Exercise vested stock options

Employee Stock Options: Definitions and Key Concepts.

Before delving into the finer details of Employee Stock Options (ESOs), it is crucial to have an understanding of basic option terms. Here’s a brief description of 10 key option terms you should know.

Call Option : Also known simply as a “Call,” a call option gives the buyer the right but not the obligation to buy the underlying security or asset at a certain price within a defined period of time. The call buyer thus benefits when the underlying security or asset increases in price.

(Option) Exercise : For a call buyer, option exercise means executing the right to buy the underlying security at the exercise price or strike price. For a put buyer, option exercise means executing the right to sell the underlying security at the exercise price or strike price.

Exercise Price or Strike Price : The price at which the underlying asset can be purchased (for a call option) or sold (for a put option); the exercise price or strike price is determined at the time of formation of the option contract.

Expiration Date : The last day of validity for an options contract, after which it expires worthless. The time left to expiration is a key determinant of the price of an option; in general terms, the longer the time to expiration, the higher the option price.

In the money (ITM) : A term that indicates the option has intrinsic value, i. e. for a call option, the market price of the underlying security is higher than the exercise price, and for a put option, the market price is lower than a put option. Conversely, an option is said to be “ out of the money ” (OTM) if the market price of the underlying is lower than the exercise price for a call option, or the market price is higher than the exercise price for a put option. An option is said to be “ at the money ” (ATM) if the market price of the underlying is equal to the exercise price for a call option, as well as for a put option.

Intrinsic Value : A call has intrinsic value if the market price of the underlying asset is higher than the exercise price. A put has intrinsic value if the market price of the underlying asset is lower than the exercise price.

Option Premium : The price paid by an option buyer to the option seller or “writer,” generally quoted on a per-share basis. The premium is paid up front by the buyer at the time of option purchase and is not refundable.

Spread : The difference between the market price of the underlying security and the exercise price of the option, at the time of exercise.

Time Value : One of the two components – along with intrinsic value – of an option’s price or premium, time value is any premium in excess of an option’s intrinsic value. For an option with zero intrinsic value, the full premium is attributable to time value.

Underlying (Asset) : The financial asset or security on which an option’s price is based, and which must be delivered to the option buyer upon exercise.

Now let’s look specifically at ESOs, and begin with the participants – the grantee (employee) and grantor (employer). The grantee – also known as the optionee – can be an executive or an employee, while the grantor is the company that employs the grantee. The grantee is given equity compensation in the form of ESOs, usually with certain restrictions, one of the most important of which is the vesting period .

The vesting period is the length of time that an employee must wait in order to be able to exercise his or her ESOs. Why does the employee need to wait? Because it gives the employee an incentive to perform well and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant.

ESOs are considered vested when the employee is allowed to exercise the options and purchase the company’s stock. Note that the stock may not be fully vested in certain cases, despite exercise of the stock options, as the company may not want to run the risk of employees making a quick gain (by exercising their options and immediately selling their shares) and subsequently leaving the company.

If you are in line for an options grant, you must carefully go through your company’s stock options plan, as well as the options agreement, to determine the rights available and restrictions applied to employees. The stock options plan is drafted by the company’s Board of Directors and contains details of the grantee’s rights. The options agreement will provide the key details of your option grant such as the vesting schedule, how the ESOs will vest, shares represented by the grant, and the exercise or strike price. If you are a key employee or executive, it may be possible to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, or a lower exercise price. It may also be worthwhile to discuss the options agreement with your financial planner or wealth manager before you sign on the dotted line.

ESOs typically vest in chunks over time at pre-determined dates, as set out in the vesting schedule. For example, you may be granted the right to buy 1,000 shares, with the options vesting 25% per year over four years with a term of 10 years. So 25% of the ESOs, conferring the right to buy 250 shares would vest in one year from the option grant date, another 25% would vest two years from the grant date, and so on.

If you don’t exercise your 25% vested ESOs after year one, you would have a cumulative increase in exercisable options; thus after year two, you would now have 50% vested ESOs. If you do not exercise any of ESOs options in the first four years, you would have 100% of the ESOs vested after that period, which you can then exercise in full or in part. As mentioned earlier, we had assumed that the ESOs have a term of 10 years. This means that after 10 years, you would no longer have the right to buy shares; therefore, the ESOs must be exercised before the 10-year period (counting from the date of the option grant) is up.

Paying for the Stock.

Continuing with the above example, let’s say you exercise 25% of the ESOs when they vest after one year. This means you would get 250 shares of the company’s stock at the strike price.

It should be emphasized that the price you have to pay for the shares is the exercise price or strike price specified in the options agreement, regardless of the actual market price of the stock. Withholding tax and other related state and federal income taxes are deducted at this time by the employer, and the purchase price will typically include these taxes in the stock price purchase cost.

You would need to come up with the cash to pay for the stock. This is a nice problem to have, especially if the market price is significantly higher than the exercise price, but it does mean that you may have a cash-flow issue in the short term.

Cash exercise – wherein payment has to be made in cash for shares purchased by exercise of an ESO – is the only route for option exercise allowed by some employers. However, other employers now allow cashless exercise, which involves an arrangement made with a broker or other financial institution to finance the option exercise on a very short-term basis, and then have the loan paid off with the immediate sale of all or part of the acquired stock.

