Should a company allow the early exercise of stock options?

Should you allow early exercise of stock options? There’s no one-size-fits-all answer — it depends on your company’s situation and goals.

Some startups like early exercise. It’s a tax benefit for employees and can align interests with long-term company growth. At a one-year cliff, the exercise rate is 5x higher among employees who are given the option to exercise early vs. those who aren’t. But it’s not without risks and complications. For example, it financially strains employees when the company fails, and they have to pay upfront cash, creating a liquidity crunch.

Before making a decision, you must have a comprehensive understanding of the concept. This article will explain how it works, the tax implications, and the key factors to consider for early stock options.

Factors to consider for early exercise of stock options

You must consider some factors while setting up a stock compensation strategy for early exercise. Let’s look at the factors to consider for the early exercise of stock options.

• Liquidity and Buyback Risks – You must remind employees that exercising early means investing in illiquid shares. Unlike public stocks, selling private company shares isn’t easy. If you offer secondary market transactions, this risk is less. Be clear about your company’s share buyback policy if an employee leaves before full vesting, as this can impact their potential returns.
• Financial Burden – Sometimes, employees might have to pay upfront to exercise options early. They’ll need to consider not just the exercise price but potential tax obligations, too. As not every company continues to thrive, you must warn about the risk of loss if the company’s value declines or fails. Make sure staff understand the financial stakes.
• Company Policies and Compliance – Allowing your employees to exercise their stock options early means you’ve understood the securities and tax laws. Ensure the program complies with all relevant laws to protect both the company and employees. Consider consulting legal experts to design a compliant program.
• Accounting and Reporting Considerations – Implementing early exercise demands capable administrative systems. You must manage vesting schedules, documentations, and departing employee share buybacks. It might get complicated as your company grows. You can consider investing in specialized software or staffing.
• Potential Downside Risks – Highlight the main risks for employees – company-specific stock risk, termination risk, and capital risk. Employees bear the full risk of stock value changes after exercise. If they leave before full vesting, they might lose money on buybacks. The upfront capital requirement can also create a liquidity crunch for employees.

Should a company allow the early exercise of stock options?

Allowing early exercise can enhance loyalty and tax efficiency but requires careful consideration, clear communication, and robust support systems. Considering the benefits and risks below, you might decide whether to allow the early exercise of stock options.

Benefits of early exercise of stock options

These are the benefits of early exercise of stock options:

• Tax advantages – Early exercise allows employees to start the capital gains holding period sooner. For ISOs this means they can qualify for long -term capital gains tax rates if shares are held for at least 2 years from grant date and 1 year from service. This can significantly reduce liabilities compared to exercising at vesting.
• Reduced tax Liability – Employees can potentially pay lower taxes upon early exercise, as they may only incur AMT on the spread between the exercise price and FMV, which is often negotiable at the time of grants. This is more beneficial in early-stage companies where stock prices are typically low.
• Increased employee ownership – Allowing early exercise can enhance employee commitment by giving them immediate ownership stakes,even though it is subject to vesting conditions. This can foster a sense of belonging and investment in the company’s success.
• Share Management Flexibility – Companies can repurchase unvested shares if an employee leaves before full vesting, maintaining control over their equity structure while still providing employees with some immediate benefits.

Risks of early exercising of stock options

Here are the potential risks associated with early exercising of stock options:

• Potential for loss – If a company fails after employees have exercised their options early,those employees may lose their investment without recouping any value, as they would have already paid to convert options to share.
• Administrative burden – Companies must ensure that employees understand the implications of early exercise, including the necessity of filing an 83(b) election within 30 days to avoid unfavorable tax treatment later on.
• Impact On capital Structure -Early exercising increases the number of shareholders and may complicate cap table management, though modern tools and practices can mitigate these concerns.
• Employee Education – Companies need to invest time and resources into educating employees about stock options and the benefits of early exercise to ensure informed decisions are made.

Inshort early exercise of stock options has both positive and negative sides,so being a founder it is important to make an informed decision if you’re offering employees with early exercisable stock options.

