It is a difficult question, ESO is here to help.
Exercising employee stock options is like buying stock in a company for a discounted price. With this mindset, it only makes sense to exercise if you think the company will succeed. In a private company this means you believe the company will exit at some point either via an Initial Public Offering (IPO) or a Merger/Acquisition (M&A). In a public company this simply means you have confidence in the future of the company. Below we will dive into 3 primary reasons why you would exercise your stock options in a private company.
There are 3 primary reasons to exercise your employee stock options:
- You are leaving the company or want the flexibility to leave soon.
If you have already left the company, then you need to know how long you have before your options expire (For ISOs it is 90 days, otherwise the company decides). In this case your incentive to exercise is clear: to prevent the options from expiring and losing ALL value. If you haven't left the company, but either plan to leave or want the flexibility to look around (or fear you may lose your job) it can be appealing to exercise because it will lower the stress once you do leave.
- You want to reduce your tax impact and trigger long-term capital gains.
If you have high confidence in the future of the company, you can exercise early to trigger taxes on long term capital gains. It may seem appealing to wait until the last-minute to exercise your options so that you don't have to risk your own hard-earned cash up front. While this may be true, it fails to factor in that you pay taxes based on the spread between your exercise price and the current Fair Market Value of the stock. If you wait, by the time you exercise, the tax implications may have gone up considerably. When considering this tactic, you should understand the implied tax savings. According to TurboTax, in 2019 short term capital gains taxation ranged from 10-37% and long-term capital gains is typically 0%, 15%, or 20%. If you are subject to AMT, the rate can be as high as 28%. You will need to weigh the savings of triggering long term capital gains based on how much you think the price of the company will rise. Beyond triggering long-term capital gains, there any many other ways to reduce stock option taxes.
- Your expiration date is approaching.
This is simple: given that you have confidence in the company, it is almost always better to exercise than let your hard-earned options drop off the table for nothing. If you can't afford to take this risk on your expiring stock options, a non-recourse loan with the Employee Stock Option Fund allows you to keep your money in the short term, while maintaining the long-term upside potential of your options, all without taking on any personal risk.
If you are still employed and have no plans of leaving the company, it typically makes the most sense to wait as long as possible to exercise your stock options.
When you are first hired and vest your first batch of options, it is worth looking into option 2 above; however, unless you can afford to lock up your capital for an extended period of time this may be too risky of a bet. The average time it takes a startup to exit is 9 years, so it may be advantageous to invest your money elsewhere, such as in a publicly traded asset or a mortgage payment. Per TurboTax, the most you can possibly save by triggering long term capital gains is 17%, so your return only needs to eclipse that value before the company's exit. Not to mention your cash will be liquid the entire time and not at risk in case the company's prospect falter.
For more information on how to monetize your private company equity, please contact us at the Employee Stock Option Fund.