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Lesson in Course: Finance at work (advanced, 13min )
Now that I know the basics about stock options. What do I need to know before exercising?
We read somewhere that Facebook's IPO helped 1,000 employees became millionaires overnight because they were owners of the company. We work for a promising startup now with stock options. How do we also become owners in our startup? We can start to become owners by exercising our options.
Options are simply a contract and it’s the common stock in the startup that is sold for money. To receive common stock in the company, we have to exercise our rights stated in the options agreement to buy common stock for the strike price. In the future, if we plan to sell our shares, we must exercise our options.
To exercise our option to buy shares in the company, we need to notify the company (legal counsel or HR) and pay the company the total exercise cost.
The cost is calculated by multiplying the strike price, or the price we need to pay for each share, and the total share count.
Exercising options are a good idea when we are confident in the business however, exercising stock options have risks involved. Let's dive in and cover what they are.
Exercising can be risky. When we exercise, we should be aware of the following risks which are broken out from least risky to most risky.
Exercising in advance of a liquidity event or early exercise in general carries the risk of the company shutting down and us losing the money we paid to exercise.
While early exercising presents a risk, waiting to exercise can be even riskier. Let's say we end up resigning and decide to hold on to our stake in the company. Waiting to exercise during our resignation will require us to owe taxes on the difference calculated between the FMV and the strike price. On top of the taxes owed, we also need to pay for the cost to exercise our shares. In the worst-case scenario that the company eventually shuts down, we would lose the taxes paid as well as the exercise cost.
There's no upfront cost in choosing not to exercise. However, if the company is successful, and the shares in the company become very valuable, we would be looking at an opportunity cost of upwards of hundreds of thousands of dollars. Learn more about opportunity costs here.
If we are resigning from a startup and haven't exercised early or filed an 83(b), we will need to choose whether to exercise our options. Most companies provide a post-termination window of 30-60 days to make the decision. As long as we decide within the window period, we can purchase common stock in the company at the strike price. If we wait beyond the window, we will forfeit all of our equity.
No action is needed if we decide to walk away without exercising. Generally, if the business prospects are in decline or are in peril, the risk to exercise is too large.
If we had early exercised, the company owes us the amount we paid to exercise the remaining unvested shares. We should follow up and make sure that this amount is refunded!
When we exercise our options, we are making an investment in the company. As prudent investors, we should only invest when we are confident the company will do well. This also doesn't mean we need to invest in the full amount. Instead, we should invest an amount we are comfortable with possibly losing. If we are confident in the business and make a decision to invest by exercising our options, we should always consider early exercising—the benefits greatly outweigh waiting. And if the future of the business is uncertain, we can exercise only a portion of our shares.
It’s helpful to consult a tax accountant. Particularly in estimating if AMT will be owed.