Should a company allow early exercise of stock options?
Takeaway: Allowing option holders to early exercise their options can allow them to start the long-term capital gains holding period and get more favorable tax treatment if they ever sell the shares in an acquisition. However, it can be an administrative headache if lots of option holders want to early exercise their options, particularly if they do so each time they vest a portion of the option.
Early exercise of stock options refers to the practice of allowing employees to exercise their stock options before they have fully vested. Once the option has been exercised, the unvested stock is still subject to a right of repurchase wherein the company can buy the shares if the employee’s service terminates (having a right of repurchase is another way of saying the stock is subject to vesting). The company’s repurchase price in this scenario is the exercise price of the option. Note that options are not typically early exercisable unless the company’s board of directors approves the grant as early exercisable and the company’s equity incentive plan materials permit early exercise.
Early exercise can be an attractive option for employees because it allows them to lock in their exercise price at an earlier date, potentially resulting in greater gains if the stock price increases. However, it's important for startups to carefully consider the pros and cons of early exercise before offering it to their employees.
Cash requirements
Early exercise requires employees to pay for their shares upfront, which can impact their personal cash flow. Startups should consider whether their employees are in a financial position to take on this expense, and whether the company is able to offer any support or assistance in covering the costs.
Tax implications
Early exercise can have significant tax implications for employees, particularly if they are subject to the alternative minimum tax (AMT). Specifically, it can allow employees to begin the clock for the long-term capital gains holding period with respect to all of the shares subject to the option. If an employee knows that they will early exercise an option, the timing of this exercise can impact the which type of option is appropriate. If the option is to be exercised immediately (i.e., when there is no difference between the exercise price and fair market value of the stock), the employee would likely prefer an NSO because they can get long-term capital gains tax treatment after one year. Stock issued upon exercise of ISOs on the other hand needs to be held for more than one year after exercise and more than two years after the date the option was granted in order to get long-term capital gains treatment.
Practical implications
Very few startups permit early exercise of stock options because there are a number of disadvantages, including the following:
By exercising the stock option, the employee is putting up their own money to exercise and taking the risk that the stock decreases in value. Further, the stock that employees hold is typically illiquid and can be difficult to sell if they need cash in the future.
If there is a difference between the fair market value at the time of exercise and the exercise price, the employee will be taxed at ordinary income rates on this spread and may also trigger AMT liability.
Startup employees are often not accredited investors and having more than 35 unaccredited stockholders at the time of an acquisition where the consideration is stock can create complications and delay.
The administrative burden of processing early exercises can stack up. Employees will often early exercise chunks of their option, creating repeat administrative responsibilities for the company. In addition, 83(b) elections should typically be filed within 30 days of each exercise.
Option holders do not have rights as stockholders until they exercise their option. Once the option holder exercises the option, they have the same rights as the other stockholders (including the founders) though they typically hold many fewer shares.
Conclusion
Overall, early exercise of stock options can be a valuable tool for startups to attract and retain top talent but is not very common. It's important for startups to carefully consider the financial, tax, and liquidity implications of early exercise, and to consult with legal and tax professionals to ensure that their policy and processes are structured in a way that benefits both the company and its employees.