Incentive Stock Options: When to Exercise
You own incentive stock options and aren’t sure when to exercise. Your incentive stock options are a high stakes balancing act. If you get it right, you get to enjoy newfound wealth…get it wrong, and you may walk away with nothing but an expensive tax bill. Exercising at the wrong time may subject you to a tax approaching a shocking 50 percent. And yes, one single day can make the difference.
My friends, welcome! It’s Riley Hale here, financial planner specializing in equity compensation. In this article, I’m going to cover when to exercise your incentive stock options.
There are roughly three different times when you can exercise:
Pre-IPO
Approaching IPO
Post-IPO
I’ll address the pros and cons of each exercise time-frame to help you make the best decision for your personal situation. First, let me start with a word of caution: implementing the strategies described below requires professional help. Please don’t try this without the help of your financial professional. I am not liable for what you do with the information provided in this article.
Okay, that said, let’s dive in!
Pre-IPO
Benefits
1. More choices on when to sell and exercise
When a company is private, there are fewer chances to sell your stock. Generally, the company decides when shares can be sold—not the employee. Occasionally, when the company opens the window allowing employees to sell (i.e. a tender offer), accounting protocol requires that the shares were exercised 3-6 months prior to selling. So if you can’t sell unless you’ve exercised 6 months prior, doesn’t that make it more beneficial to exercise sooner? Yes! Exercising sooner will give you a greater chance to sell, where those who didn’t exercise early can’t sell because they’ve missed the time window. These restrictions around selling can often surprise unexpecting employees who didn’t exercise soon enough. Now that you’ve read this, you won’t be surprised.
Another example is if you’re wanting to exercise upon your company going public. Problem is, once a company files for an IPO, there’s typically a lock up period for 3-6 months where you can’t sell or sometimes even exercise. That period can be even longer for upper management and those who are “in-the-know” with sensitive information. If you don’t exercise early, this lockup period can be a barrier to your plans whereas exercising early, gives you more options before the lockup period.
2. Smaller Alternative Minimum Tax (AMT)
The difference between the grant price (specified in the grant document) and the fair market value on the date of exercise is the amount that may become subject to AMT. This spread is referred to as the bargain element. By exercising early, that spread is smaller because the company is worth less. With a smaller spread, you may even avoid AMT altogether. In the case you do become subject to it, the amount owed will likely be much smaller. Exercising sooner is one of many strategies to avoid AMT—in addition to the AMT crossover, deduction clustering, and income shifting. I discuss these strategies here. These strategies take serious planning beforehand, so don’t delay taking action now.
3. Potential AMT avoidance
When you exercise shares, you get a positive AMT adjustment—meaning you may have to pay the AMT tax. When you sell shares, you get a negative AMT adjustment —meaning you get those tax dollars back through a credit. By exercising as your shares vest, for instance, you are inadvertently staggering them to the point where the taxes and credits can offset each other. You’re effectively utilizing previous AMT taxes to offset or reduce future tax liability as you continue exercising. This makes exercising much more affordable, knowing you can manipulate the AMT tax to your favor.
4. Retain tax savings
Incentive stock options have tax advantages. Namely, the capital gains tax rate and avoidance of payroll tax. The term that’s used to explain this tax advantage is qualifying disposition. There are two things to do in order to retain qualifying disposition...or the tax advantage. The first I will discuss here and the second is in benefit #5 discussed below.
To retain qualifying disposition, the first thing you need to do is exercise within a specified time frame. By exercising early, you ensure that your incentive stock options retain qualifying disposition. For those who neglect their stock options, they run the risk of losing qualifying disposition and have to pay more taxes as a result. Miss the window? Unfortunately the tax advantage is lost and there’s a slim chance of getting it back. Unless you’re wanting a potential increase in taxes, I suggest exercising early.
Let’s discuss these windows even further. Most people have a 10 year window from the date of grant in which to exercise their stock options to keep their qualifying disposition. For people who own more than 10 percent of a company, that window is even smaller. These people have 5 years to exercise from the date of grant.
Now, if you are leaving the company or retiring, that window gets even smaller. You will have 3 months from the date of termination of employment to exercise. That’s if you terminate without cause. If there is separation with cause such as any fraud, dishonesty, serious misconduct, disclosure of confidential trade secrets, or the like, the plan administrator has the right to immediately terminate any options you hold. That is total forfeiture of all options: vested and non-vested. If, on the other hand, there’s termination because of retirement, death, or disability, you generally have 1 year to exercise.