The ESO Spread and Taxation.

We now arrive at the ESO Spread. Since the acquired stock can be immediately sold in the market at the prevailing price, the higher the market price is from the exercise price, the larger the “spread” and hence the compensation (not the “gain”) earned by the employee. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread.

The following points need to be borne in mind with regard to ESO taxation (see Get The Most Out Of Employee Stock Options ):

The option grant itself is not a taxable event . The grantee or optionee is not faced with an immediate tax liability when the options are granted by the company. Note that usually (but not always), the exercise price of the ESOs is set at the market price of the company’s stock on the day of the option grant . Taxation begins at the time of exercise . The spread (between the exercise price and the market price) is also known as the bargain element in tax parlance, and is taxed at ordinary income tax rates because the IRS considers it as part of the employee’s compensation. The sale of the acquired stock triggers another taxable event . If the employee sells the acquired shares for less than or up to one year after exercise, the transaction would be treated as a short-term capital gain and would be taxed at ordinary income tax rates. If the acquired shares are sold more than one year after exercise, it would qualify for the lower capital gains tax rate.

Let’s demonstrate this with an example. Let’s say you have ESOs with an exercise price of $25, and with the market price of the stock at $55, wish to exercise 25% of the 1,000 shares granted to you as per your ESOs.

You would therefore need to pay $6,250 (ignoring taxes for the moment) for the shares ($25 x 250 shares). Since the market value of the shares is $13,750, if you promptly sell the acquired shares, you would net pre-tax earnings of $7,500. This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares . This aspect can give rise to the risk of a huge tax liability, if you continue to hold the stock and it plummets in value, as thousands of workers in the technology sector discovered in the aftermath of the 2000-02 “tech wreck” (see “Tech workers stock options turn into tax nightmares’’).

Let’s recap an important point – why are you taxed at the time of ESO exercise? The ability to buy shares at a significant discount to the current market price (a bargain price, in other words) is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate. Thus, even if you do not sell the shares acquired pursuant to your ESP exercise, you trigger a tax liability at the time of exercise.

Table 1: Example of ESO Spread and Taxation.

Intrinsic Value vs. Time Value for ESOs.

The value of an option consists of intrinsic value and time value. Time value depends on the amount of time remaining until expiration (the date when the ESOs expire) and several other variables. Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, their time value can be quite significant. While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them.

To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model (see ESOs: Using the Black-Scholes Model ) to compute the fair value of your ESOs. You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO. From there, it is a simple exercise to calculate time value, as can be seen in Table 2. Remember that intrinsic value – which can never be negative – is zero when an option is “at the money” (ATM) or “out of the money” (OTM); for these options, their entire value therefore consists only of time value.

The exercise of an ESO will capture intrinsic value but usually gives up time value (assuming there is any left), resulting in a potentially large hidden opportunity cost. Assume that the calculated fair value of your ESOs is $40, as shown in Table 2. Subtracting intrinsic value of $30 gives your ESOs a time value of $10. If you exercise your ESOs in this situation, you would be giving up time value of $10 per share, or a total of $2,500 based on 250 shares.

Table 2: Example of Intrinsic Value and Time Value (In the Money ESO)

The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and above all, volatility. Consider a situation where your ESOs are out of the money, i. e. the market price of the stock is now below the ESOs exercise price (Table 3).

Table 3: Example of Intrinsic Value and Time Value (Out of the Money ESO)

It would be illogical to exercise your ESOs in this scenario for two reasons. Firstly, it is cheaper to buy the stock in the open market at $20, compared with the exercise price of $25. Secondly, by exercising your ESOs, you would be relinquishing $15 of time value per share. If you think the stock has bottomed out and wish to acquire it, it would be much more preferable to simply buy it at $25 and retain your ESOs, giving you larger upside potential (with some additional risk, since you now own the shares as well).

Exercising Stock Options.

Exercising a stock option means purchasing the issuer’s common stock at the price set by the option (grant price), regardless of the stock’s price at the time you exercise the option. See About Stock Options for more information.

Tip: Exercising your stock options is a sophisticated and sometimes complicated transaction. The tax implications can vary widely – be sure to consult a tax advisor before you exercise your stock options.

Choices When Exercising Stock Options.

Usually, you have several choices when you exercise your vested stock options:

Hold Your Stock Options.

If you believe the stock price will rise over time, you can take advantage of the long-term nature of the option and wait to exercise them until the market price of the issuer stock exceeds your grant price and you feel that you are ready to exercise your stock options. Just remember that stock options will expire after a period of time. Stock options have no value after they expire.

The advantages of this approach are:

you’ll delay any tax impact until you exercise your stock options, and the potential appreciation of the stock, thus widening the gain when you exercise them.

Initiate an Exercise-and-Hold Transaction (cash-for-stock)

Exercise your stock options to buy shares of your company stock and then hold the stock. Depending on the type of the option, you may need to deposit cash or borrow on margin using other securities in your Fidelity Account as collateral to pay the option cost, brokerage commissions and any fees and taxes (if you are approved for margin).

The advantages of this approach are:

benefits of stock ownership in your company, (including any dividends) potential appreciation of the price of your company's common stock.

