Should I Exercise My Incentive Stock Options?
Incentive stock options (ISOs) are high risk, high reward opportunities, which often leads to high stress. On the one hand, exercising early can be incredibly risky as it’s possible that you exercise before the stock tanks in value. On the other hand, you can potentially save big on taxes if you exercise early, the stock soars, and you divest at the right time. Stock options are just one more consideration that leads to anxiety for startup founders and employees.
There are many factors that need to be considered when deciding to exercise stock options. These include your risk tolerance, the amount of wealth you have already accumulated, how diversified your assets are, your family situation, etc. It would be impossible to cover all of these in a blog, however the scenarios below should provide some guidance on when best to exercise ISOs. Keep in mind that this is not investment advice, and your specific situation will not fit neatly into any of these boxes.
The Stage of your Company May Influence your Decision
Early-Stage Companies
When assessing whether to exercise ISOs, you must first consider the cost to exercise. If your company is very early stage, and the shares are priced very low, then it’s usually prudent to exercise a large percentage, if not all, of these shares. This is because the tax savings on exercising ISOs early can be substantial. Just be fully aware that early-stage companies often fail for a variety of reasons, many of which are not controlled by the company. There is a good chance that you never get this money back, so only exercise early if this is money you can afford to comfortably lose.
Private but Not so Early Stage
If your company is private but has taken one or several rounds of funding, then your ISOs will probably be more costly to exercise due to higher taxes. Because of the higher cost to acquire shares,it’s usually prudent to exercise a much smaller percentage, if any, of your options immediately. Again, keep in mind that the stock could easily go to zero – so be prepared to potentially get nothing back for the price you pay. You can hold the remainder of the ISOs until you’re more certain that the company will succeed, and you will profit from the sale of the position. Unfortunately, this may not be until after a liquidity event.
Public Companies
If your company is already public, and you aren’t currently in a blackout period or lockup, then the most tax efficient strategy may be to exercise your ISOs one year prior to selling. This way you receive the full tax advantages of the ISOs (your gains will be treated as capital gains instead of ordinary income), which can be significant. Just make sure you wait at least one full year after exercise, and two years after they were granted, before selling or you won’t get the tax benefits. And once again, keep in mind that there is serious risk involved with exercising and holding. The stock could easily crater while you hold it, in which case the tax advantages won’t end up mattering at all.
The Safest Strategy
The safest strategy is always to wait until your ISOs are in a profitable position then exercise and sell them the same day. This will end up costing more in taxes because you won’t get the long-term capital gains tax treatment, but you get to exercise the options with the certainty that you will have a payout. This is the best strategy for the majority of investors because it’s the most certain, there is virtually zero chance of loss, and it causes minimal stress and anxiety.
Most employees and investors undervalue peace of mind when making decisions. Too often we see employees attempting to maximize profit and minimize taxes at all costs. Sometimes this works and sometimes it doesn’t, but what’s guaranteed is that you are adding a lot of stress onto what’s already a very stressful work environment. This stress is also often compounded by dependents and other responsibilities outside of work. This is why we urge clients to take peace of mind very seriously. Consider lower profit potential for the certainty that you will not lose money on the trade.
Other Very Important Considerations
AMT Taxes
If you end up making a large profit from your ISOs, then there is a good chance you will be hit with AMT taxes on top of your capital gains taxes. The AMT tax can be significant, so you need to consider this when deciding if you want to exercise and hold your ISOs. We recommend having a financial planner and tax professional run estimates on your AMT taxes when deciding if you should risk exercising and holding your ISOs. This will allow you to make a better informed decision.
Your Specific Company
Make sure you research your company before exercising. Begin by looking at your company's financials if they are available to you. You should also analyze the company's competitive landscape, market position and management team. Additionally, research industry trends to get an idea of where the company is headed. Lastly, talk to other shareholders and employees to hear their perspectives on the company, its prospects, and potential risks and headwinds they may face. Just remember that management teams and employees are often blind to the true risks a company faces and the various threats in the industry. Furthermore, leadership teams are incentivized to motivate employees so, more often than not, they greatly exaggerate their companies prospects for future growth.
Economic Cycles
Even great companies sometimes fail due to bad timing and/or a bad economy. Early-stage companies rely heavily on market liquidity and a strong economy. It’s important to know that there are certain risks that are out of your company’s control. For example, in this climate, decisions by the Federal Reserve to increase or lower interest rates have a tremendous impact on startups and their ability to succeed.
Share Dilution
Additionally, consider the potential for dilution of your shares. Your company may issue more stock as it grows, which will lower your percentage share in the company.
Regulatory Risks
All companies face regulatory risks but disruptive startups are particularly susceptible to these risks due to their “move fast and break things” nature. Any disruptive technology naturally causes fear in the halls of Congress which can lead to restrictive legislation. For example, technologies such as the internet and ride sharing faced regulatory scrutiny that could have stifled growth severely. Today Coinbase faces similar scrutiny and could potentially be regulated out of business. This is yet another risk that is somewhat out of the company’s control.
IRS Form 83(b)
Often early-stage ISOs are for “restricted” stock meaning you don’t fully own the shares yet if you exercise them. In this case you will need to file a for 83(b) with the IRS to exercise them. Make sure this gets filed according to IRS guidelines or the IRS may determine that your shares were not exercised. Most importantly 83(b) must be filed within 30 days of the grant or purchase date of the restricted stock.
Sometimes Help is Needed
Ultimately, the decision to exercise stock options is a personal one and should be made based on your specific situation. Making the right decision can be very difficult, and we recommend working with a financial planner and a tax professional to make sure you analyze all your specific risk factors.