First, be aware this is not designed to answer the question for you. There are several factors that all apply to any individual situation that no single article could answer the question for you. However, this should help you understand what to look for and be aware of when beginning this decision making process for yourself. These are the topics I would discuss with my clients to help develop a specific action plan for when to exercise ISOs.
Taxes
With nonstatutory stock options (NSOs, a.k.a non-qualified stock options or NQSOs), when you exercise, you pay taxes on the spread (or bargain element) between the exercise price and the fair market value (FMV) and the time of exercise. This is spread is taxed as ordinary income, added to your W-2, and your company will withhold for taxes. With Incentive Stock Options, if you follow all the IRS rules, you do not pay taxes when you exercise, only when you sell the shares, AND the spread is taxed at preferential long-term capital gains rates. This difference between long term capital gains tax rates and ordinary income tax rates on the spread can save you thousands of dollars if executed correctly.
To qualify for the special tax status, you need to hold the acquired shares for at least two years from grant date and one year from exercise. This normally lines up with a one year vesting period before you can exercise, and holding the shares another year after exercise.
Thought process number one:
Wait until the options vest after one year, then exercise as soon as possible to start the 12 month clock before you can sell.
This also helps to exercise when the spread is smallest and reduces the chances of hitting AMT*.
BUT, this doesn’t account for one of the biggest benefits of stock options in general…
Leverage
If your employer is publicly traded, you could open a brokerage account and buy shares of your employer stock all by yourself. You can participate the same way as everyone else. You open the account, transfer money from a checking account, choose how many shares to buy [factor in the commission/trading cost], and click ‘BUY’. If the stock goes up 10%, your investment goes up 10%.
With stock options, you have the opportunity to participate in the increase of the stock price without spending any of your own money. This is leverage, and this is pretty powerful.
If you have options with a strike price of $1.00 and a current FMV of $2.00, you currently have 2-1 leverage, so if the share price goes up 50% (from $2 to $3), you get a 100% return (your in-the-money value goes from $1 to $2).
As the share price goes up and the spread increases, the effect of the leverage diminishes. The 33% increase in FMV from $3 to $4 only provides a 50% return on the option (from $2 to $3).
And when you get to the point where the majority of the option value is in the money (such as a strike price of $1 and a FMV of $10), the benefit of leverage becomes significantly reduced. Now, a 20% increase in the FMV corresponds to 22% increase in the option spread value.
Thought process number two:
Don’t exercise ISOs while the leverage is high. Wait until the Fair Market Value goes up enough that the benefits of leverage are mitigated.
This also lines up with the idea of…
How are you paying the strike price to exercise?
To maintain the preferential tax benefits, you need to hold on to the shares for one year after exercise, which means you can’t really do a cashless exercise like you can for other equity compensation. You need to have outside assets to fund the exercise. This could be cash in your checking or savings account that you have built up (possibly in anticipation of this exercise) or non-qualified investments (not in retirement accounts). Now you are not just planning around the specific company stock, you are also comparing to the opportunity cost of what you would do with that money if you weren’t exercising the options. Cash could be an emergency/opportunity reserve. It’s possible that outside investments grow faster than your company stock. The strike price of the options isn’t going to change. Delaying exercise can allow you to use that money that would go to exercising options to better use.
Thought process number three:
Along with the idea of leverage, investing outside assets can theoretically increase your net worth more than using that money to exercise ISOs.
And your willingness to put your own money at risk to exercise must consider the…
Company Outlook
At an early stage start-up, there is a very real risk the company never has a liquidity event and the equity is never worth anything. Venture capitalists might invest in 10 different startups hoping that 1-3 payoff to offset the losses from the other 7-9. As an employee earning a salary, the options you have may feel like a bonus if they eventually are worth something, but you aren’t going to lose money by working at your company. This changes when you exercise your options. You are taking money out of your pocket to buy shares in your company, even if it is at a very low price. For employees of startups, the risk of losing their investment may not be worth putting the money in to exercise.
For more mature private companies, the valuation and stock price matter a little more. If you were there early and have options with a low strike price, and now the company has grown enough that your spread is larger (and you have less leverage), the odds of the company completely failing have reduced. If the company has a viable path to revenue and profitability that venture capitalists are willing to invest in, this implies there is some enterprise value that could be bought out if the company isn’t doing well. The stock price can still go down, possibly significantly, but the odds of going to zero might be comparable to other publicly traded companies of a similar size. Now you have a little more confidence that even if the stock price drops significantly, it could stay above your exercise price, meaning you haven’t suffered a loss. This lines up with the idea of maintaining leverage. If your options have a large intrinsic value (share price value significantly above the exercise value), you don’t have much leverage, but you do have room to absorb a drop in the stock price without suffering a loss. If there is little or no intrinsic value (share price near or below the exercise price), it doesn’t make as much sense to exercise and take on the additional investment risk.