Initiate an Exercise-and-Sell-to-Cover Transaction.

Exercise your stock options to buy shares of your company stock, then sell just enough of the company shares (at the same time) to cover the stock option cost, taxes, and brokerage commissions and fees. The proceeds you receive from an exercise-and-sell-to-cover transaction will be shares of stock. You may receive a residual amount in cash.

The advantages of this approach are:

benefits of stock ownership in your company, (including any dividends) potential appreciation of the price of your company's common stock. the ability to cover the stock option cost, taxes and brokerage commissions and any fees with proceeds from the sale.

Initiate an Exercise-and-Sell Transaction (cashless)

With this transaction, which is only available from Fidelity if your stock option plan is managed by Fidelity, you may exercise your stock option to buy your company stock and sell the acquired shares at the same time without using your own cash.

The proceeds you receive from an exercise-and-sell transaction are equal to the fair market value of the stock minus the grant price and required tax withholding and brokerage commission and any fees (your gain).

The advantages of this approach are:

cash (the proceeds from your exercise) the opportunity to use the proceeds to diversify the investments in your portfolio through your companion Fidelity Account.

Tip: Know the expiration date for your stock options. Once they expire, they have no value.

Example of an Incentive Stock Option Exercise.

Disqualifying Disposition – Shares Sold Before Specified Waiting Period.

Number of options: 100 Grant price: $10 Fair market value when exercised: $50 Fair market value when sold: $70 Trade type: Exercise and Hold $50.

When your stock options vest on January 1, you decide to exercise your shares. The stock price is $50. Your stock options cost $1,000 (100 share options x $10 grant price). You pay the stock option cost ($1,000) to your employer and receive the 100 shares in your brokerage account. On June 1, the stock price is $70. You sell your 100 shares at the current market value.

When you sell shares which were received through a stock option transaction you must:

Notify your employer (this creates a disqualifying disposition) Pay ordinary income tax on the difference between the grant price ($10) and the full market value at the time of exercise ($50). In this example, $40 a share, or $4,000. Pay capital gains tax on the difference between the full market value at the time of exercise ($50) and the sale price ($70). In this example, $20 a share, or $2,000.

If you had waited to sell your stock options for more than one year after the stock options were exercised and two years after the grant date, you would pay capital gains, rather than ordinary income, on the difference between grant price and the sale price.

Next Steps.

See FAQs – Stock Options If you have stock options in a plan that is administered by Fidelity, you can view, model or exercise options online.

View and Exercise Your Stock Options.

If you have stock options in a plan that is administered by Fidelity, you can view, model or exercise options online.

5 Mistakes You Can’t Afford to Make with Stock Options.

by David E. Weekly Jun 5, 2011 - 8:00 AM CST.

Disclaimer: I am not a lawyer or tax attorney. Please consult with one before making any financial decisions as to what to do or not do with your options.

Stock options are complicated; the paperwork that accompanies them can sometimes be a full inch thick of financial legalese. Most employees are just glad to get some ownership in the company — and maybe a lottery ticket if the startup does really well. But most employees don’t recognize what their options really are, nor do they understand that there are some catastrophic choices they can make with those options that could leave them bankrupt or worse.

For the executive summary: If you can afford it, forward-exercise 100 percent of your options the week you join a startup and file an 83(b) election immediately.

Here are five common mistakes employees make, as well as why they spell bad news.

1. Believe that a fortune awaits.

Many employees join a startup and work incredibly hard at a sub-market salary for years in the hopes of “striking gold.” The sobering math around startup exits, however, is that unless you’re one of the very first few employees, you’re probably not going to get more than a nice hiring bonus, even if the company does pretty well for itself.

Let’s say you’re employee No. 20 at a Valley startup. By usual Valley standards, if you’re a fabulous developer, you’ll probably get a four-year option package worth about 0.2 percent of the company. Two years after you join, the company sells for $30 million. Wow, that sounds like a lot of money! You’re rich! Right?

Not so fast. If the company has taken $10 million of financing (at a 1x preference) that leaves $20 million to be split among the shareholders. You’ve vested half your 0.2 percent, so you get 0.1 percent, or $20,000 before taxes. Since exits are taxed federally as income (

25 percent) and you live in California (

9 percent state tax), you get to keep $13,200. That’s $550 for each of the 24 months you just worked your ass off. Oh, and in many deals, most of this money is not doled out right away to employees. It’s only offered after one to three years of successful employment at the acquiring company, to keep you around. Oy.

So if you join a startup, you should do so because you love the environment, the problems and your coworkers, not because there’s a giant pot of gold at the end of the rainbow.

2. Quit with unexercised options.

Most employees don’t realize that that the unexercised options they worked so hard to vest completely vaporize after they leave the company, usually after 90 days. If you haven’t exercised your vested options, your ownership goes to zero. Even if the startup eventually gets acquired for a billion dollars, you get zilch. So if you join a startup and don’t exercise, you should probably try to stick it through to an exit.

3. Wait until the company is doing really well to exercise.

This mistake can catch a lot of otherwise smart people. They join a startup, work hard and see the company grow. Then after a few years they say: “Wow, the company just raised a huge round or has promising prospects to be acquired for a lot of money or file for IPO! I should exercise those stock options I haven’t been thinking about!” These people usually don’t bother to talk to a tax attorney or even a mentor; they just fill out their options paperwork, write a small check, and the company duly processes it. The employee feels not only pumped but really, really smart. After all, they just paid this tiny price to exercise their options, and in return they get this big wad of super-valuable stock!

