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In Part 2 of our compensation series, Understanding Equity Compensation, we laid out some basics and methods for determining how many shares to ask for in compensation negotiations. Here in Part 3, we’ll dive deeper into this question of if and when you should exercise those options, addressing timing, tax implications, and other considerations.
Disclaimer: This is not tax or legal advice, and you should always consider your unique circumstances and consult the appropriate professionals.
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First a note on restricted stock units (RSUs) vs. stock options. RSUs grant employees a specific number of company shares subject to a vesting schedule. That is to say, you don’t need to make any decisions regarding exercising your RSUs – they will automatically become yours upon vesting. They will be reported on your W-2 as income and be subject to social security and tax withholdings just as with cash compensation.
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Since RSUs don’t require a decision regarding exercising, we’ll talk about stock options from here on out. In this case, you have an option to acquire company stock at a predetermined price – the exercise or strike price (usually the value at the date the option was granted). There will still be a vesting period, and once that period is up, you are eligible but not required to exercise.
Unlike RSUs, stock options expire, and there is a period over which you are entitled to exercise them. This is often a 10-year term, meaning you can exercise any time between the date of grant and 10 years. There is also usually a certain amount of time after you leave the company that you are still eligible to exercise.
So when to exercise? Put simply, if the share price is higher than the strike price. Let’s say your options were valued at $1.00 on grant date, and once vested, the share value has increased to $2.00. In this case, it would make sense to exercise.
Mark Barrus, CPA and professor at Case Western Reserve University, advises, “It’s basically a lottery ticket. If the value of the company goes up, you now have a lottery ticket that’s worth something. If the value of the company stays the same or does not increase, there’s no point in exercising your option.”
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There are two main types of options, qualified and non-qualified, which determine the tax treatment of your shares. You will know on the grant date which type you have.
Tax-qualified shares are also referred to as ISOs, or incentive stock options. These come with more favorable tax incentives, specifically, the opportunity to get long-term capital gains treatment on the entire amount of appreciation of your shares.
Capital gains are profits you make from selling most assets, like shares. If you held the asset for less than one year before selling, those are short-term capital gains, and they’re typically taxed at the same rate as your ordinary income, anywhere from 10-37 percent. If you’ve held the asset for longer than one year, then the profits are long-term capital gains. These are typically taxed at a lower rate, 0-20 percent depending on income.
With ISOs, you aren’t immediately taxed when you exercise. That happens when you ultimately sell your shares. Let’s look at an example:
In this case, you paid $1.00 for a share when you exercised then later sold it for $3.00, meaning $2.00 is all income. All of that could be taxed as long-term capital gains, as long as you meet two requirements.
Barrus explains, “You have to wait two years from the date of grant before you sell the shares and one year from the date of exercise. That’s the main requirement. If you do that, it’s considered qualifying. You’ve met the IRS rules, you’ve held it long enough, and at that point, any gain over the amount you paid, the exercise price, is all capital gain.”
Since you have to wait a year from exercise to qualify for long-term capital gains tax treatment, there is a strong incentive to hold your shares rather than selling right away. It is also a reason to exercise as soon as you’re vested, in order to start that one-year clock ticking, particularly if you anticipate the value of your shares increasing.
“Yes, you’re out of pocket to pay the strike price, but then the time period comes quicker to get the capital gains. And if you think your shares are going to increase rapidly, there’s an IPO down the road or what have you, then you want to get exercising so you make sure you get capital gains, and you can sell as soon as possible.”
One big consideration and potential downside with ISOs is the alternative minimum tax (AMT). Exercising could trigger AMT, which could mean you’ll pay more in taxes than you would otherwise. You can only exercise a certain amount each year before triggering AMT, and it basically comes down to timing.
“You might time your exercises – one per year for example – so you come in under the AMT exemption and then you’ll never have AMT hit you,” says Barrus. “If you’re going to exercise and hold, you have that AMT tax that could be due in the year of the exercise, even if you haven’t sold the shares.”
(Speak with your tax advisor and/or see here for more details on the AMT.)
Non-qualified stock options (NQSOs), also called non-statutory, are basically options that aren’t ISOs. When people talk about options, this is usually what they mean. The main difference between NQSOs and ISOs is that NQSOs don’t have holding period requirements.
Let’s use the same example as above. Your strike price is $1.00, and the value is $2.00 at exercise date. Unlike ISOs, that difference is all ordinary taxable income in the year you exercise, even if you don’t sell.
You can still get some favorable treatment with NQSOs, however. Let’s say the value of your shares goes up to $3.00 after your exercise date. You can still wait 12 months and get long-term capital gains treatment on that dollar.
“It’s the same kind of math,” says Barrus. “If you really think it’s going up in an IPO situation or a liquidity event, the sooner you can exercise [the better], so you get your clock ticking for the 12-month capital gain treatment on sale of shares. The only downside here is you’re going to have that first ordinary income occur as soon as you exercise the shares.”
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Of course, exercising options means you have to come up with the cash to do so. There are a few options for this if you don’t have the cash on hand, and there are pros and cons to each.
Some companies will let you surrender a portion of the shares – this is referred to as a “cashless exercise.” Or, less commonly, your company might offer you a loan. The problem there is, you owe your company money, which leaves you open to a risky situation if the stock ends up being worthless.
There are also a number services (Equitybee, SecFi, e.g.), that will come in and value your stock, and they will pay for the exercise of those options in exchange for a success fee (some percentage on the proceeds) to be collected when the stock becomes liquid or the company gets acquired. Other companies will simply lend you money against your shares, but in this case, you will have to put up a personal guarantee.
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If you’re in a situation where your company didn’t offer you equity upfront, but now they do offer it to new hires, you should absolutely feel comfortable asking for some type of retroactive plan.
Barrus offers, “You can even negotiate and say, not only do I want an option that is the same amount as another person, but I want my vesting to reflect back when I started. There are some rules about backdating, but there’s a fair amount of flexibility. I would not be afraid to ask.”
Read more tips on compensation negotiation here.
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