Employee stock options: exercise some now or wait?

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arithmetic
Posts: 1
Joined: Sun Jul 25, 2021 1:21 pm

Employee stock options: exercise some now or wait?

Post by arithmetic »

I can’t decide if it’s worth exercising $10-15k of illiquid stock options today in my series A company to limit tax exposure in future years, or if the uncertainty of a future liquidity event outweighs any potential benefit.

My biggest fear is facing a huge tax bill if I choose to leave in a few years and want to exercise my (still illiquid) vested options after the FMV-strike spread has grown considerably, and regretting not exercising earlier.

Financial picture:
  • I’m 33, my spouse is 30
  • $282k household income (dual income, no kids yet, no state income tax)
  • $76k in expenses over the last year
  • No debt except for a mortage
  • $51k going into two Roth 401(k)s and two backdoor Roth IRAs
  • We own a house in a MCOL city and we’re saving for a down payment on a second home
  • $400k total net worth, not including home value or mortgage
  • $300k retirement portfolio (98% stocks, only US and international index funds)
I don’t want money spent on exercising options to be more than ~5% of my invested portfolio.

Stock option details with approximate numbers:
  • I was granted 100,000 options (ISO, 1% of total outstanding shares at the time of grant) with a $0.40 strike. I have currently vested about 50% of them.
  • I exercised 12,500 options at a cost of $5,000 in 2020 when the FMV was $0.40.
  • The company raised $10M in a series A round 6 months ago at a $60M post-money valuation (10x annual run rate of $6M). With that the FMV increased to $1.00.
  • Annual run rate has grown to almost $10M in the last 6 months. Company is close to cash flow break-even, and has even turned a profit in past months.
Now, normally I don’t put much faith in any random series A startup being able to achieve an exit where employees with common stock make money. Most startups fail, and many exits don’t net anything for employees thanks to liquidation preferences.

However, given my company’s health and trajectory, am I crazy to think this company has better-than-average odds? Or am I just biased?

I’ve been thinking about this for way too long and I could use some outside perspective. What’s the right way to think about this?

Thanks for reading.
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David Jay
Posts: 14569
Joined: Mon Mar 30, 2015 5:54 am
Location: Michigan

Re: Employee stock options: exercise some now or wait?

Post by David Jay »

Welocme to the forum!
arithmetic wrote: Thu Jul 29, 2021 10:45 amHowever, given my company’s health and trajectory, am I crazy to think this company has better-than-average odds?
The odds don't matter. What matters is your excessive financial concentration in your company - Both your income and much of your potential assets.

You need to diversify as soon and as much as is financially feasible.
It's not an engineering problem - Hersh Shefrin | To get the "risk premium", you really do have to take the risk - nisiprius
mosilaby
Posts: 76
Joined: Mon Sep 28, 2020 8:47 pm

Re: Employee stock options: exercise some now or wait?

Post by mosilaby »

As you indicated, as the spread between your strike price and the current strike price (FMV) grows, your AMT tax liability will grow. You can work through an AMT calculator or your accountant (probably a better choice) to keep yearly exercise amounts below AMT limits. A good accountant will work through your various tax liabilities given different scenarios. For example, given your shares, have someone calculate AMT liability should you purchase all the shares at various new FMVs.

If you exercise 37,500 shares now, I'm not seeing any additional AMT burden, so it's just the cost to purchase.

Exercising sooner allows you to hold the stock for over 1 year and reach long-term gain treatment in the case of a liquidity event.

Google QSBS (https://www.investopedia.com/terms/q/qs ... -stock.asp) to see if your shares qualify for that treatment because, if so, you can potentially save on a lot of federal tax down the road.

It doesn't have to be all or nothing, you can exercise some now and then purchase some every x months as you feel comfortable. A $10M raise really isn't that big. Lots of things can go wrong, but thinks can also go very right!
Boatguy
Posts: 233
Joined: Fri Apr 19, 2019 7:54 pm

Re: Employee stock options: exercise some now or wait?

