By: Joe Ferreira, Sam Marshall, Jack Rabuck
“The best time to plant a tree was 20 years ago. The second-best time is now.”
It’s doubtful that whoever said that was talking about stock options, but that does not make the advice any less relevant. Making decisions can be difficult. Making decisions that impact your long-term financial wellbeing in the face of uncertainty and competing priorities? That can be paralyzing, and indecision is just a decision without intention.
A question we often get asked is: When should I exercise my ISOs? Like all great questions, there is no easy answer. We have identified 6 key factors that influence the best course of action:
How long you plan to stay at your company
Tolerance for risk
Bargain Element or gain of the option (409a valuation minus exercise price)
Qualified Small Business Stock (QSBS, AKA 1202 Stock)
Knowledge of 409a change
If the cost of your options is fairly insignificant to you, then it likely makes sense to exercise as soon as possible. For early-stage employees, it may only cost a few thousand dollars to exercise all shares, but it could be much more expensive than that for later-stage employees. What is significant will vary widely by situation and needs to be considered in the context of your assets, income, and short-term financial goals. While we can’t provide specific advice here on where to draw the line on significance, if you must borrow the money at a market interest rate (i.e., not from a family member who might cut you a sweet deal) it probably doesn’t make sense to exercise.
One of the most overlooked variables is how long you plan to stay at your current company. In our experience, people rarely consider this factor until it is staring them in the face and frequently find themselves on the horns of a dilemma. Oftentimes, they are “forced” into staying at their current job because exercising all their vested options is too expensive (cost to buy + potential AMT bill) and they don’t want to leave money on the table. Employees with large amounts of unexercised options seem to attract job offers like magnets. As an aside, if you do take a new job, you should use the equity you had to leave on the table as a starting point to discuss your new equity grant and ask for the ability to early exercise. Companies are very willing to offer the ability to early exercise options as a “win-win.”
Your risk tolerance is another key factor. In the early stages of a company, it is a risky investment, and many people lose some or all of the money they invest in buying shares (though you do get a tax deduction for any loss!). If you exercise early, and the value of the company subsequently appreciates, you will reduce or possibly eliminate AMT, which can be a huge benefit. Exercising early also gets the clock ticking on the one year you need to hold the stock to be subject to the lower long-term capital gains rate.
Another plan is to only exercise shares after they have appreciated a great deal. This way you can be assured of only putting money into an investment that is a winner. You might pay a lot more in AMT (money you’ll eventually recover if you plan well), but at least you knew the outcome before playing.
But waiting for big gains comes with a downside. For successful companies, we often see that it is the case that employees are forced to sell shares (sometimes at higher short-term capital gains rates) to fund the purchase of other shares and pay the corresponding AMT. This can be tremendously frustrating because you might have a lot of wealth on paper but are constantly paying huge tax bills and not seeing much of an increase in assets outside of company stock.
We will go into more detail about Qualified Small Business Stock in another article, but we would be remiss not to mention it here. The rules are complicated, and in some cases, unclear since it’s still a relatively new feature of the tax code. The gist is this: if you exercise an option while a company is still considered QSBS—very loosely defined as a real business operating as a US C-corporation with less than $50 million in assets, not valuation—you could exclude up to $10,000,000 in federal capital gains if you held the stock (meaning you’ve exercised the option) for at least 5 years. Under current tax law that could be worth up to $2,380,000 in tax savings.
The last variable of our six is if your company has provided information that the 409a valuation (the value the IRS will use for your company's stock) is about to increase. They won’t know exactly where it will fall—outside auditors determine this value—but some companies are pretty open about when the valuation will shift. If your company has had a great year, the 409a value will likely be increasing. Unfortunately, a lot of companies are not open (especially as they grow and hire legal counsel) about disclosing when the valuation will be adjusted, and you might find yourself trying to exercise during a blackout period and be subjected to a 409a increase.
Because the 409a valuation is a direct input in the AMT calculation, and a higher 409a valuation means more AMT, all else equal, exercising before a big update can be tremendously valuable.
In general, we’re fans of trying to exercise ISOs sooner rather than later, although the wait-and-see approach has its own merits and may be a better fit for any given individual. If nothing else, we advise people to consider exercising as many shares as they can without owing AMT.
There are many strategies to consider, and more than one way to arrive at a great outcome. Great outcomes and decisions rarely happen by accident when it comes to stock option planning.