When to exercise ESOs
Determining the best time to exercise your Employee Stock Options (ESOs) is crucial. With the correct conditions and exercise strategy, an ESOP can be much more profitable than a standard salary and bonus compensation package. Conversely, an Employee Stock Option Plan (ESOP) can leave you with less money than you started, so it is vital you understand the associated risks and be ready to lose 100% of your investment – or even more.
It only makes sense to exercise Employee Stock Options when they are ‘in the money,’ meaning the market price is higher than the option’s strike price. Once they are in the money, you face four issues that may push you to exercise.
- 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
Not all companies allow for early exercise, so carefully review your contract with a financial professional.
The risks of exercising early
It’s one thing to take a lower salary in exchange for options. It’s wholly another to exercise those options early using a lot of cash to do so, and then the company never go public. Had you not exercised early, you would just be stuck with useless options and a lower salary. By exercising, you’re potentially throwing away cash.
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
As you can see, there is a slew of complexities regarding employee stock options. If you have been issued employee stock options, we strongly recommend you contact us for a consultation. We can look into all possible plans of action to determine what works best for you.