They usually don’t realize – at least, not for some time — that the IRS considers this exercise a taxable event under the Alternative Minimum Tax because they just got something that’s worth more than what they spent on it. The IRS does not care that you don’t actually have the cash on hand to pay this tax. Nor do they care that you can’t even sell off some of the stock to pay for the tax. They are brutal.

In two cases, friends of mine had to arrange for a decade-long repayment period to the IRS for hundreds of thousands of dollars, wiping out their savings and their next decade of earnings. In both cases the stock that my friends exercised was ultimately rendered illiquid/worthless. Ouch.

4. Fail to early exercise.

Most startup employees don’t realize that it’s possible to ask to “forward exercise” their unvested options immediately after receiving their options grant. “But wait!” they cry, “with a one-year cliff, my boss told me none of my options will vest at all until I’ve worked a year!”

Perfectly true. But follow this carefully: Your option vesting schedule covers your right (“option”) to purchase Common Stock. If you exercise your option before it vests, you’ll receive not Common Stock but Restricted Stock instead. Restricted Stock can be purchased back from you by the company at the amount you paid for it if you quit.

Let’s say you think you’re really clever and join a company. The next day, you forward-exercise your four-year option package and quit. The company will simply buy back all of your restricted stock, and you’ll end up with nothing. The restricted stock vests into common stock at the same schedule as your options vest. So if you did a forward exercise, on your one-year anniversary a quarter of your restricted shares “magically” (with no paperwork to fill out or action to take) become common shares that the company cannot force you to sell if you leave.

This also means you get to start the clock ticking on long-term capital gains, which is currently 15 percent in the US! So if your company does end up hitting a liquidity event, a much smaller portion of your gains will be taxable. Indeed, if you hold on to your stock for more than five years, you might be eligible to roll over all of the proceeds into another qualified small business completely tax-free!

5. Fail to file an 83(b) election.

Some folks who are clever enough to realize that they can exercise early unfortunately forget that they need to tell the IRS to recognize the event with a form called an 83(b) election. Without an 83(b), your vesting is counted as income under AMT since your restricted stock that you paid $X for is converting into common stock that’s worth more ($Y>$X), since hopefully the company is getting more valuable.

The 83(b) tells the IRS that you’d like to immediately “fast forward” all of the tax impact, so pretty please tax you now for your gains. But since you’re paying fair market value for the common stock, there are no gains, so you pay no taxes at all! Clever you. As long as you file your 83(b) with the IRS within 30 days of your forward exercise and include it again in your annual personal income tax return, you’ll be in the clear regarding AMT.

If you found this helpful, check out my Guide to Stock & Options, embedded below.

[scribd id=55945011 key=key-dabr15b167c296f9mi5 mode=list]

A Stanford CS grad, David Weekly has been coding since he was five and loves bringing people together and starting things, including PBworks, SuperHappyDevHouse, Hacker Dojo, and Mexican. VC. He is an award-winning mentor for Founder Institute, i/o ventures, and 500 Startups. He is dweekly on Twitter and can be reached at davidweekly. org.

Exercise options early and file 83(b) : t. co/IDtRPoP2.

Dave, I recently had to get creative with compensation at my company, so ended up building fairsetup. We were paying people startup wages and, once revenues started coming in, we faced a problem: if we increase salaries, we don’t invest into scaling the business. Stock-options and equity distribution were not a good short-term solution, so I tried to implement a program that:

A. compensates people for the effort that they put in.

B. gives people a feeling of ownership in the company.

The way I’ve set things up is that I say to the team: everyone will own a portion of a compensation pool. The compensation pool is a set percentage from the profit margin. Your ownership is a function of how long you’ve been with the company, your level in the company (e. g. senior developers max out owning more than junior developers). Once you start working with us, your ownership will increase to its maximum over a period of 2 years. Once you leave, your ownership will go down to 0 over 2 years. We are using the logistic curve to calculate growth of ownership over time.

Here is a sample scenario: if P1 and P2 start working together and there is a payout in a year with P1 at level 1 and P2 at level 2, then P1 gets 1/3rd of the pool and P2 gets 2/3rds. Then P2 says “screw this” and leaves. P1 then hires P3. A year from then, P1 is at 2, P2 is at 1, P3 is at 0.25. And so each gets their portion: P1=2/3.25, P2=1/3.25, P3=0.25/3.25.

In the end, the idea is simple: if you work hard, you don’t have to stay with the company to profit. At the same time, if you did something valuable today and the company gets a lot of money 10 years from now, you don’t really deserve that much credit, if any. Moreover, you have a career path (going up levels) and then there can be a performance multiplier allowing management to rate your performance.

Sorry for the long post, but I thought you may find this interesting and am very curious about your thoughts on this. I don’t see FairSetup as a replacement for stock options, but as something that could provide a simple short-term model that provides a strong incentive getting people to work on the company as their own while preserving cash for operations.

I agree with most of what this article, but the “early exercise”

advice has some HUGE caveats.

