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What does it mean to early exercise options?

Most stock options granted to service providers of a corporation are designed to allow the optionholder to purchase only vested shares. To exercise a stock option, therefore, normally means that an optionholder is purchasing a number of shares of stock underlying the option that have already vested. Some stock options, however, are designed to allow “early exercise,” which means that the optionholder may purchase shares of stock underlying the option that have not yet vested. The purchased but unvested stock continues to vest according to the vesting schedule of the option. The issuing company, meanwhile, has the right to repurchase any shares of unvested stock upon termination of the optionholder’s service, at a repurchase price equal to the lesser of the stock’s original purchase price or the stock’s then-current fair market value.

Should I early exercise my options?

Not all stock options are early exercisable. Your stock option paperwork will tell you when you can exercise the stock option. If the stock option is early exercisable, you should realize that the decision whether to early exercise a stock option is a highly personal financial decision and it is an optionholder’s responsibility to obtain any independent, professional advice necessary to make such a decision. Many factors can influence the decision to early exercise a stock option and purchase unvested stock, including:

Is the early exercisable stock option an ISO or an NSO?

Early exercising a stock option that is an ISO poses an increased risk of a “disqualifying disposition.” A disqualifying disposition occurs when stock exercised from an ISO is sold or otherwise transferred before it is held by the optionholder for both (a) more than 2 years after the date of grant, and (b) more than 1 year after the date of exercise. In the event of an early exercise of an ISO followed by a disqualifying disposition, ordinary income would be recognized on the difference between the exercise price of the stock and the fair market value of the stock at each vesting date, and capital gains would be recognized equal to the difference between the fair market value of the stock at each vesting date and the price at which the stock is sold. In such a situation, the clock for long-term capital gains treatment begins on the vesting date of the stock, and not the date of early exercise. Vesting dates that are later than the date of early exercise mean that it is more likely that any capital gains in a disqualifying disposition will be short-term capital gains and taxable at ordinary income rates. Early exercisable stock options are usually granted as NSOs to avoid this risk.

Even if an early exercisable stock option is an NSO, there may be a risk of an unexpectedly large tax bill if the optionholder does not exercise the option before the fair market value of the underlying stock significantly exceeds the exercise price. Since NSOs are taxable upon exercise based on the difference between the exercise price of the stock and the fair market value of the stock at the time of exercise, it is beneficial to early exercise a stock option when the difference between these amounts is small, or even zero (such as immediately at the time of grant when the exercise price is equal to the fair market value), and less beneficial to early exercise the stock option later when the difference in these amounts may have increased due to the growth in value of the company. The “best” time to exercise a stock option is highly unpredictable, and holders of early exercisable stock options in a growing company who do not exercise their early exercisable options “early enough” could face unexpected tax consequences.

Can you afford to pay for the stock?

A stock option’s exercise price must be paid by an optionholder to the company at the time of exercise. If a company already has a high valuation when an early exercisable stock option is granted, the stock option exercise price may be relatively high, and an optionholder may be less likely to have the full amount of cash available to pay for all of the stock. If a company permits an optionholder to borrow money from the company to purchase stock, the loan from the company must be substantially full recourse with respect to the personal assets of the optionholder in order for the IRS to respect the purchase and allow for the long term capital gains clock to commence. In addition, if an optionholder purchases a company’s stock with a loan, the loan must eventually be repaid to the company, the loan will accrue interest until it is repaid, and any forgiveness of the loan by the company could result in income to the optionholder from the cancellation of debt.

Are you able to hold the stock indefinitely?

As with any investment, purchasing a company’s stock through the early exercise of a stock option means that the optionholder may not be able to invest or use the funds elsewhere. Stock of private companies can be difficult to liquidate quickly, if at all.

Are you able to comfortably bear the risk that the value of the stock may decline?

An optionholder is under no obligation to exercise the option and purchase the underlying stock. Holding onto a stock option without exercising it allows an optionholder to continue assessing the prospects of a company without taking on direct exposure to price fluctuations in its stock. As with any investment, purchasing a company’s stock (through the early exercise of a stock option or otherwise) before there is a possibility of liquidity exposes the optionholder to the risk that the value of the stock may decline. Investments in stock of private companies can be highly speculative and the future price of the stock could settle lower than the price that the optionholder paid for the stock.

Can you afford to pay applicable taxes?

When early exercising a stock option, an optionholder will usually be advised to make an 83(b) election in order to realize certain tax benefits. The result of making an 83(b) election when early exercising an NSO is that the optionholder will recognize income and pay taxes on the difference, if any, between the exercise price of the stock and the fair market value of the stock on the date of exercise. Even this typically beneficial tax treatment could be problematic and result in an unexpectedly large tax bill for an optionholder if the early exercise of the stock option does not occur until after a financing or some other company milestone has caused the fair market value of the stock to significantly exceed the exercise price of the stock. Choosing not to file, or failing to file the 83(b) election within 30 calendar days after the date of early exercise could also result in burdensome tax consequences. An optionholder who early exercises and purchases stock from an NSO but fails to timely file an 83(b) election will recognize ordinary income, each time any of the stock vests, equal to the difference between the fair market value of the stock at the time it vests and the exercise price for the stock.

Although ordinary income is normally not recognized upon the exercise of an ISO, an optionholder may file an 83(b) election upon the early exercise of this type of option. However, the result of an 83(b) election with respect to an ISO is to minimize and accelerate income recognition from the stock only for purposes of the alternative minimum tax (AMT). An optionholder who early exercises and purchases stock from an ISO but fails to timely file an 83(b) election will have an item of adjustment for AMT purposes, each time any of the stock vests, equal to the difference between the fair market value of the stock at the time it vests and the exercise price for the stock.

Furthermore, any tax that an optionholder pays as a result of early exercising a stock option is not recoverable. This is true even if the optionholder resigns or is terminated from the company before the purchased stock is fully vested. Since a company will repurchase any early exercised stock that remains unvested at the time of an optionholder’s termination, an optionholder may end up paying taxes, as a result of early exercising a stock option and making a typically beneficial 83(b) election, for stock that they are not certain to own in the future

Will you benefit from early exercising the option?

It must be emphasized that the decision whether to early exercise a stock option is a highly personal financial decision. It is usually advantageous to exercise an early exercisable stock option if it is an NSO and the exercise is occurring before the fair market value of the underlying stock has appreciated significantly beyond the exercise price of the stock. Early exercising an NSO and properly making an 83(b) election in this situation usually enables the optionholder to minimize the income recognized and the taxes payable upon exercise. Making the 83(b) election in this situation will also start the long-term capital gains holding period for all of the purchased stock, whether vested or unvested, which can improve the chances of any capital gains from a later sale of the stock being taxable at the lower, long-term capital gains tax rates.

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