If You’re Planning to Exercise Your Pre-IPO Employee Stock Options, Do It ASAP

Disclaimer: I’m not a tax professional, and I don’t know your personal finances. This is simply my own understanding of stock option payoffs; if you follow my advice you take all responsibility for listening to the opinions of some guy on the internet.

Tl;dr: For Non-qualified Stock Options (NSOs or NQSOs), you should likely purchase your options as soon as you can if the following are all true:

1. You believe your company will have a worthwhile exit event such as a big acquisition or IPO.

2. You have the cash on-hand to purchase the options.

3. You can afford to not see that cash again for an undetermined amount of time, understanding that if your company underperforms you risk losing it all.

For the most common type of startup option, NSOs, the math is very simple: because your income tax rate is higher than your capital gains tax rate, the longer you wait to exercise (purchase) your options, the more you will have to pay immediately out-of-pocket to get them and the lower your eventual profit will be.

Let’s look at an example. You are an employee of Unicorn, Inc., a private company with IPO aspirations, and you have been granted (offered the right to purchase) stock options. This means that in the future you may choose (you have the “option”) to buy shares of the company at the price of the stock on your grant date (commonly referred to as the “strike price”). Let’s also say that you live in the US, your effective income tax rate (what you pay on normal income such as your paycheck) is 35%, and the long-term capital gains tax rate (what you pay when you sell a stock whose value has increased since purchase) is 15%. This chart shows the costs that incur when you exercise (purchase) your options and eventually sell your shares:

Assuming the stock price keeps going up over time, the longer you wait to exercise your options, the more you will pay immediately out-of-pocket in income taxes. Generally speaking, upon exercise your company will ask you for two checks, one that pays for the stock itself:

and one that covers the tax bill:

One key implication is that depending on how much the stock price has risen since you received the option grant, your immediate tax bill may be significantly higher than what you’re paying for the stock! For example, if your strike price is $0.25 and the current stock price is $10.25, with our example tax numbers you will pay $0.25 to purchase each share and a whopping $3.50 per share to pay your income tax bill.

Waiting to purchase not only means you pay more immediately in tax, it also means you pay more tax overall: because you only pay the lower capital gains tax rate (15%) on any stock price increase that happens between exercising and eventually selling your shares, the longer you wait to exercise, the more tax you pay per share, meaning the less profit you realize per share.

Let’s expand our Unicorn, Inc. example a little more:

• You have an income tax rate of 35% and a capital gains tax rate of 15%
• You have been granted 48 options, vesting (purchasable) evenly over 48 months
• Your grant does not have a vesting cliff (most option grants have a clause which delays purchase of any options until you hit one year of employment — it’s extremely common but only complicates this example)
• Your options have a $1 strike price (purchase price)
• At month 48, Unicorn will exit, selling to BigCorp for $5 per share
• Unicorn’s stock price increases evenly over those 48 months from $1 to $5

If you were to purchase every option as soon as you could, the payments flow per share would look like this (note that Net Profit takes into account the money paid to purchase that option):

As you can see, you end up pocketing more profit from options purchased early. The closer the price is to $5, the more total tax you pay per share, and the more you have to pay out-of-pocket to buy your options.

If you instead decided to purchase all your options when Unicorn exits at month 48, you would not only pay more immediately in income tax, but you would also lose a chunk of your potential profit to income tax (outlined by the triangle):

Remember: for early employees especially, that extra income tax can be substantial. If you wait too long, you may be unable to purchase all of your options due to the very high tax bill. If you find yourself in this situation, you may be obligated to wait until the exit event to purchase your options so that you can immediately sell shares to cover your tax bill, just like Mark Zuckerberg did in 2013 to pay his tax $1.1 billion tax bill.

The risk of not purchasing early is compounded if you don’t plan to stay employed at that company for the exit event. Most companies have a clause which forces you to determine whether to purchase all your vested options within 90 days of leaving the company. If you wait, you will have to make a big financial decision at the moment when you no longer have influence over the future direction of the company, and in the event you are fired you may be too financially insecure to exercise.

So why would you not want to purchase your options as soon as possible?

You don’t believe the company will have an exit event, or you believe the exit event will be at a very low price.

Obviously, if you don’t believe that your shares will be worth anything, either on the open market or by an acquisition, you shouldn’t purchase them. As something like 80% of venture-backed companies fail to have a meaningful exit, this is a serious possibility to consider. In general, the younger the company, the higher the risk of failure. I can’t give you any advice about this one — it’s up to you to gauge the risk that your company will fail to exit when making a purchase decision.

You’re not comfortable with the possibility of never seeing that cash again.

If the company tanks, you don’t get a refund on what you paid for your options. You may get a tax deduction in the year your shares become worthless, but that’s not really something to celebrate. Similarly, when an exit event will happen is almost completely unpredictable, and you may be waiting to realize a profit from selling your shares for quite some time. Even if your company makes it to an exit, there’s no guarantee the stock price will be higher than now; it’s very possible your option purchase price may be higher than the future market price of the stock, which is what happened to employees of Zynga, Gilt, and countless other companies.

It’s considered risky to have a large percentage of your assets invested in a single company, doubly so if you’re getting your paycheck from them too — if the company fails you could lose both your job and your savings. Don’t make a decision where a failure of the company would wipe out your security blanket or retirement fund.

You don’t have the cash on-hand to purchase the options.

This is a “golden handcuffs” situation that applies to our early employee with a high tax bill. If you can’t afford to purchase all of your options, you may need to stick around until an exit to do so. I would still look into purchasing a chunk of options now — the longer you wait, the more immediately expensive it will be to purchase, meaning your out-of-pocket cost will be even higher if you decide to leave before an exit. The 90-day window to purchase after leaving is not kind to employees (but we’re starting to see this change: see Coinbase and Pinterest).

You want to use that cash for other investments with potentially higher payoffs.

Remember the opportunity cost of purchasing your options — you may see a higher return with other investments. $100 paid in options can also buy you $100 in the S&P, which with an average 10% return means in five years you could net something like $61 in profit. Will you get a higher payoff from your eventual stock sell price? Keep in mind that because pre-IPO shares lack a (legal) market, any money invested in pre-IPO stock is illiquid, meaning it’s not possible to easily convert your investment back to cash.

Your options are not NSOs, but rather ISOs (Incentive Stock Options).

ISO, which are occasionally offered to employees later in a company’s life once robust accounting practices have been established, have a nice tax benefit — as long as you sell them more than two years after your grant date and one year after you exercise the option, all your gains between the strike price and sell price are taxed at the capital gains tax rate, meaning you do not have to pay any income tax when you exercise ISOs. This pretty much eliminates the tax penalties of purchasing your options later as long as you’re willing to hold on to the shares a bit. Note that when you exercise ISOs you may trigger some complicated Alternative Minimum Tax things that I don’t have much familiarity with.

You live outside the US.

I don’t know anything about foreign stock option tax laws. You’re on your own here.

This decision whether to purchase your NSO stock options reflects the fundamental financial trade-off of risk and reward — the more risk you assume (purchasing stock options early in a company’s life when the future is much more uncertain), the higher reward you can get. Whether you exercise your options is a personal decision, but if you’ve already decided that you’re going to purchase your shares, and especially if you plan on leaving the company before an exit event, you should probably exercise your options as soon as possible.