If you work for a start up, it’s likely part of your compensation is incentive stock options (ISO’s).
And if you have unexercised ISO’s the question is when should you exercise your options?
OPTIONS 101
There are two kinds of stock options – incentive stock options (ISO’s) and non-qualified stock options (NQSO’s).
The difference between the two is how they’re taxed. Since very few companies issue NQSO’s, we’ll only focus on ISO’s in this post.
To cash out your options and put actual money in your actual pocket, there are 4 steps:
1. grant > 2. vest > 3. exercise > 4. sell
ISO TAXATION 101
When you sell (not exercise), you’ll pay taxes at either ordinary income rates (your tax bracket) OR at long-term capital gains rates (maximum 23.8%).
Which one depends on two dates:
1. The grant date – when your company gave you the options
2. The exercise date – when you paid the money to buy the shares
(Notice that the vesting date doesn’t matter for tax purposes.)
To pay long-term cap gains, you have to sell the shares 2 years after the grant date and 1 year from the exercise date.
WHEN TO EXERCISE
When you exercise you pay money out of your pocket to purchase the shares.
HOWEVER, the price you’ll pay to exercise NEVER changes. It’s set in stone when the options are granted based on the company’s most recent valuation.
Options are all paper money until there’s a liquidity event – either an IPO or an acquisition.
Therefore the optimum time to exercise is one year before the IPO or acquisition (assuming you’re already 2 years past the grant date).
If you exercise any earlier, then you’re wasting your money because you just locked up capital in an investment with a purchase price and a return that will never change.
It’s kinda like queueing for a movie 3 hours before showtime. You’ll definitely be first in line, but you’ll also waste 2.5 hours to achieve the same outcome.
CONCLUSION
If you’ve got ISO’s, don’t get antsy. Set the money you need to exercise aside in a high-yield savings account and earn your 4.5% while you wait patiently with your fingers crossed.
BONUS TIP
If your start up is more likely to IPO than get acquired, then you can safely wait 6 months before the projected IPO to exercise and lock up your capital.
That’s because most IPO’s have a 6 month blackout period where employees aren’t allowed to sell. So exercising 6 months before will still give you 12 months in total before you sell.