Tax implications of early exercise of stock options

One of the main impacts of early exercise of stock options can be seen in its tax implications. Let’s discuss this aspect with respect to different types of stock options.

Ordinary income tax

Early exercise can be tax-friendly for Incentive Stock Options (ISOs) as you don’t report the bargain element as income for ordinary tax purposes. However, Non-Qualified Stock Options (NSOs) are different.

Any positive bargain element from exercising NSOs must be reported as income and taxed at your highest marginal rate.

Alternative Minimum Tax (AMT)

While ISOs don’t trigger ordinary income tax, they can subject you to AMT. The bargain element of ISO gets reported as AMT preference income. This means even if you avoid ordinary income tax, you still face AMT depending on your overall tax situation.

Strategic tax planning is important here. You can determine the optimal amount of ISOs to exercise each year to minimize AMT impact. Remember, when the FMV equals the exercise price, you’ll avoid ordinary income tax and AMT.

83(b) Elections

If you’re considering early exercise, filing an 83(b) election is important. This form, sent to the IRS within 30 days of exercising, indicates your choice to pay taxes now on the minimal spread rather than later when options vest and the spread could be larger.

From a tax standpoint, it never happens if you don’t file an 83(b) election with the IRS within 30 days of exercising. Instead, each time your options vest, you will be required to pay taxes on the spread. Thus, if the spread widens further, you will be responsible for an increasing amount of taxes and may miss out on advantageous tax treatment.

Why consult experts before allowing the early exercise of stock options?

Before you allow your employees to exercise their stock options, it’s important to understand why expert guidance is necessary.

• Stock option regulation changes need you to stay on top of SEC rules, state laws, and company bylaws to keep you compliant. Expert consultations help you avoid legal pitfalls that could cost you big time later on.
• Early exercise can have major tax consequences for both the company and its employees. Experts can structure the plan to minimize the tax hit. They’ll guide you through 83(b) elections, AMT considerations, and potential changes in tax laws.
• Your company’s needs may not be similar to those of others in the industry. Therefore, experts can customize your equity plan to fit your specific business goals and culture.
• Early exercise affects your cap table, cash flow, and valuation. Financial experts can help you model different scenarios and also guide you on reserving shares for future hires and funding rounds.
• An early exercise program requires clear communication between management and employees. Experts can help you address common questions and concerns and support your employees in decision-making.
• Experts can locate potential issues before they escalate. They might suggest implementing clawback provisions, setting up holding accounts or making special agreements for early exercisers.

Frequently Asked Questions (FAQs)

What are the tax benefits of early exercising stock options?

Early exercising stock options can offer tax advantages:

• ISOs – Keep shares for two years post-grant and one-year post-exercise for favorable tax treatment.
• NSOs – Start your holding period earlier, potentially qualifying for long-term capital gains rates sooner.
• If exercised at grant, you might avoid additional taxes since there is no spread between FMV and the exercise price.

How does early exercise impact employees?

If you exercise your stock options before the company becomes public, you will have more flexibility over when to sell your stock. When the lockup period for your company’s shares ends, employees have the option to either hang onto them or sell them, with the latter having the potential to incur long-term capital gains tax.

What are the alternatives to early exercise of stock options?

A cashless exercise during an exit event is an alternative to exercising early. In this instance, participants sell their shares to generate the necessary funds to pay for their exercise expenses and associated taxes in what the IRS considers a same-day transaction

When is early exercise not recommended?

It is not recommended for employees to pre-pay taxes on the values of the shares at the time of exercise rather than at vesting.

Partner with Eqvista to Upgrade Your Equity Strategy

In summary, allowing early exercise of stock options can be beneficial for startups and employees by providing tax benefits and increasing employee ownership. Even though it requires a careful consideration of the risks associated with this including the liquidity challenges and the potential for financial loss if a company is not performing well.

Eqvista’s Tax Advisory and Equity Consultation Services can be helpful here. We can implement a personalized strategy that fits your company goals and culture. Our certified experts can guide you on 83(b) elections and the tax implications of your equity decisions.

At Eqvista, you get accurate valuation reports with insights into your company’s position in the market so you can develop equity plans accordingly. Reach out to us for a quick consultation now.