Become a better investor
Lesson in Course: Finance at work (advanced, 3min )
I understand an option is an agreement that allows me to buy shares in the company. Should I ever buy shares early?
In our careers, there may come a time when we decide to work for a startup and forgo a higher salary offered at a more established company for something more exciting and flexible. If the startup is successful, then our bet has paid off. Our equity, or ownership in the company, will be worth much more than the wages we left behind.
Before we call victory, the large payout from our stock sale can result in extremely high taxes—over a 50% tax rate if we live in a state like California or New York. Yikes! The good news is that we can early exercise as a strategy to shield ourselves and prevent losing so much of our hard work to taxes. Before we jump into the strategy, let's understand why most people choose to wait to exercise.
Most folks choose to wait to exercise their options until a liquidity event. We've listed 2 possible reasons why someone would wait.
To exercise, we have to pay the company for our shares. Depending on the cost to purchase and the number of options we are granted, some folks end up waiting to exercise. However, delaying the decision to exercise stock options can become a taxable event. According to the IRS, we’ve technically made money if the value of the company has gone up. The strike price or price we are buying shares for is lower than the current value of the shares and it looks like we've made money by buying at a discount—even if we can't directly sell our shares just yet. The difference of this value is what we will be taxed on when we choose to exercise. Read more about ISO and NSO exercise taxes.
While this is unavoidable for folks who cannot afford to exercise, many folks fall into this situation merely because they don't know about the early exercise strategy.
Early exercising means that as an option holder and employee, we decide to enact our right to purchase stock in the company even before we own the stock.
Normally, option grants are tied to a vesting schedule, which is a timetable of when we would formally receive shares. Early exercising allows us to exercise all of our vested and unvested shares by paying the strike price. The result is that we lock in the taxable gains now for all our shares.
Early exercising our shares eliminates owing taxes for exercising both ISOs and NSOs!
Early exercising when we receive our stock option grants allows us to avoid future taxes. The moment we receive our option grants, the strike price of our options and the value of the common stock (FMV) are the same. Thus the difference between the two is $0, just like our tax liability.
Not all stock option purchasing plans provided by companies allow for early exercise; however, it's more common to have them than not.
If the company allows it, anyone can take advantage of the tax breaks and choose to early exercise. To do so we would need to notify the company and come up with a plan. We may need some assistance from the company; however, we can do most of this ourselves. Read more about this in forming an action plan for early exercise lesson.
Early exercising also offers the extra bonus of starting the clock on QSBS.
QSBS is known as qualified small business stock. It is an exception granted by the IRS to avoid paying up to $10 million in taxes from the sale of stock in a startup. Read more about QSBS in our lesson found here.
Early exercising is a very powerful strategy that allows us to save on future taxes. However, there are some risks associated with early exercise. These risks are common to exercising stock options in startups and will vary depending on the future success of the company. If we truly believe in the vision and success of the company and can afford to pay for the shares, early exercise is something that we should strongly consider.
Regardless of how we feel about the future of the company, we should do ourselves a favor and check in with our company's legal department to see if our stock option plan allows for early exercise. That would give us a clear understanding of our available options for the future.