02 —

Exercising your options

Feeling anxious about when to exercise your options? You're not alone. Here's our perspective on the best times to exercise, whether your company is still private or already public. Because every person's situation is unique, we highly recommend that you speak with a good tax accountant.

Exercising before your company goes public

If your company is still private, it can be a challenge to figure out when you should exercise your vested equity. There are a few factors to consider: the amount of cash you have on hand to exercise, the tax implications, and the risk that you may lose your investment if your company doesn't have a successful exit.

Our advice in a nutshell: If your company offers early exercise AND is less than one year old, you should consider exercising early. Otherwise, wait to exercise until your company begins the process to go public.

Much like for any riskier investment, a good rule of thumb is not to spend more than 10% of your entire net worth exercising.

Early exercise only if your company is less than 1 year old

In an early exercise, you purchase some or all of your unvested options upfront, then receive your shares at vesting time. Exercising early is a way to minimize or avoid taxes, because the fair market value of your options may be at or only slightly above your strike price.

We only recommend exercising your options early if it is very early in your company's life. In this situation, your options may have an extremely low strike price, perhaps just pennies per share — so exercising even hundreds of thousands of shares might cost just a few thousand dollars and will not owe much in taxes. And if your company succeeds, then the amount of taxes you save will be enormous.

Note that not all companies offer the ability to early exercise; if it's something you're interested in doing, it's worth checking with your employer before signing an offer.

Get additional savings with an 83(b) election

If you decide to exercise your options early, it's important to make an 83(b) election within 30 days. This is a special election you can make with the IRS to let them know that, despite the fact that you have not yet vested your stock, you still want to recognize the income associated with ownership immediately. The benefit? You won't have to pay any taxes when you early exercise.

Learn more about taxes

Your taxes will vary depending on the type of options you have and the timing of when you exercise them.

Read more →

Not an early employee? IPO not on the horizon?

When to exercise and hold

If you have enough cash on hand and if you're willing to take on the risk, you may still want to consider exercising your equity as it vests and then holding onto the stock until a liquidity event. The benefit is that it reduces your potential tax liability (both at the exercise date and if your shares are eventually sold). Talk to your accountant if this is something you want to explore.

Leaving your job before IPO?

Don't miss the exercise window

If your company is still private and hasn't announced plans to go public, our advice is to only exercise what you're comfortable losing. After leaving, the clock will start ticking on your window to exercise the options you vested during your time there. The vast majority of companies give you 90 days from the day of your departure to exercise — so if you want to exercise, act fast.

The best time to exercise (for most people)

Our CEO Andy Rachleff believes the optimal time to exercise options for most people is when your company begins the process to go public.


"To find the ideal time to exercise, you need to work backwards from when your shares are likely to be liquid and valued at what you will find to be a fair price," Andy says.

"You will take the minimum liquidity risk — that is, you have your money tied up the least amount of time without being able to sell — if you don't exercise until your company tells you it has filed for an IPO."

You first want to make sure that if you have ISOs, you qualify for the much lower long-term capital gains tax rate (more on that in our section on Tax Overview & Glossary).

Moreover, once a company files for IPO, you generally won't be able to sell your stock for about a year:

  • A company's stock doesn't usually trade publicly until approximately six months after it starts the IPO process (i.e. drafting a prospectus)
  • Once a company is public, employee shares are typically restricted from being sold for the first six months (the employee lock-up period)
  • Once employees are eligible to sell, the company's shares typically trade down for a period of about two weeks to two months after the lock-up ends, as large numbers of employees sell their shares all at once.

So if you wait to exercise until your company starts the IPO process, it not only gives you the most certainty that your shares will be worth more than your strike price, but it also may allow you to sell your options as soon as possible while still qualifying for the long-terms capital gains tax.

Best time to sell Best time to sell

 

Exercising after your company goes public

The benefit of exercising after your company goes public is that you know what the stock is worth at any given time. If your exercise price is above or equal to the fair market value of the shares, it probably doesn't make sense to exercise your options.

If you're ready to exercise post-IPO, you can do what's called a "cashless exercise": simultaneously exercising your options and selling the stock in the same transaction. There are a few strategies to consider, but you should check with your CPA about the specific tax implications for your equity.

Why not "exercise and hold"?

We analyzed the impact of selling $100,000 worth of a single company's stock over 18 different windows, ranging from selling immediately to holding on indefinitely. On average, the best returns came from selling the stock immediately after the lock-up period, and investing the proceeds in a diversified portfolio. We found the longer you held onto the stock, the less you'd be left with — with the lowest proceeds coming from holding on to the stock indefinitely. Read more →

Post IPO exercise-and-sell strategies

Same-day sale of options

If your company goes public and you haven't previously exercised your options, it might make sense to do a same-day sale (exercise your options and immediately sell the underlying stock in the open market) if there's a substantial spread between your exercise price and the current trading price of the stock.

Exercise and sell to cover

You might want to only sell enough shares to cover the income and payroll tax withholdings, so that you're still left holding a portion of the exercised shares. The benefit to holding your exercised shares is that you can qualify for the lower long-term capital gains tax rate.

Staggered exercise

You can also exercise and hold in a staggered approach — this gives you the opportunity to sell stock as you exercise additional options. This choice can be particularly beneficial if stock has been held for over one year and the associated gain qualifies for favorable long-term capital gain tax treatment.

Why not "exercise and hold"?

We analyzed the impact of selling $100,000 worth of a single company's stock over 18 different windows, ranging from selling immediately to holding on indefinitely. On average, the best returns came from selling the stock immediately after the lock-up period, and investing the proceeds in a diversified portfolio. We found the longer you held onto the stock, the less you'd be left with — with the lowest proceeds coming from holding on to the stock indefinitely. Read more →

Working with a tax accountant

It's important to work with a great tax accountant so that you can really understand the tax implications of exercising your equity. There are sophisticated tax strategies that you might want to consider before you exercise private or public company stock. Exercising is a decision you're not going to make very often, and it's not worth getting wrong.


What to look for in a tax accountant

It's not always easy to find the right accountant. Toby Johnston, CPA at Moss Adams, suggests looking for the following qualities in a CPA:

  • Experience with tech startups
  • Experience working with different types of equity compensation
  • Strong communication skills, specifically the ability to explain things simply without a bunch of IRS jargon. (As Toby says, "You can't take action on ideas that you don't understand.")
  • A broad background in finance, with the ability to consider the full picture of your finances and goals — a CPA narrowly focused on just taxes can lead you to make poor decisions and will "jeopardize your overall financial plan," according to Toby.

Review: Exercising your options

Exercising is complicated, but there are some general rules you should follow:

  • Find a tax accountant you trust ASAP. We can't stress this enough.
  • Only consider early exercise if you're a very early employee. Otherwise, the best time to exercise is when your company begins the process of going public.
  • If your company is already public, only exercise if the exercise price is below the fair market value of the shares. You'll also want to review the various cashless exercise strategies with your tax accountant to determine the best tax scenarios for your personal situation.
  • If you're leaving a private company before it announces its plans to go public and want to exercise your options, don't miss the exercise window! (And only exercise what you're comfortable losing, since it's a risky investment.)
  • Don't spend more than 10% of your entire net worth exercising.