Assume that the strike price of your options is at the current price.

of the stock (if they aren’t there are tax implications). The whole.

point of options is to let you buy stock at a lower price than the stock is currently. If you exercise them immediately upon receipt, you will have to pay the company exactly what the stock is worth. You.

just became an investor, and a start-up would have to be pretty hot.

for you to say that the privilege of investing in the company is.

compensation for being an employee (most likely, as mentioned, at a.

salary less than market).

What’s worse is that the event that someone have to use to establish.

the company’s value is most likely the latest investment of Preferred.

Stock. You will be receiving common stock and unless the strike price.

was set very thoughtfully (taking into account liquidation preferences.

sitting above common and the other substantial rights that preferred.

has common), you are probably actually paying a premium over what the.

company’s investors paid. That doesn’t sound too much like.

compensation now, does it?

The whole point of options is that if the company tanks you will have.

paid nothing for the chance to participate in the upside. Its finance.

101: Tax implications aside, an un-exercised option is ALWAYS worth.

more than the difference between the strike price and stock price.

Early exercise is not a decision to take lightly, the idea is to.

maximize your NPV, not just your future tax liability.

In an early-stage startup, the fair market price of Common is usually set to between 1/4 and 1/8 of the price of the last Preferred round, so I’m not seeing how that comes out to be “a premium over what the company’s investors paid”. In the formation stages, Common might even be priced at fractions of a penny! Consequently, while you are making a bet, it is a bet that is cheaper to make sooner rather than later (when serious tax consequences could come into play).

This article is perfect. Is exactly the same I told to every startup who promised me wonderful magical stock insteade of the real value of a super work. Great David.

Does anyone happen to know the tax consequences of forgetting the 83b?

For example: Jan 1, 2000: it’s day 1 of a new job and you get a grant for 100k options at a $.01 strike price).

Jan 1, 2004: It’s your 4 year anniversary, and you exercise your options and quit your job. The stock price is still $.01/share, so you pay $1k and there are no gains. You forget to file an 83(b).

Jan 1, 2009: your company IPOs at $10/share, so the FMV of your stock is now $1 million.

What is your tax status? Do you pay capital gains on $1 million – $1k? Income tax on $1 million – $1k? Something else?

83b only serves to accelerate when the shares are included in income when the shares are subject to risk of forfeiture. There is no risk of forfeiture in your example so no 83b is needed. So you’d pay LT Cap Gains Tax on $1M.

However there is also 1202 Implications here might mean that you pay 0% Capital gains tax. But that’s another Story.

Thanks for the answer. I really appreciate it.

Tyler’s comment are incorrect with respect to RSUs, which should not be conflated with grants of restricted stock.

If you exercise vested options, the taxable event is always at exercise, for regular tax as well as AMT. Only when you exercise unvested options does 83b and AMT come into effect, because it regulates the treatment of vesting as taxable event.

When you join a start-up, consider asking for a signing bonus to cover (after tax) the pre-exercise! (I wish I’d thought of that in the past :-)

Don’t take this the wrong way, but your disclaimer that you are not a lawyer or tax attorney is a very important one, as this article is incorrect in several important respects, only a couple of which I will touch on. I will preface this by saying I am a tax attorney, but this information does not constitute tax or legal advice. Please consult a tax professional.

1. The recognition income from the exercise of an option depends on the type of option. There are two main types of options Incentive Stock Options (ISOs, also called statutory options) and Non-Qualified Stock Options (Non-quals). If certain holding period requirements are met then there is no income recognized from its exercise, contrast non-quals in which there is income recognized equal to the intrinsic value of the stock received, fair market value less price paid to exercise. I won’t get into the differences in basis and the resulting capital gain or loss on sale.

2. The income from exercising an option is gross income for both regular tax and alternative minimum tax (AMT) purposes. AMT is an alternative system that starts with regular taxable income and makes certain adjustments and preferences, but at the base both AMT and regular tax rely on gross income under IRC Section 61. Just saying that the exercises are “taxable events under the Alternative minimum tax,” while correct, is misleadingly underinclusive.

3. Many companies provide way to mitigate the tax that may be due upon the exercise of a 83(b) election or taxable option exercise, including trading in some of your options for cash to pay the taxes on the options exercised. Everyone should consult with a tax professional before exercising any substantial amount of options. If we’re only talking a few hundred or even couple thousand dollars it might not be worth it, but much more than that and you can save yourself a lot of trouble.

4. It completely depends on your option if you have the ability to convert to restricted stock before you can exercise, but in my experience that would be rare. In addition to options companies can also issue Restricted Stock Awards or Units (RSAs and RSUs). These are different than options in that they are actual stock, with restrictions, i. e., a substantial risk of forfeiture if you don’t maintain certain conditions such as employment. Another difference is with regard to when the income is recognized for tax purposes. Income from non-quals for instance, are recognized upon you exercising the option – you decided to exercise and paid cash or performed a cashless exercise, while for restricted stock there is no cash due and vesting happens automatically based on the deferred compensation plan. It’s incorrect to say that the company is buying back the restricted stock if you leave before it vests, as you never really had clear title to it before. The restriction on the stock was that you have to give it back if you leave, which leads to the substantial risk of forfeiture that prevents it from being income when received.

