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Step-by-Step Guide to Planning for Initial Stock Option Exercises

Planning an early stock option exercise can be overwhelming and challenging. If you are one of the many employees of early-stage startups and private companies that receive equity compensation in the form of stock options and RSUs, this article will give you a starting point.

Planning an initial stock option exercise

You probably want to understand how owning stock options will affect your long-term wealth. The exact specifics of your equity compensation will vary widely from company to company. There is also a wide range of possible outcomes in relation to the value of your equity and the timing of your liquidity event. Your tax implications depend on when and how you exercise your stock options and how long you hold your vested stock. In addition, many employees will struggle with the high concentration of your net worth in a single company. Burdened with many questions and few answers, technical workers often delay early stock option exercises until the close of an IPO or other liquidity event.

So, what do you do next? Here are some tips that can help you navigate the complex world of equity compensation and beginner stock options exercise.

1. Know What You Have

The best way to master your equity ownership is to take a step back and find out what you own. Contact your payroll department or stock option seller to ask for more information about your stock option holdings.

In general, there are two types of employee stock options – incentive stock options (ISOs) and non-qualified stock options (NSOs). You will most likely own one or the other or some combination of both. Although they may look very similar on the surface, there are significant financial and tax differences between ISO and NSO.

ISOs, generally, offer more favorable tax treatment. There is no tax on your ISO practice, but it may force you to pay the alternative minimum tax.

In comparison, NSOs offer slightly more flexibility but in practice trigger immediate taxable income. Both the employer and other stakeholders can obtain NSO.

2. Keep track of key dates and figures

Keeping track of important dates and figures is the next step in mastering your stock options. In most cases, you should start from the moment you receive your job offer. In my article “Guide to Understanding Your Job Offering with Stock Options,” I discuss evaluating a job offer that includes a combination of salary and stock options. There are some important dates and statistics that you need to keep an eye on. Here’s an alphabet of words you’ll need to remember — multiple shares, vesting dates, exercise dates, strike price, fair market value, and vested versus non-vested shares.

In addition, as you continue to work for the same firm, you may receive other stock option grants with different strike prices. Create a spreadsheet or use the information provided by your option vendor to track all the numbers. This can be cumbersome, but it can be of great help in making an early stock option exercise decision.

3. 83B Election

Some companies may allow you to have an IRC 83(b) election. This IRS rule allows companies to offer stock options early exercise. When making this election, you will pay income tax on the fair value of your stock options. Early election is incredibly attractive to founders and employers of early-stage startups with low fair market value.

The 83(b) election is rarely made because of the complexities in calculating the value of early-stage startup options. If you can determine the value at the time of the grant and decide to go down this road, you will owe taxes on the fair market value of your options at the grant date. But no income tax shall be payable at the time of vesting. Another disadvantage of this strategy is the risk of the employee stock price falling below the grant date level. In this scenario, waiting until the vesting period would have been beneficial.

4. Navigate Your Taxes

Managing and planning your taxes is by far the most challenging step in the process of initial stock option exercise. The biggest hurdle comes from the uncertainty of having enough cash to cover your tax expenses. In addition, frequent changes in the company’s fair market value and the inability to sell vested shares complicate the process of planning your taxes.

Given so many moving parts, you’re probably wondering what your best course of action is. For one, once you get to this juncture, it’s time to drop the turbo tax (no offense, I used it several years ago) and get expert advice. Despite all the uncertainties about the future, we recommend our clients to make regular tax estimates. Taking a snapshot of your current circumstances will allow you to take an objective view of your finances and make informed financial decisions.

5. Plan Ahead for Initial Stock Option Exercise

In my practice, I often talk to people whose company goes public within a few days or weeks. A good number of them are looking to exercise their stock options first time,

There is a strong appeal to not do anything until you reach a critical liquidity event. Waiting to exercise until the IPO eliminates a lot of financial and business uncertainty. However, the waiting strategy has a notable trade-off – paying higher taxes in the future and exposing yourself to material concentration risk.

What we recommend to all our clients is: plan ahead, Don’t leave these important financial decisions for the last minute. Even with a wide range of future outcomes, you can reduce your taxes and reduce your anxiety levels by taking small, measured steps.

What makes early stock option exercise decisions so difficult is that no magic formula or one-size-fits-all solution works for everyone. Working with many clients, I realized that we all face different situations and challenges. If one approach works well for your coworkers, it may not work very well for you. When we work with our clients, we try to strike the right balance between managing uncertainty and planning for the future.

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