For publicly traded companies, you have more information about the range of possibilities. There is still a very real possibility of significant stock price movement up or down over the following 12 months, but now you have one extra planning tactic. You can sell the shares. You don’t NEED to hold them for 12 months. This is called a disqualifying disposition. They no longer get the tax benefits of ISOs, so you would owe ordinary income taxes on the spread, but the ability to liquidate shares to cover the exercise or taxes, or as an investment decision (selling after an increase or reducing risk/exposure to downside), provides additional planning flexibility.
Thought process number four:
If the exercise price is close to the FMV, it probably isn’t worth the investment risk to use your own money to exercise options.
If the intrinsic value is higher and no longer much leverage, there is less investment risk, but your decision to exercise or not may be more dependent on your…
Employment Satisfaction
The IRS makes it clear that ISOs are only for employees. If you are no longer working at the company, you have 90 days to exercise your ISOs or lose their special tax status. Some companies have written in to their stock plan that if you leave the company, you need to exercise all your ISOs within 90 days or lose them completely. Other companies say you can keep the options, but they are no longer ISOs; after 90 days they become Non-Qualified Stock Options (NQSOs).
Having to come up with the money to exercise all your options at once, in the same year, can be prohibitively expensive, both in terms of the exercise cost AND the taxes owed. These are called “golden handcuffs”. You end up staying at the company because you would lose so much of your equity that it becomes financially painful to leave.
If you think there is a possibility you won’t stay at the company forever, it may make sense to begin exercising some options early so that you aren’t beholden to the golden handcuffs. When you find other employment that fits your lifestyle better, the requirement to exercise ISOs within 90 days becomes more manageable.
Thought process number five:
Consider exercising some options each year. Target options with the lowest strike price and greatest intrinsic value; probably the oldest options. These probably have the least leverage, cost the least, and have the capacity to absorb a stock price decline.
When possible, avoid exercising too many options to avoid triggering…
Alternative Minimum Tax (AMT)
ISOs are not taxable at the time of exercise under normal tax rules. However, the bargain element is an AMT preference item, meaning the spread between exercise price and FMV at time of exercise is added to your income for the purposes of calculating AMT. Prior to the Tax Cut and Jobs Act (TCJA), the level of income to trigger AMT was low enough that most people exercising ISOs found themselves paying AMT. Now, after the TCJA, it is more likely to be able to exercise some ISOs without going into AMT.
Private companies – Consider waiting until the end of the year when you have more information regarding your income for the year. Consult a CPA to determine how much spread you can realize by exercising ISOs without going into AMT.
Public companies – Consider exercising early in the year, based on your expected income for the year. At the end of the year, recalculate (with a CPAs help) and if it looks like you might go into AMT, you can sell some of the shares creating a disqualifying disposition. This has the double effect of raising your regular income (because the bargain element of NQSOs are taxed at ordinary income) and reducing income for AMT purposes.
The following January, you can sell the shares after waiting 12 months to maintain ISO status. You now have cash to cover the exercise of the next round of ISOs and any additional taxes owed that spring.
Other factors to consider or be aware of:
Concentration risk – How much of your net worth is in the stock of a single company? How are you affected if that stock price goes down dramatically? It may be worth employing a sub-optimal tax strategy if it is a superior financial planning strategy.
Qualified Small Business Stock (QSBS) – If you own shares in a company worth less than $50 Million and hold on to those shares for more than five years, it may be possible to pay 0% capital gains taxes. There are many other complications for you to research, but this may be a reason to exercise ISOs early. You need to hold the shares while the company is worth less than $50M, not options. (Although the shares can be acquired through exercised options.)
Spread value vs option value - The option value using a Black-Scholes valuation method incorporates the volatility of the stock and the time until expiration. For most of the examples in this article I am referring to the spread value or bargain element. This is the difference between exercise/strike price and the current Fair Market Value (FMV), usually the FMV at the time of exercise.
Do you have any questions regarding ISOs? Want to learn more?
Check out my answers on Quora or contact me.
Aaron Agte, CFP®, founder of Graystone Advisor, is a fee-only Financial Planner located in Foster City, CA, serving clients virtually in the Bay Area and across the country. He specializes in helping couples with stock options, RSUs, and other equity compensation.
@AaronAgteCFP