When to exercise employee stock options in a private company
How to know when to exercise employee stock options
Recently, Dropbox joined the relatively short list of billion dollar "unicorn" startups that are going public. According to the Wall Street Journal, only 26 venture backed companies of any size went public last year, and there are more than 100 US companies valued at $1b or more still sitting on the sidelines waiting to IPO. The ultimate question for the people who work at those companies is: should I exercise my stock options, and if so, when?
Tl;dr It only makes sense to exercise startup employee stock options (ISOs) if you know how much the tax from the exercise is going to cost you, and you can afford to pay it out of pocket. You should also be pretty sure the stock is going to appreciate going forward. So how do you figure all of that out? Read on...
A brief review of startup stock options (ISOs)
For those who have been following me for a while, you've probably already had a chance to check out my detailed post on what an ISO (Incentive Stock Option) is, how to value stock options in a private company, and how to avoid going bankrupt from the taxes you may owe when you exercise them. I've also talked about my own experience navigating the treacherous waters of startup stock options. Consider all of those posts suggested reading, but I will try to summarize what's pertinent to the question at hand.
Incentive stock options are the vehicle that startups and other venture backed companies use to incentivize their workers. It's a simple concept. A company gives an employee the right (but not the obligation) to purchase a specified number of shares in the company at a specified price (the strike price). Over time, as the company rapidly grows, and the stock appreciates, those options become valuable. That's the idea anyway.
Because of some incredibly generous tax laws in the US, employee stock options that have been purchased (purchased=exercised) are taxed at LONG TERM CAPITAL GAINS rates as long as they are held over a year. If they are held for less than a year, they are taxed as income. In states like California with high income tax, that can be a 25% difference in take home value. That's why it's so important to discuss WHEN and IF to exercise.
Knowing when to exercise stock options is tough
There are a couple of important guidelines to follow when purchasing employee stock options in private companies. Before I go into detail there, I highly advise using a free tool like Personal Capital to map out your vesting schedule so you can have an idea of how much you will have available to exercise at any given time, and how much it may be worth. You can see in the image below the vesting schedule for my own stock displayed over time in Personal Capital... I removed the details but you can understand the basic premise. Having a view like this is the first step to knowing when to exercise stock options.
1. Exercise employee stock options early, if possible
Anyone who is exercising stock options is trying to achieve the lowest possible tax rate on the stock that they purchase. As I described above, this generally means that it's best to exercise as early as possible. It can be difficult to determine when “early” is though since it is so hard to know how to value stock options in a private company.
As long as the stock is held for at least a year, the difference between the price at exercise and the value of the stock when it is eventually sold is taxed at the long term capital gains rate. The difference between the exercise price and the price at exercise is taxed as income. For instance, if John started at Uber in 2011 with 10000 options at a strike price of $1.00 that he exercised in 2015 when the value per share was $10, he would have owned $100,000 worth of Uber stock. He would have to pay income tax on $90,000 of that ($10-$1=$9 per share x 10000 shares). That doesn't sound great, but here's the good part. If he then sold those shares in the recent Softbank financing round for ~$50 per share, he would only owe long term capital gains (15-20%) on the rest of the appreciation. That equates to around $60,000 in taxes ($50-$10=$40 in appreciation, $40*.15=$6 per share) on his $500,000 in equity.
If he had waited until the financing round to exercise? He would owe up to $20 per share, or $200,000 in taxes! That's $140,000, just because he exercised early.
So, as has been established... exercising early is a good thing.
2. DO NOT exercise options too late
I know, I know. This seems like the same piece of advice, but it isn't. The biggest risk with employee stock options is exercising at a relatively high price, and then having to sell at a much lower price. This is because of the income tax that is incurred when the shares are exercised. If the shares are exercised at a high differential between the exercise price and the price at purchase, all of that is taxed as income.
Using the same example as before, let's say that John joined Uber in 2011 with the same 10000 shares at $1. In 2017, John exercised his shares at a fair market value of $68 (which is actually a realistic value, since their highest fundraising amount was at that level at that time). His stock is worth $680,000... on paper. In doing so, John saddles himself with a massive tax bill, because he owes income tax on $67 per share ($68-$1=$67). That tables out to somewhere between $250k and $320k that he owes on his next tax return.
But... 2018 rolls around, and Uber gets the aforementioned financing round that sets the common stock price back to $50. Unless John has enough cash to pay his tax bill without selling his stock, he'll be forced to sell at a loss in order to cover his tax liability. That would leave him with potentially as little as $18 ($50 a share - $32 per share in taxes = $18) a share. As I am sure you can see, if he had to sell any lower (which is a real possibility) he would have been in real trouble, possibly even owing more than he could sell.
Long story short, exercising late can be a huge disaster.
3. Exercise an affordable amount of options
Unfortunately, exercising employee stock options costs money. If someone is lucky enough to have 50,000 shares in their company at $1 a share, they still have to cough up $50,000 to exercise. That's a lot of money. As we can see from the experience of employees at companies like Uber, you could wait years and years for the opportunity to sell in an IPO or a private market transaction.
The optimal window to exercise employee stock options
These three guidelines point to a simple truth: it only makes sense to exercise employee stock options if the share price is likely to appreciate more in the next 3-4 years than it has over the time since the options were issued. Let's take a look at John, our Uber employee, one more time.
Share Price Over Time (theoretical 10000 shares granted in 2011 at $1 per share, vesting over 4 years, 25% per year)
2014 - $5 per share fair market value
In this example, John has been vesting for 3 years and has 7500 shares (3*.25*10000). But, with rapidly accelerating growth it would make sense for John to exercise his shares at that time. True, he would owe ~$2 per share in income taxes, or around $12000 ($5-$1=$4 per share * 7500 * 40% tax rate overall), but he could probably pay that out of pocket. If the shares go down afterwards, it's only a small ding.
2015 - $10 per share fair market value
It still makes sense to exercise the 2500 shares he vests in 2015, but the taxes have doubled (per share) along with the share price to $9,000 ($10-$1=$9 per share * 2500 * 40% tax rate overall).
2016 - $30 per share fair market value
By 2016, the share price has risen enough where it might make sense for John NOT to exercise his shares, if he didn't already. He'd have a relatively big tax bill (~$30k) that would be tough to pay out of pocket, and the value of the company has risen so quickly and so much that it would be hard to know for sure that it would continue to grow so quickly.
2017 - $68 per share fair market value
As has been established, exercising at $68 a share would be crazy. Hopefully, John has already exercised.
It only makes sense to exercise stock options if you know how much the tax is going to cost you, and you can afford to pay it out of pocket. You should also be pretty sure the stock is going to appreciate going forward. Unless you have those boxes ticked, be careful... and also make sure to always consult a real advisor instead of just some random Finance Guy on the internet :)