Stock options are a highly favourable financial asset for many, as they offer the holder the choice to purchase shares now or later down the road. These allow the person to have an extended amount of time to decide whether they want to buy their employer’s stock at a fixed price, in which lies the value of the option. This is also one of the main reasons why publicly-traded stock options have a much larger value than just the difference between the stock price and exercise price.
That is why companies are starting to offer a better kind of stock option called early exercisable stock options, instead of standard ones. But what happens in such a case? And what are early exercisable options? Keep reading to find out.
Understanding Early Exercisable Stock Option
The “early exercisable” stock option is just like every other stock option that is awarded to a director, consultant, employee or other advisors in the company. The only difference is that the holder may exercise the option before it’s fully vested.
For instance, a stock option can vest for over a period of four years keeping in mind that the employee keeps working in the company over this time. Even though there is a vesting requirement here, an early exercisable stock option would let the shareholder have the option to exercise all or even a portion of the option instantly, even with unvested options.
But for a person to get early exercisable stock options, the board of directors in the company would have to approve it first. Usually, this is done when the board approves the stock option grant, and is reflected in the option paperwork. Other than this, the board of directors can also approve an amendment to an already existing option to allow for an early exercise.
What happens when an early exercise occurs?
In an early exercise, the shareholder gets the common stock subject to the same vesting schedule, applied to the stock option. And in case the shareholder subsequently leaves the company before the stock vests completely, then the company would get the right to repurchase the unvested stock.
Why would the shareholder want to early exercise a stock option?
Early exercise has a lot of advantages for a shareholder. These include:
- The option holder becomes a shareholder in the company;
- If the shareholder exercises the stock options instantly or soon after the grant date, they would owe little or no taxes for the exercise (that is assuming that the FMV of the stock of the company hasn’t changed or has increased slightly) and the capital gains holding period would begin after the exercise;
- Can avoid any taxes upon vesting by filing an 83(b) election.
Why would the shareholder not want to early exercise a stock option?
The stock options permit the shareholder to lock an exercise price and then wait to see if the price of the stock increases before they pay and become a shareholder of the company. By exercising the shares early, it means that the person is investing in the company earlier and in the expectation that the value of the shares would increase in the future.
Basically, if the value of the company doesn’t increase, then the person who has invested in the company’s stock would lose all of their investment. While the aggregate cost to exercise the options increase relative to the financial means of the shareholder, the decision to exercise the options early is likely to turn into something more difficult for the shareholder. Which is why some might not want to exercise their stock options early.
The next section would explain things in detail for you to understand.
Should a company allow early exercise of stock options?
A few companies permit their employees to exercise their unvested stock options or perform an early exercise for their stock options. Under this, the unvested stock is subjected to the right of repurchase by the company as soon as the services are terminated. The repurchase price is the exercise price of the option here.
It has to be noted that the stock option is usually not early exercisable unless the board of directors has approved it, as shared above. And the company would also have to issue the stock option with an option agreement that permits an early exercise.
By giving the choice of an early exercise to employees for their unvested shares, you will be offering them with a potential tax advantage. They would be able to begin their long-term capital gains holding period for all their shares. And with this, they would also be able to reduce their alternative minimum tax (AMT) liability.
If an employee is ready for the early exercise of their stock options, the employee would want to get an NSO instead of an ISO. This is because the long-term capital gains treatment for the stock issued upon exercise of an NSO happens only after a year. On the other hand, when ISOs are exercised, they have to be held for more than a year after the date of the exercise and more than two years after the grant date. And with this it gets favorable tax treatment.
But even though there are many advantages to offering early exercise options to employees, there are many disadvantages as well. These include:
- The Risk of the Employee: When an employee exercises an option early, they are taking the risk. This is because if the value of the stock decreases, they would lose the capital they put in. They could use a promissory note to purchase the stock, which is a future post to come. But the note has to be full recourse for the IRS to respect the purchase.
Additionally, if the employee repurchases the shares with a promissory note, the note will continue to accrue interest until it is repaid to satisfy accounting requirements. All this doesn’t satisfy the amount put in initially on the gain of the stock options.
- The Tax upon Spread: If there is a spread during the time of exercise, the employee:
Will trigger the ordinary income tax (if the NSO exercise is equal to the difference between the exercise price and the FMV of the common stock on the date of exercise); and
May trigger the AMT liability (if it is ISO exercise, the difference between the FMV and the exercise price on the date of exercise will be the AMT preference item).
Any paid tax would not be refunded if the unvested shares are repurchased at a different cost. As mentioned above, there are many other tax differences when it comes to the ISOs and NSOs that also come into play.
- Securities Law Issues upon a Sale: When a company has more than 35 unaccredited shareholders at a time after it has agreed to be acquired in a stock for stock transaction, the acquisition will likely be more complex and take longer to complete.
- “Back Door” Public Company: By permitting your employees to early exercise their options, it can increase the number of shareholders in your company. And when the company reaches the limit of 500 shareholders, as per Section 12(g) of the Securities Exchange Act of 1934, it would have to be registered as a publicly reporting company.
- Administrative Hassles: With shareholders increasing, it puts a tremendous amount of administrative burden on the company. This is true when employees get the promissory notes and repurchase shares from the company. In such a case, there are many lengthy forms that have to be completed and signed. In short, the administrative hassle increases.
- Stockholder Rights: Optionees have no rights as a shareholder until they exercise their stock options. Once they exercise it, they have the same voting rights as any shareholder regardless of if the shares are vested or not, which might be something you do not want for your company.
In short, an early exercisable stock options has both positives and negative points for the company and option holder. So being a founder, it is important that you make a well-informed decision if you are thinking of offering your employees with early exercisable stock options.
To understand more about the share restrictions and other things, check out the knowledge-based articles here!