5. Filing an IRC Section 83(b) election is an important consideration and should not be taken lightly. An 83(b) election, which applies to restricted stock, changes the character of the future income from the sale of the stock. For example, if you receive RSAs/RSUs and do not make an 83(b) election when the stock vests you recognize ordinary income equal to the fair market value (FMV) of the stock on the vesting date. Ordinary income is taxed at the highest rates, 35%. When you subsequently sold it you would recognize a smaller capital gain (if any), taxed at a lower 15% rate. However, if you had made an 83(b) election at the date of grant you would recognize only ordinary income equal to the FMV of the shares at the grant date, and only recognize capital gain or loss when sold. But, and this is a big but, if the stock goes down in value you could have some trouble. On subsequent sale you would recognize a capital loss, which, is severely restricted in your ability to deduct those losses. You may have just picked up ordinary income in the year of grant but then be severely limited in your ability to recognize a loss on the sale.

Firstly, thank you so much for taking the time to put together your feedback on this article – it’s awesome to get some feedback from a real tax attorney! I’m looking forward to writing future editions of the Guide (embedded above) to ensure it’s as correct *and* approachable as possible.

The thing that I didn’t succeed in clarifying in this article is that I’m really targeting my advice towards founders and relatively early employees of Silicon Valley companies. RE: #1, Most employees will only ever encounter ISOs, so I (as you note) omit a substantive treatment of NSOs to keep the conversation focused on situations likely to be more commonly applicable. Continuing this theme of wanting to focus on the likely scenarios that a startup employee will face, most startup options are priced at FMV and thus don’t have any exercise income to recognize if a forward exercise is done relatively expediently (since the FMV has not had a chance to tick upward between when the employee was hired vs exercised), which should address your point #2. #3 (having a company allow the employee to cash in some options to take care of the AMT due from the exercise) sounds like a really cool / sweet thing for a company do to help out employees, but I’ve not often seen this done – is this a practice you’ve seen commonly? Conversely with #4, I’ve seen early exercises fairly commonly permitted at startups, whereas RSAs/RSUs tend to be more relevant for late stage (public or near-public) companies. Finally with #5, at an early stage startup common will be pretty violently discounted, in theory making a full early exercise relatively inexpensive (a few thousand dollars) – the tradeoff is starting the long-term cap gains tax (and avoiding AMT) vs the very real possibility of losing the full principal – and you’re obviously totally right that you could only write off such a loss as a capital one. So it’s admittedly a gamble, but it’s one that keeps things simpler for the employee IMHO.

If there are things I’ve written that are Wrong (vs simply not inclusive of situations less likely relevant to startups), I’d be delighted to incorporate your corrections (with credit) in the next of the document! The first edition got a number of such bits of constructive feedback that were incorporated into the second edition of the Guide embedded above. It’d be awesome to have the fixes of a real tax lawyer in there.

Just to preface my responses with saying I don’t practice in the individual tax area, as my clients are all corporations, mainly public. However, under IRC 83(h) a company’s tax deduction is limited to the amount of income reported on a employees W-2 as income, so I’m decently well versed on their treatment. Also, since most of my clients are medium/large publics, I haven’t seen the startup phase very often. I did have a few other comments to your responses:

1. ISOs are becoming less and less common, especially as companies grow. Many of my large clients have abandoned ISOs. Under ISOs an individual includes income, and the company only gets the tax deduction. when there is a disqualifying disposition (DD). However, a lot of people will fail to report the DD if they can sell the stock publicly, and as a result the issuers lose the tax deduction. Admittedly this isn’t likely a problem for a startup, but becomes an issue later on. Even non-public companies are limiting uses of ISOs anticipating future problems. Nevertheless, I think its important to point out there is a distinction.

2. I see your point about the AMT as it relates to ISOs and the bargain purchase element. I wasn’t aware of this issue, as I don’t deal with individual tax. My comments were directed more towards the non-qual side because its what affects companies more and because I’ve started seeing fewer ISOs issued. I do think some clarification could be made to with respect to the holding period for ISOs.

3.a. On the 83(b) election side, I don’t think there is an AMT issue here because it relates to restricted stock rather than ISOs. The vesting of restricted stock is income, and I don’t think there is any bargain purchase element. The reason for the income is under 83(c)(1) – substantial risk of forfeiture. Basically until the stock is vested you may have to return it, and because of this substantial risk of forfeiture you don’t have to pick up the income for regular tax purposes. Upon the lapsing of the restriction, i. e., vesting, you’re free to do with the stock as you wish (ideally, though for non-publics there are going to be restrictive legends determining who you can sell it to, but this shouldn’t affect the tax treatment) and then you pickup the income on your return.

b. In the second paragraph of 5 you said that you won’t have any tax because you’re paying fair market value for the stock, but since RSUs/RSAs are compensatory in every case i’ve seen you don’t pay anything, its basically a form of salary. You are merely awarded the stock subject to vesting. Therefore when they vest you pickup the income, or, if at grant you file an 83(b) election, you pickup income equal to FMV of the stock.

c. Another consideration is the deferral of tax. As some have said, “a tax delayed is a tax not paid.” If you’re not expecting the value of the stock to increase dramatically over the vesting period, then you end up paying tax earlier rather than later, and with the time value of money you end up paying more tax than you otherwise would. Though this is a gamble. Additionally, if you are granted restricted stock, make an 83(b) election, and then quit or the stock is otherwise forfeited, you paid tax that you won’t get back. I think my point is not that its never a good idea to make one, it certainly is in a good number of circumstances, only that there should be careful consideration of if the 83(b) should be made. Based only on anecdotal evidence (i. e., looking at vesting reports that list 83(b) elections) I would say at least for large companies, only a fraction of people make 83(b) elections. Whether this is because of lack of knowledge on the part of the recipients or some other reason, I can’t say.

