive. It is important to keep in mind that in order to receive the favorable tax treatment for ISOs, the employee must hold the shares for at least two years after the grant date, and at least one year after the date of exercise. For NSOs, on the other hand, being able to exercise early will allow the employee to reach the long-term capital gains rate sooner, effectively lowering the overall cost of exercising the options.

Another important consideration when exercising early is that the employee may owe less in taxes if he/she exercises the options immediately upon receiving the grant. This is merely a result of recognizing zero spread between the current fair market value of the stock and the offered exercise price at the time of granting, as these prices will be the same in that moment. Furthermore, please note that in order to qualify for this tax treatment, the employee must file an 83(b) election with the IRS within 30 days of exercising.

While early exercise may be a very powerful tool for many employees, this method is not risk-free. One such risk or limitation is that the employee is not able to make a cash-free transaction (a cash-free transaction means that some of the stock is immediately sold to cover the costs of exercising); thereby requiring the use of cash to finance the exercise. When an employee uses his/her own cash to cover the cost of exercising, there is inherently more risk involved in addition to the opportunity cost of not having the cash on hand to finance certain purchases in their personal lives, such as a home or education for children.

Another, more noteworthy risk associated with an early exercise is the uncertainty in the movement of the underlying, in this case the stock price of the company. The stock price of a company, especially that of a younger company, can have a great deal of volatility and general uncertainty in its ultimate direction.

Typically, exercising immediately does not provide the employee with a great deal of time to observe the direction of the company and overall business/market to make an informed decision about whether it’s worthwhile to exercise or not. Failing to make an informed decision in combination with financing with personal cash can lead to a substantial loss if the company doesn’t take off like they hope. Therefore, it is important to access the company’s prospects of success with thorough due diligence before making the decision to exercise early.

Summary:

• In certain grant contracts, there is a clause that gives holders the ability to exercise options immediately upon receiving the grant
• When making the decision to exercise early, one should carefully consider the riskiness of the underlying stock and tax implications
• When done correctly, an early exercise could lower the tax basis for both ISOs and NSOs

Not sure if you should do an early exercise? We want to help. Contact us here and or keep reading about options here.