When to exercise ESOs
- Expiration is imminent
- Most options have an expiration date of ten years from granting to an employee. If that date is coming up fast, and you fear the company’s stock will lose value and go down below the strike price, you may consider exercising early.
- You want to diversify your portfolio
- Holding on to such a large number of shares may take up an overly large proportion of your overall portfolio and may go against the principles of diversification. You may want to reduce risk and exposure to market volatility by exercising early and using those funds to purchase diversified funds.
- Pay Fewer Taxes
- This is relevant to companies whose shares are not yet available on the open market. The difference between the strike price and the 409a Valuation of a company (fair market value minus the strike price) is the taxable portion of a non-qualified employee stock option. If Mary receives 1,000 options at a strike price of $1, the Fair Market Value is $2, and she believes the company will be successful, it would behoove her to exercise early and pay taxes only on that dollar
The risks of exercising early
The risks of exercising early
- Lack of liquidity
- You don’t know when the company will go public. Frequently, IPOs are pushed back, possibly even for years. Early exercising can tie up a large sum of money that you could use elsewhere, such as a down payment for a home, maxing out your 401(K) or IRA, or just as a rainy day fund.
- 100% loss in investment
- Frankly, the granter of your Employee Stock Options could go bankrupt, leaving you with worthless shares. Or, they could decide not to go public, as was the case with WeWork. Maybe they’ll buy back your shares (possibly lower than the strike price at which you bought them), or they may not. If they don’t repurchase any of them, you’ve lost all your money, plus the taxes you paid on them when you exercised them.
- It’s one thing to take a lower salary in exchange for options. It’s another to exercise those options early using a lot of your own personal cash to do so and not being sure of the company’s trajectory. Had you not exercised, you would be stuck with useless options and a lower salary, but you wouldn’t be down however much cash would have been necessary to exercise. By exercising, you’re potentially throwing away cash that you could have put into safer investments.
- Leaving the company before being fully vested
- If you end up leaving the company, the company can repurchase any shares you received from exercising early at a lower price than the strike price. Not only would you pay taxes on the difference between the strike price and fair market value, but you would also lose money on the stock buyback. All in all, it would be a losing deal.
In Conclusion
Disclosures
Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s portfolio. All investment strategies have the potential for profit or loss. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author/presenter as of the date of publication and are subject to change and do not constitute personalized investment advice.
A professional advisor should be consulted before implementing any investment strategy. WealthGen Advisors does not represent, warranty, or imply that the services or methods of analysis employed by the Firm can or will predict future results, successfully identify market tops or bottoms, or insulate clients from losses due to market corrections or declines. Investments are subject to market risks and potential loss of principal invested, and all investment strategies likewise have the potential for profit or loss. Past performance is no guarantee of future results.
Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s portfolio. There are also no assurances that any portfolio will match or outperform any particular benchmark. No content should be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell any securities mentioned herein.