Qualifying disposition (the tax advantage) will expire on the earlier of these deadlines...whichever comes first. So if you just left the company and think you have 3 months to exercise, but the 10 year expiration happens tomorrow, then you’ll only have until tomorrow to exercise without losing qualifying disposition and paying more taxes. This is one of those things where there is no wiggle room. Just like in school when the teacher warns you saying “there is no late work in real life.” This is one of those times. It doesn’t matter if it’s an accident, if you forget, or you miss the deadline by a minute. So don’t let this happen to you. Employees need to check the grant notice to confirm the length of time they have to exercise as these dates may vary by the company.
Exercise early. It’ll increase the likelihood of keeping qualifying disposition and reaping tax savings.
5. Start the tax advantaged timer sooner
Remember that term qualifying disposition? Well here it is again. In addition to exercising within a prespecified time frame, there is a second requirement you must meet: don’t sell until it has been at least two years from the date of grant and one year from the date of exercise. Exercising sooner will get you to qualifying disposition sooner—effectively locking in those beneficial tax rates.
As mentioned in benefit #1 above, opportunities to sell shares at private companies are few and far between. When they do pop up, it hardly seems there’s enough warning. As such, you’ll want to ensure that you have met qualifying disposition before one of those opportunities surprises you. It’d be sad to sell when you haven’t waited the two years from grant and one year from exercise because you’ll have to pay the higher, less advantageous tax rate.
If done right and qualifying disposition is retained, there’s a possibility of paying zero taxes when selling your ISOs. In order to unlock the glorious 0% tax rate, you’ll likely have to implement strategies to get yourself into lower income tax brackets. It’s easier to obtain these lower tax brackets when you’re not making as much money, which happens to be towards the beginning of your career. This is an additional reason to exercise early. Paying taxes sooner may mean less taxes. Ultimately, exercising sooner allows you greater ability to manipulate the taxes in your favor.
If your company hasn’t IPO-ed yet, be a champion by sharing this article in your company Slack channels so your co-workers can learn about these advantages too!
Bonus!
Before getting to the risks of exercising pre-IPO, let me share this secret bonus! It’s called early exercise. An “early exercise” is where an employee exercises their incentive stock options before they vest. Not all companies offer this, so this may or may not be applicable. Ask your employer or check your grant document to see if this is a possibility for you. This is mostly for the first few employees at a company that’s less than a year old. Depending on your financial situation, it might not make sense to do this so it’s important to seek professional help. If an early exercise is applicable, you should consider making an 83(b) election. This must be filed within 30 days of exercise...so you’ll need to get on it quick. An 83(b) election is where you choose the bargain element for AMT purposes. While section 83(b) doesn’t usually apply to ISOs, early exercising is the rare case it does. It only works for exercising unvested stock.
If you truly are one of the first few employees of a tech startup, you should also look into the tax benefits of qualified small business stock (QSBS) which I discuss in another article.
Risks
As a fiduciary, let me also explain the risks of exercising early:
1. Risk of loss
One risk of exercising sooner is that you’ll be purchasing and paying taxes for shares that could potentially be deemed worthless in the future. Because not all companies take off, there is inherent risk in purchasing your options and paying taxes on them. If your company fails, you might not be able to write-off some of those losses. It’s important to exercise if you’re confident in the future of your company. You should also make sure you can afford to exercise your shares and only exercise what you’re willing to lose. A good rule of thumb is to not exercise more than 10 percent of your net worth. In addition, a major concern when you exercise is that you may incur a tax bill and be unable to sell any shares to pay that tax bill (since you’re pre-IPO). So make sure that you have enough cash to pay for any AMT if applicable.
2. Liquidity risk
The sooner you exercise, the sooner you lose liquidity with your cash or savings. When you exercise, you have to pay for your shares. This ties your money up into something that you’re not sure if (or when) you’ll be able to sell and turn back into cash. Take this into consideration before exercising. Make sure you have adequate cash for future expenses while your money is locked up. Do you need money for a down payment, an education, or other big purchase? If yes, you might consider finding a balance between having available cash for your needs and locking it up into an investment in your company’s stock options.
Approaching IPO
Benefits
1. Optimizing liquidity
If you want to minimize the amount of time your money is “tied up” in the stock option, exercising just before the IPO may be the best time for you. When you exercise, you have to purchase the shares at the grant price—effectively tying up your money until you sell and hopefully recoup your investment. The shorter time your money is locked up, the more access you have to it for other purposes.
There are two periods where your money should be tied-up: waiting for qualifying disposition (at least one year), and the lock-up period (six months). If you want your money tied up for the least amount of time, then why not overlap these two periods? Rather than waiting one year for qualifying disposition, and then tacking on another six months for the lock-up period. Bump that time down to just one year by overlapping these two waiting periods. This will minimize the time your money is tied up. Once your lock-up period ends, you have two wonderful things: liquidity and the best tax rates through qualifying disposition. Meanwhile, those who exercise earlier, have their money “tied up” for a longer period of time.