Good summary, Dave. Your calculation in 1. assumes participating preferred, which is less common for early rounds these days.

Thanks! I’m intrigued; is non-participating preferred the norm in the term sheets you’re seeing for e. g. Series A these days?

When you say: “The last engineer youbrought on board, Fred, was quite junior but is turning out well – you gave Fred a 3% grant, but….” My question is 3% of what?

When Should You Exercise Your Stock Options?

S tock options have value precisely because they are an option . The fact that you have an extended amount of time to decide whether and when to buy your employer’s stock at a fixed price should have tremendous value. That’s why publicly-traded stock options are valued higher than the amount by which the price of the underlying stock exceeds the exercise price (please see Why Employee Stock Options are More Valuable than Exchange-Traded Stock Options for a more detailed explanation). Your stock option loses its option value the moment you exercise because you no longer have flexibility around when and if you should exercise. As a result many people wonder when does it make sense to exercise an option.

Tax Rates Drive the Decision to Exercise.

The most important variables to consider when deciding when to exercise your stock option are taxes and the amount of money you are willing to put at risk. There are three kinds of taxes you should consider when you exercise your Incentive Stock Options (the most common form of employee options): alternative minimum tax (AMT), ordinary income tax and the much lower long-term capital gains tax.

You are likely to incur an AMT if you exercise your options after their fair market value has risen above your exercise price, but you do not sell them. The AMT you are likely to incur will be the federal AMT tax rate of 28% times the amount by which your options have appreciated based on their current market price (you only pay state AMT at an income level few people will access). The current market price of your options is determined by the most recent 409A appraisal requested by your company’s board of directors if your employer is private (see The Reason Offer Letters Don’t Include a Strike Price for an explanation of how 409A appraisals work) and the public market price post IPO.

Your stock option loses its option value the moment you exercise because you no longer have flexibility around when and if you should exercise.

For example, if you own 20,000 options to purchase your employer’s common stock at $2 per share, the most recent 409A appraisal values your common stock at $6 per share and you exercise 10,000 shares then you will owe an AMT of $11,200 (10,000 x 28% x ($6 – $2)). If you then hold your exercised options for at least one year before you sell them (and two years after they were granted) then you will pay a combined federal-plus-state-marginal-long-term-capital-gains-tax-rate of only 24.7% on the amount they appreciate over $2 per share (assuming you earn $255,000 as a couple and live in California, as is the most common case for Wealthfront clients). The AMT you paid will be credited against the taxes you owe when you sell your exercised stock. If we assume you ultimately sell your 10,000 shares for $10 per share then your combined long-term capital gains tax will be $19,760 (10,000 shares x 24.7% x ($10 – $2)) minus the $11,200 previously paid AMT, or a net $8,560. For a detailed explanation of how the alternative minimum tax works, please see Improving Tax Results for Your Stock Option or Restricted Stock Grant, Part 1.

If you don’t exercise any of your options until your company gets acquired or goes public and you sell right away then you will pay ordinary income tax rates on the amount of the gain. If you’re a married California couple who jointly earn $255,000 (again, Wealthfront’s average client), your 2014 combined marginal state and federal ordinary income tax rate will be 42.7%. If we assume the same outcome as in the example above, but you wait to exercise until the day you sell (i. e. a same day exercise ) then you would owe ordinary income taxes of $68,320 (20,000 x 42.7% x ($10 – $2)). That’s a lot more than in the previous long-term capital gains case.

83(b) Elections Can Have Enormous Value.

You will owe no taxes at the time of exercise if you exercise your stock options when their fair market value is equal to their exercise price and you file a form 83(b) election on time. Any future appreciation will be taxed at long-term capital gains rates if you hold your stock for more than one year post exercise and two years post date-of-grant before selling. If you sell in less than one year then you will be taxed at ordinary income rates.

The most important variables to consider in deciding when to exercise your stock option are taxes and the amount of money you are willing to put at risk.

Most companies offer you the opportunity to exercise your stock options early (i. e. before they are fully vested). If you decide to leave your company prior to being fully vested and you early-exercised all your options then your employer will buy back your unvested stock at your exercise price. The benefit to exercising your options early is that you start the clock on qualifying for long-term capital gains treatment earlier. The risk is that your company doesn’t succeed and you are never able to sell your stock despite having invested the money to exercise your options (and perhaps having paid AMT).

The Scenarios Where It Makes Sense to Exercise Early.

There are probably two scenarios where early exercise makes sense:

Early in your tenure if you are a very early employee or Once you have a very high degree of confidence your company is going to be a big success and you have some savings you are willing to risk.

Early Employee Scenario.

