At Vested, our rule of thumb is typically to exercise only when you’re facing a specific circumstance when it makes sense to do so.
Those events may include: you have very favorable terms to early exercise, you’re leaving the company for a new job elsewhere, or there’s a liquidity event on the horizon.
You can anticipate the cost to exercise your shares based on your strike price. However, what you'll need to pay in taxes will depend on the type of shares you’re granted and their fair market value (FMV) when you exercise.
Exercise when you can answer these questions
Making the decision to exercise is a big one. Exercise your options at the right time, and you could take a minimal risk for a potential big payout down the road. But exercise them at the wrong time, and you could be faced with paying a lot of cash upfront, unexpected tax bills, sinking shares, or massive concentration risk. First, you may want to consider these questions:
When will your stock options expire?
What is the shares’ fair market value (FMV) compared to your strike price?
How or when can you realize cash value from your shares?
How much will you owe in taxes?
How does exercising factor into your personal financial plan?
Do you believe in your company’s chances of success?
Remember, most equity grants are subject to vesting. Until equity — in whatever form it has been granted — has vested, the company can take it back, so it's not really yours yet. "Vesting" means the release of the company's take-back right, and a "vesting schedule" is the schedule according to which that release happens.
Now that you have some vested stock options under your belt, let's dig into these questions and how to answer them.
1) When will your stock options expire?
Commonly, stock options will expire 10 years after the grant date, which is a long time and assumes you’re working at your company that whole time. Chances are you're probably not going to stay that long.
In fact, the median length of time spent in a startup job is around two years, which means you’ll need to understand what your post-termination exercise window (PTE) is if you plan on leaving before a decade of work.
This PTE window drastically cuts short the shelf-life of your options when you leave the company. This exercise window can be as short as 30 days and as long as 10 years — although the industry standard tends to be 90 days. It’s important to read the fine print on your agreement.
👉 In recent years, companies have started to extend the exercise window to be more employee-friendly. Check out this list of companies that have extended exercise windows.
2) What is the shares’ fair market value (FMV) compared to your strike price?
You are assigned a strike price on the day your grant is issued that is equivalent to the fair market value (FMV) on that day. Over time, and as your company grows and raises more money, the FMVis likely to go up. To be sure, this is a trend, not a rule — and sometimes the FMV can decrease.
Consider the following scenarios you could face after working at your company for a year:
In the last scenario, you would essentially be paying more for the shares than they’re currently worth. When the shares’ fair market value sinks below your strike price, your options are considered “underwater.” Only in the first two scenarios might it make sense for you to exercise.
Of course, keep in mind that these scenarios may be a bit more complex if you have multiple stock options with different grant dates (and thus different strike prices). In such a case, it may sometimes make sense to exercise one option grant, but not the other.
3) How or when can you realize cash value from your shares?
Let’s say all the indicators for you are good and the FMV is indeed above that of your option strike price. You leave your company and exercise your vested options. Now consider this — how liquid are they? In other words, how easily are you able to convert them into cash?
If your startup has already gone public, the answer would be “very easy.” You can just sell them on the public market and receive cash almost right away. But if the company is still private, then the only way to monetize the shares would be to either wait for a liquidity event — for example, it goes public or gets acquired — or sell them on a secondary market.
Remember, exercising costs money (either your own money or via option funding). And of course, spending your own cash to purchase an asset that could remain illiquid for years is always a risky proposition. This can be an especially long wait for early employees — the average time to IPO is now 12 years.
4) How much will you owe in taxes?
Before exercising, ask yourself: what are the near-term and long-term tax implications?
First, there are most likely going to be tax implications when you exercise your options. If you have incentive stock options (ISOs), you may owe alternative minimum tax (AMT) when you exercise even if the ISOs themselves don't incur a tax bill. If you have non-qualified stock options (NSOs), you will have to pay ordinary income taxes when you exercise the options themselves.
👉If you are curious what your AMT taxes could be, check out our AMT Calculator.
This tax burden may feel like a deterrent to exercising your options, especially if it’s unclear what the future of the company will be. That’s a very good reason to consider using outside option funding to cover the costs without risking your own money to pay taxes on something that has an uncertain future outcome.
Second, there are more taxes to consider when/if you plan to sell your shares after exercising your options. Keep in mind that the tax rate applied when you sell the shares depends on how long it has been since the exercise and grant date. To qualify for the long-term capital gains rate you’ll need to sell the shares at least one year after you exercise them and at least two years after they were granted.
👉 Note for employees on the verge of an IPO: If you have ISOs, a good time to exercise (at least for capital gain tax purposes) could be six months before the startup goes public, factoring in that you will have to wait an additional six months after the IPO to sell. (This is known as a lock-up period.)
5) How does exercising factor into your personal financial plan?
Of course, stock options and equity planning are likely only a slice of your own personal financial situation. And the bigger the slice, the more you may want to think about diversification. For those working at startups, it could be that a big part of your net worth gets tied up in one big bet with your income and equity concentrated in one company — or even one sector of tech.
👉 Our rule of thumb is typically to exercise only when you’re facing a specific circumstance when it makes sense to do so.
So if you want to diversify your holdings without waiting for a liquidity event, one strategy to consider could be exercising your options (while optimizing for fewer taxes), selling them on a secondary market, and reinvesting that money elsewhere. That could be a down payment for a house your retirement portfolio, or in a business in a different sector. In short, it’s worth taking a holistic view of your finances when you think about exercising your options.
6) Do you believe in your company’s chances of success?
Lastly, it’s time to think like a venture capitalist and ask yourself: what are the chances my company will realistically succeed? Remember that by exercising your options, you are now an investor taking a bet on the company and there’s real money and you have skin in the game.
Do you believe that your company has only a small — but not negligible — chance of success? Is it still worth spending your money to exercise your options? That’s a tough dilemma many startup employees face and a reason using option funding is a great alternative. It means you can continue to have exposure to the potential upside in the future but limit your personal risk today.
At the end of the day, exercising your stock options is a personal decision. However, we estimate that employees walk away from $600 billion in value in equity that's left on the table. With option funding, you can still retain some potential for upside — and not have to risk your own money.
So maybe the real question is: Are you ok with regret if you don't exercise your options?
👉 What could your equity be worth? Check out the Equity Outcome Simulator to see the potential value in different scenarios.
This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for investment, tax, legal, accounting, or other professional advice. Vested does not provide investment, tax, legal, accounting, or other professional advice. You should consult your own investment, tax, legal, accounting, or other professional advisors before engaging in any transaction or equity decision.