2. Smaller risk of loss
If your company is approaching an IPO, that means that your company and its shares are more likely to have value. Would you trust your investment in a company that has reached the point of IPO or one that just started a month ago? Case in point. Waiting for the news that your company is looking to IPO ensures that your shares are worth something and there’s a potential payout coming up.
Risks
Again, let’s consider the risks of exercising as your company is approaching an IPO.
1. Your company might not IPO after all
Not all young companies take off. In fact, it is more rare to IPO than not. That’s why they call it a unicorn. If you wait for an IPO and it never happens, you may have just wasted all that time when you could have exercised early, met qualifying disposition, and sold shares through a tender offer (for example).
2. More taxes
Because you’re waiting a longer period, the company has more time to experience growth and increase in value. This means more potential taxes. The AMT you pay could be much higher because the spread of the bargain element is greater. And if your incentive stock options lose their qualifying disposition (also known as DISqualifying disposition), then your tax bill could skyrocket. While company growth is a good thing, waiting until your company approaches an IPO also raises the stakes with your taxes and requires even greater planning on your part.
Post-IPO
Benefits
1. You know if it’s “in the money”
“In the money” means you have something to gain by exercising your stock options. You wouldn’t exercise if you would lose money by doing so (i.e. paying $5 for a share that’s worth $1). When a company is public, you can see second to second updates on what your shares are worth. And when you know the exact value, it’s easier to plan around. On the other hand, while the company is private it’s hard to know if you’re “in the money” or what your shares are currently worth. Private companies are only required to get their stock valued once a year through a 409A valuation. There can also be valuations when a round of funding is secured. So you may be dealing with a number that’s up to a year old. If you exercise after an IPO, you don’t have to wait for a valuation...you’ll know instantly if you’re “in the money” or not.
2. The highest liquidity
It is much easier to sell public company stock (post IPO) than it is private company stock. When you exercise post IPO, you can sell your exercised shares very easily. That said, just because these shares are more liquid doesn’t mean you should sell for the sake of selling. Remember the timing around qualifying disposition. If possible, wait to sell until two years after grant and one year after exercise to maintain those beneficial tax rates. In the case, however, that you need cash sooner, post IPO liquidity can be very advantageous.
When you can sell shares, remember the importance of diversification. Ownership of stock options can be financially life changing, but most owners have an overconcentration of company stock in their portfolio. This is dangerous since a greater portion of your net worth is tied up in a single asset...namely your company. No matter how well you think your company will do, overconcentration is risky for your portfolio. Despite the company’s product or service, there are too many variables that could go wrong—creating a decline in the company’s value and devastating your portfolio. Fortunately it’s easy to diversify once you can sell shares. Try and get into a low cost, globally diversified, ETF portfolio. If you’re told anything else, then you’re probably being sold something. Watch my video on how to set up a diversified portfolio. You may consider hiring a fee-only financial planner to make a plan for diversification...or getting into a diversified portfolio through services like Betterment or Wealthfront.
Risks
1. The company could flop on an IPO
Waiting to exercise post-IPO might be too late. Why? Not all public companies enjoy their stock price going up. This is something that you have no control over, even if you think you know the numbers and believe in the product. There are many examples of companies flopping upon IPO. So if you wait and the stock prices plummet, you may have lost your opportunity to cash in your equity.
2. Increased taxes for successful IPOs
If share prices skyrocket upon going public, that’s wonderful news...but you may also have to pay more taxes. If you exercise post-IPO (after the share price has skyrocketed), that means a larger bargain element for AMT and, hence, more taxes to shoulder. Even worse, if you suffer disqualifying disposition and have to pay normal income tax rates on the capital gains, that will be much more painful with the higher gains.
3. Selling right after IPO can minimize gains
Once a company is public, the stock prices can drop for a couple of months because all the employees start selling their shares. They all sell at once because the lock-up period ends and they all want to recoup their investment.
Conclusion
If there’s one thing you get from this article, it’s this: there are many opportunities to minimize your taxes and optimize your incentive stock options.
You should work with your financial professional to create a strategy that works best for you. If you’d like some helpful tips regarding your personal ISO situation, you may schedule an appointment here for free. This offer is subject to availability, so hustle on over and schedule before they’re all gone.
Did you find this article helpful? If so, make sure to share it with your coworkers...there’s a chance they need help understanding their ISOs as well.
