For companies fighting for the best talent, or those that are well-advised, offering the early exercise of unvested stock options, also known as “early exercise stock options,” can be a key tool in the toolbox. Allowing early exercise of stock options offers a key tax advantage by enabling holders to begin the holding period for purposes of recognizing long-term capital gains, and minimize the potential for alternative minimum tax liability.
Here are six key things entrepreneurs and investors should know about early exercisable stock options:
1. What is an Early Exercisable Stock Option?
When you receive stock options from a company, you get the right to buy shares of company stock at a specific price, also known as the strike price. This price should be set at the fair market value of the shares when you are granted your options (as determined by the Company’s board of directors, hopefully based on a third party valuation), with the hope that the value will increase. An early exercisable stock option is like any other stock option, except that the holder may exercise the option before it has vested. In particular, this type of stock option allows the option holder to exercise all or a part of the option immediately. The company’s board of directors always needs to approve an early exercise, which is often done when it approves the stock option grant or may authorize an amendment to an existing option to allow for early exercise.
When it comes to early exercisable stock options, there are several advantages to the option holder:
- the capital gains holding period starts immediately;
- if the option holder exercises the stock option early, immediately or soon after the grant date, then the option holder should owe little or no taxes upon exercise, and can avoid any taxes upon vesting by filing an 83(b) election; and
- the option holder becomes a stockholder.
Early exercise is a means of investing in the company earlier, with the expectation that the stock’s value will increase in the future, and you will be able to sell it for far more than you paid for it originally. The flip side of the coin is that the option holder risks losing all or part of the investment if the company’s common stock value decreases. Before becoming a stockholder, stock options allow holders to lock in a price and wait to see if the company’s stock value increases before being required to pay the exercise price. As the aggregate cost to exercise the options increases relative to the option holder’s financial means, the decision to early exercise the options could become more difficult for the option holder.
4. The Incentive Stock Option
If the company is a corporation, incentive stock options (ISOs) and nonqualified stock options (NSOs) can include early exercise stock options. If the company knows that an employee will immediately exercise her options, they should grant the employee his or her option as an NSO to avoid a two-year ISO holding period rule. Also, early exercise impacts one rule that applies to ISOs – a stock option may qualify as an ISO only as to $100,000 of share value that is first exercisable in any calendar year. But, if an ISO allows early exercise, the value is taken into account in the calendar year, and it becomes early exercisable in determining the $100,000 maximum that applies to ISOs.
5. Stockholder Rights
The option holder is eligible to vote to the extent the shares are voting shares, receive dividends, and request company financial information. By filing a Section 83(b) election, the option holder agrees to immediately include in gross income any spread associated with the option’s exercise, based on the stock’s fair market value on the exercise date. To be effective, 83(b) elections must be filed 30 days after the exercise date. Unfortunately, the company can face disputes with option holders who neglect to make this filing. These option holders might fault the company for not giving notice of the deadline or might expect the company to handle the filing for them.
6. Repurchasing Early Exercisable Stock
If the option holder early exercises, the company can repurchase the unvested stock when the option holder terminates service. The repurchase price tends to lower the exercise price or the previous, current fair market value of the stock. This repurchase right will end as the stock vests, as companies ordinarily do not have the right to repurchase vested stock. Usually, the company holds the unvested stock in escrow for the repurchase in case the person leaves the company, and collects all signed documents that would be required to re-sell the unvested shares back.