Post by Boatguy »

Slightly off topic, but I’m curious as to why, with a household income of almost $300k, you’re each doing a Roth 401k rather than pretax? How high do you expect your tax bracket to be during retirement?
shess
Posts: 2163
Joined: Wed May 17, 2017 12:02 am

Re: Employee stock options: exercise some now or wait?

Post by shess »

Personally, I think all of the bit about percentage of the company, series A, post-money valuation, etc, is a distraction. In the end, the error bars on things are so big that when you multiply everything out the range likely overlaps both $0 and $infinity. That kind information is super useful if you are building a portfolio of companies, but, unfortunately, you don't get the averages, you get a specific outcome. The fact of the matter is, of ten companies with the exact same financial layout, 6 or so will do poorly, 2 or 3 will do meh, and one will do so well that nobody cares about the others, and there's no real way to know which your company is.

Keep in mind that by working at the company, you are inherently biased in a positive direction. If you thought the company sucked, the problem wouldn't even come up, and you'd instead be asking about whether to find a different job.

Anyhow, that out of the way, I think the resolution really comes down to "Can you afford it, and if so, is it an onerous cost?" Once Upon A Time, I was super clever, and early-exercised 1/3 of my ISO grant. My thinking was that I had no idea if I'd be there long term, but it seemed like a year and a half was pretty reasonable. In the event, we went public, I stayed for almost four years, the dotcom bust undercut us, and I netted a very modest amount (around half a year's salary, I think? Something like that). The roller-coaster ride meant that I ended up spending an ABSURD amount of time worrying about how to early-exercise/hold/strategically-sell/etc on those options I didn't early exercise, and in the end it didn't turn into enough money to justify all the planning.

Having learned my lesson, on the next startup I joined I just early-exercised the whole grant. It wasn't because I strongly believed in the company or anything. Rather, I just didn't want to have to deal with revisiting all of those tax issues, and we could afford to do the early exercise, so ... I just did it, even though it was a somewhat uncomfortable amount to lock up, and it would have made me sad to lose it. In the event, it went well enough that I can't with a straight face claim that the best part was not having to deal with complicated tax issues. But I have to admit, not having to worry about those tax issues was really nice. All long-term gains, across the board!

So, my read is that you have options it will cost $15k to exercise, plus any AMT exposure (likely low given SALT limitations these days). Given your described income and assets, I'd guess coming up with $15k wouldn't be a huge stretch for you. So go for it! File an 83b election and early-exercise the rest, while you're at it!

Against that ... sounds like you've already been there two years and the FMV has only gone up maybe 3x? To me, that doesn't sound like a company charging for the IPO exit. So I guess that argues maybe for not jumping in with both feet, because you might be locking up those funds for many years.

OK, OK, so ... let's say the company doesn't have a good exit. In that case, exercising is probably not a good idea, you're spending money now for less money later. If the company has a "meh" exit, exercising is kind of neutral. If the company has a gangbusters exit, then even if you don't exercise now, you'll have oodles of cash to pay taxes with. So it's kind of like the problem of having large tIRA RMDs, where it's hard to feel REALLY bad for someone who's being forced to realize so much income that they have to pay taxes! The "worst case scenario" for not exercising just isn't all that terrible, IMHO.

Your concern about whether to exercise if you leave is more pertinent - leaving often implies a change of opinion on the long-term prospects, so I could see it going either way. You might want to exercise because of FOMO, or you might wish you could sell your fully-owned shares because you don't think the company will beat the market (or because you want the cash to early-exercise shares wherever you land). I guess I'd be doing some reflection on whether you're the type of person who is destroyed by missed opportunities of that sort. Or maybe you're the type of person who's driven insane by quitting and having to wait five years to get your money out of the company. Maybe flip a coin, and if it comes up with "Oh! That's what I was hoping for!", you have your answer, and if you argue about what comes up, you also have your answer.

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While I agree with David's comment about excessive concentration, personally I don't consider this to be absurd concentration. Yes, you have some concentration, and leaving the options as options so you can invest that cash is one way to stay a bit more diversified. But the amounts involved are not large relative to your net worth and salary, so taking the more-diversified route isn't going to have a huge impact. Exercising probably also won't have a huge impact, but it _could_. I think it's reasonable to consider these amounts as "fun money".
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