Very early employees are typically issued stock options with an exercise price of pennies per share. If you’re fortunate enough to be in this situation then your total cost to exercise all your options might be only $2,000 to $4,000 even if you have been issued 200,000 shares. It could make a ton of sense to exercise all your shares before your employer does its first 409A appraisal if you can truly afford to lose this much money. I always encourage early employees who exercise their stock immediately to plan on losing all the money they invested. BUT if your company succeeds then the amount of taxes you save will be ENORMOUS.

High Likelihood of Success.

Say you’re employee number 80 to 100, you’ve been issued something on the order of 20,000 options with an exercise price of $2 per share, you exercise all your shares and your employer fails. It will be awfully hard to recover from that $40,000 loss (and the AMT you likely paid) both financially and psychologically. For this reason I suggest only exercising options with an exercise price above $0.10 per share if you are absolutely certain your employer is going to succeed. In many cases that might not be until you really believe your company is ready to go public.

The Optimal Time to Exercise is When Your Company Files For an IPO.

Earlier in this post I explained that exercised shares qualify for the much lower long-term capital gains tax rate if they have been held for more than a year post-exercise and your options were granted more than two years prior to sale . In the high likelihood of success scenario it doesn’t make sense to exercise more than a year in advance of when you can actually sell. To find the ideal time to exercise we need to work backwards from when your shares are likely to be liquid and valued at what you will find to be a fair price.

Employee shares are typically restricted from being sold for the first six months after a company has gone public. As we explained in The One Day To Avoid Selling Your Company Stock, a company’s shares typically trade down for a period of two weeks to two months after the aforementioned six-month underwriting lockup is released. There is usually a period of three to four months from the time a company files its initial registration statement to go public with the SEC until its stock trades publicly. That means you are unlikely to sell for at least a year post the date your company files a registration statement with the SEC to go public (four months waiting to go public + six month lockup + two months waiting for your stock to recover). Therefore you will take the minimum liquidity risk (i. e. have your money tied up the least amount of time without being able to sell) if you don’t exercise until your company tells you it has filed for an IPO.

I always encourage early employees who exercise their stock immediately to plan on losing all the money they invested. BUT if your company succeeds then the amount of taxes you save will be ENORMOUS.

In our post, Winning VC Strategies To Help You Sell Tech IPO Stock, we presented proprietary research that found for the most part only companies that exhibited three notable characteristics traded above their IPO price post-lockup-release (which should be greater than your options’ current market value prior to the IPO). These characteristics included meeting their pre-IPO earnings guidance on their first two earnings calls, consistent revenue growth and expanding margins. Based on these findings, you should only exercise early if you are highly confident your employer can meet all three requirements .

The higher your liquid net worth, the greater the timing risk you can take on when to exercise. I don’t think you can afford to take the risk to exercise your stock options before your company files to go public if you’re only worth $20,000. My advice changes if you’re worth $500,000. In that case you can better afford to lose some money, so exercising a little earlier once you are convinced your company is going to be highly successful (without the benefit of an IPO registration) may make sense. Exercising earlier likely means a lower AMT because the current market value of your stock will be lower. Generally I advise people not to risk more than 10% of their net worth if they want to exercise much earlier than the IPO registration date .

The difference between the AMT and long-term capital gains rates is not nearly as great as the difference between the long-term capital gains rate and the ordinary income tax rate. The federal AMT rate is 28%, which is approximately the same as the combined marginal long-term capital gains tax rate of 28.1%. In contrast an average Wealthfront client typically pays a combined marginal state and federal ordinary income tax rate of 39.2% (please see Improving Tax Results for Your Stock Option or Restricted Stock Grant, Part 1 for a schedule of federal ordinary income tax rates). Therefore you’re not going to pay more than long-term capital gains rates if you exercise early (and it will get credited against the tax you pay when you ultimately sell your stock), but you still need to come up with the cash to pay it, which may not be worth the risk.

Seek The Help of a Professional.

There are some more sophisticated tax strategies you might consider before you exercise public company stock that we outlined in Improving Tax Results for Your Stock Option or Restricted Stock Grant, Part 3, but I would simplify my decision to the advice stated above if you’re only considering exercising private company stock. Boiled down to simplest terms: Only exercise early if you’re an early employee or your company is about to go public. In any case we strongly recommend you hire a great tax accountant who is experienced with stock option exercise strategies to help you think through your decision prior to an IPO. This is a decision you’re not going to make very often and it’s not worth getting wrong.

The information contained in the article is provided for general informational purposes, and should not be construed as investment advice. This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Financial advisory services are only provided to investors who become Wealthfront clients. Past performance is no guarantee of future results.

About the author.

Andy Rachleff is Wealthfront’s co-founder, President and Chief Executive Officer. He serves as a member of the board of trustees and vice chairman of the endowment investment committee for University of Pennsylvania and as a member of the faculty at Stanford Graduate School of Business, where he teaches courses on technology entrepreneurship. Prior to Wealthfront, Andy co-founded and was general partner of Benchmark Capital, where he was responsible for investing in a number of successful companies including Equinix, Juniper Networks, and Opsware. He also spent ten years as a general partner with Merrill, Pickard, Anderson & Eyre (MPAE). Andy earned his BS from University of Pennsylvania and his MBA from Stanford Graduate School of Business.

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