Early exercise options can save employees millions in taxes, but many company advisors have traditionally frowned upon them because of the risks and administrative burden. But what are the risks? And what are the benefits? Should you be offering them to your employees?
Granting your employees early-exercise options can be enormously beneficial to the recipients, but it is important to manage the risks carefully. We will explore the ins and outs of the topic in three different posts:
Part 1: The Benefits of Early Exercise
Part 2: The Risks of Early Exercise and Potential Mitigation Strategies
Part 3: Evaluating If and When to Early Exercise
Part 1: The Benefits of Early Exercise
Early exercise options can literally save employees millions of dollars in taxes, yet few companies issue them. In the past, this strategy has been considered risky for employees and burdensome for companies. So what exactly are early-exercise options and how can they save you money? Let’s start with the basics.
What Is Early Exercise?
Most option grants follow a pretty standard pattern. An employee receives options with a strike price and a vesting schedule. If the option holder leaves the company or the company is sold before all options are vested, he or she will only be able to exercise the portion of shares that has vested. The remaining portion is cancelled and returned to the company. (Some option agreements will accelerate vesting when the company is sold depending on the terms.)
Let’s look at an example. Suppose an option holder has a typical 4-year cliff vesting schedule, and they decide they want to exercise two years after the date of grant. Here’s what the exercisable shares look like (assuming no accelerated vesting upon exit):
After two years, only half of the shares are exercisable. The option holder can continue to exercise shares monthly as they vest until the company is sold or they leave the company.
For early exercise options, the vesting schedule remains the same, but the option holder can elect to exercise all their options at any time. Here’s what it looks like under the same conditions as above, only with early exercise:
If the option holder exercised all their shares at the time of exit, they would receive half their shares (vested portion) as regular common stock, but they receive the other half (unvested portion) as restricted common stock.
Restricted common stock has a vesting repurchase right. This means that if the recipient leaves before all the shares vest, the company has the right to repurchase all unvested shares at the original exercise price. So to be able to retain all the restricted shares, the recipient still has to stick around for the full vesting period.
What Are the Benefits of Exercising Early?
So what’s the benefit of exercising early? Tax savings. Big tax savings.
The amount of cash an option holder takes home is heavily impacted by taxes. When a company is sold, one of the primary factors influencing tax treatment of equity compensation is how long you have held your shares after you have exercised them.
If you exercised your shares and held them for longer than 12 months after you exercised (and, in the case of ISOs, 24 months after they were granted to you), you can qualify for long-term capital gains taxation as opposed to short-term capital capital gains.
The long-term capital gains tax rate is generally about 20% lower than the short-term capital gains rate (which is the same rate as your ordinary income tax rate), regardless of your tax bracket. A 20% difference can mean hundreds of thousands or even millions in tax savings.
To illustrate, let’s look at a simple example. We’ll explore a more nuanced case later, but for now we’ll assume that a company has sold for $500M. Let’s assume that employees with options own 10%, so they received $50M as a group (we’ll ignore any waterfall features for simplicity).
Below is a graph showing the effect of early exercise options vs traditional options. If all of the employees with early-exercise options exercised and received long-term capital gains tax treatment, they would realize an additional $10M ($42M versus $32M) in after-tax value, increasing their returns by 31%.
The news gets even better. This additional $10M doesn’t come from the company. It comes from tax savings.
However, we made several simplifying assumptions in the graph above:
- We assumed that everybody who receives early exercisable shares exercises them at least 12 months before a liquidity event
- We assumed that everybody who received non-early-exercisable shares does not exercise them 12 months before a liquidity event
In reality, these assumptions are unlikely to be 100% accurate. But even if they are not totally accurate, they are directionally correct.
How Many Companies Could Benefit From This Strategy?
You might be asking, can my company benefit from this strategy? If you have–or plan to have–a significant number of optionees, then the answer is likely yes. To get a sense of the scope of the tax saving possibilities we did some back-of-the-envelope analysis.
According to Preqin, the total value of all venture-capital-backed exits in 2014 was $95.4B. It is generally safe to assume that nearly all of these companies granted stock options to employees.
Based on our exposure to thousands of cap tables, we feel it is reasonable to estimate that stock options represented approximately 10% of the capitalization of all of these companies.
Assuming all of these companies granted 10% of their capitalization in stock options, this implies that $9.54B in liquidity value was distributed to optionees in 2014 alone. As we assumed above in the case of an individual company, the difference between all employees early-exercising and achieving capital gains treatment versus none doing so is 20%, or $1.91B (20% * $9.54B).
For this analysis though, let’s make our assumptions a bit more realistic. Probably a small percentage of these shareholders did exercise and receive capital gains in these exits. So, for this analysis, let’s say 5% of the 10% option pool or 0.5% of the total capitalization of the company exercised early in these exits.
You might also wonder about situations where employees didn’t exercise because the strike price was so high that it wouldn’t have been profitable for them to exercise. These are called “underwater” or or “out-of-the-money” options. Generally, when this happens the board issues new options to the employees they want to retain at lower strike prices so that these employees stick around keeping the “in-the-money” option pool at around 10%.
So I think that it is generally reasonable to assume that 0.5% of the total capitalization of these venture-backed companies early-exercised options and another 9.5% exercised options at the time of exit (also called “net-exercising”).
If you could increase the amount that early exercised to 50% of the 10% option pool, or 5% of the total capitalization of the company, you would increase after-tax returns to employees by approximately $1B.
Since the number of companies that grant stock options is larger than the number of venture capital-backed companies, our analysis likely understates the impact of smart early-exercise strategies.
So if the tax savings are so obvious, then why doesn’t every company do this? The short answer is that successfully implementing an early exercise strategy can be complicated. There are risks to the employee and a variety of tax implications can be involved.
We’ll explore this more thoroughly in Part 2. Feel free to reach out to us with any questions or comments. We’d love to hear from you.