Offering early exercise options to employees can provide enormous tax benefits, but this strategy is not without risks. Employers and employees should understand the implications and weigh the risks carefully. Here we explore the factors you should consider.
As a reminder, this post is the second in a series of three posts:
Here we will discuss the potential pitfalls of granting early-exercise options and what you can do to help your company and employees avoid these pitfalls.
Part 2: The Risks of Early Exercise and Potential Mitigation Strategies
Granting early-exercise options can be enormously beneficial to your employees, but it is important to understand the risks carefully. In the last post, we talked about the benefits of early exercising. We estimated that venture capital-backed companies could have increased after-tax returns to their option holders by approximately $1B in 2014 alone by giving more employees early-exercisable options.
So why doesn’t every company issue early-exercise options to employees? Partly because it poses some risk to both the employee and the company, and partly because it adds some additional complexity in shareholder management. But if you understand the risks, benefits and strategies to optimize your potential outcome, the payoff can be well worth the trouble.
We used Yokum Taku’s blog article on this subject as a major source of info, so please check it out. The table below summarizes the following key components of early exercise options:
- Major problem areas for early-exercise options
- Whether the risk applies to the company, employee or both
- The level of risk relative to traditional options
- Whether or not there are ways to mitigate the risk
We will explore each of these categories below in more detail.
Employee Cannot Afford Exercise Costs
It seems obvious, but to benefit from early-exercise, your employees will need to be able to afford the cost of exercise. Exercise cost is the number of option shares x the strike price.
When the exercise cost is low, your employees can typically pay the exercise costs with little risk. Even if the company fails and the money the employee spent is lost, it is a relatively small amount. However, if the exercise cost is high, the employee may not want to risk so much capital or may not even have enough money.
Your company could provide a loan to the employee to exercise (this is called an “exercise loan”) or your employee can find another party willing to do so. However, to start the capital gains clock, these loans must be “full-recourse.”
Full-recourse loans imply that whoever holds the loan (now or in the future even if the company fails) can come after the assets of your employee. So your employee will need to carefully weigh the risks and the benefits of this approach.
Another exercise strategy involves a special arrangement with a third party who is willing to pay the exercise price for the employee in exchange for a portion of the upside. These agreements are between the employee and the third party, so the company does not incur any additional burden.
However, you often have to receive company approval to ensure that this strategy doesn’t violate any rights that the company or existing investors have to participate in a financing like this. Sometimes this strategy can be more attractive to the employee since they avoid the risks of carrying debt.
Grant Loses ISO Status and Becomes NSO
The difference between ISOs and NSOs is beyond the scope of this article, but the main factor is tax treatment. To qualify for ISO treatment, an employee can only have $100,000 worth of ISO options become exercisable every year. The equation to find the exercisable value for a given year is pretty straightforward:
Fair Value of Common x Number of Shares to become exercisable In Calendar Year
For example, suppose you granted 400,000 shares to an employee when the value of common was $1.00. If those shares vested annually over 4 years, you would NOT trigger the ISO $100K limit because the exercisable value of the shares in any given year never exceeds $100,000.
However, if you made all of those shares early exercisable, you would violate the ISO $100,000 limit because all $400,000 of value would be exercisable upon grant.
When you violate the ISO $100,000 limit, any shares granted in excess of the $100,000 are automatically considered NSO shares for tax purposes. This means that upon exercise your employee will immediately be taxed on any spread between the fair market value of common at the time of exercise and the strike price of the options.
In other words, for all NSO shares, the employee will owe taxes upon exercise equal to the following:
Ordinary Income Tax Rate x Number of Options x (Common Share Value – Strike Price)
Since most options are granted at the current fair market value of common, the difference between the value of common and the strike price is often zero. This means the employee has zero tax liability if they exercise soon after the option is granted, so all they need to do is come up with the cash to exercise.
However, let’s assume you have an employee who waits 5 years to exercise their 200,000 options with a strike price of $2.00. Suppose the fair market value of common has risen to $25.00 per share. At this point, the difference between the fair market value and the strike price is $23.00 ($25.00 – $2.00).
The great news is that the employee’s grant is worth $5M ($25.00 x 200,000). The bad news is that the tax liability is $1.6M (40% x 200,000 x $23.00, assuming a 40% tax rate).
In summary, if a large portion of the employee’s grant become NSOs, they still have the option to exercise immediately. If they do so, chances are good that the strike price will equal the fair market value of common, and the employee will owe no additional taxes. If they wait, they could have a big tax liability. So exercising immediately after grant or just before selling the shares are often the best mitigating strategies.
Employee Loses Capital Used to Exercise
Another risk to the employee is that the company could fail after they exercise their shares. In this scenario, the money spent to exercise is completely lost.
The same risk exists for regular options. An employee can exercise all their traditional options once they’ve vested and still come up with nothing.
Employee Triggers Additional AMT Taxes
Even if the employee’s early exercised options qualify as ISOs, there can be some additional tax implications. This happens if the employee exercises when there is a “spread” between the current fair market value of the stock and the strike price of the options. Even for ISOs, this spread will become part of your AMT tax in the year of exercise. The following explanation comes from the TurboTax website:
“There is a catch with Incentive Stock Options, however: you do have to report [the spread] as taxable compensation for Alternative Minimum Tax (AMT) purposes in the year you exercise the options (unless you sell the stock in the same year).”
Calculating the actual impact on your taxes can be complicated. You can get a better sense of how ISO spreads could impact your taxes here. Whenever dealing with AMT taxes, it is important to speak with a qualified professional who has access to your specific tax information. With qualified help, you may be able to minimize the impact of these taxes.
Horror Stories from the First Internet Bubble
The AMT tax issue became particularly problematic during the first Internet bubble in 2000. Many people exercised shares with low strike prices that had skyrocketed in value. The difference, or “bargain,” became part of their AMT tax. Sometimes this part of their tax was huge, even hundreds of thousands of dollars or more.
When they exercised, the tax became due in that same year. When many of the bubble companies died later, these individuals thought that they could reverse their tax obligation because their shares ended up worthless. Unfortunately, the tax obligation remained regardless of the ultimate value of the shares.
Company Becomes a “Backdoor Public Company”
If the majority of your company’s options are early exercisable, the number of shareholders at the company will likely grow faster than if you issue standard options. Securities regulations limit the number of shareholders that private companies can have before they are required to go public.
Going public is expensive and subjects the company to much more regulation and scrutiny. Specifically, the company is required to file with the SEC as a “Reporting Company.” This requires the company to submit regular public reports (10-K, 10-Q, 8-K) and subjects the company to record keeping and internal controls requirements according to the Sarbanes-Oxley Act.
The US Congress recently passed the JOBS Act that, among other things, sets the shareholder limit to 2,000 total shareholders or 500 non accredited investors, whichever happens first.
Since most startups won’t ever reach these thresholds, this risk is relatively low. Also, the rule only applies to “shareholders of record.” So with some careful use of roll-up investment entities and solid equity accounting software, the risk becomes even more manageable.
Company Becomes More Expensive to Acquire
If a company has more than 35 non-accredited stockholders, acquisitions can become more legally complicated. This can make acquisition costs higher, delay an acquisition closing and possibly even discourage some potential acquirers.
The risk here is generally pretty low. Lots of startups have more than 35 non-accredited investors, and it isn’t really a make-or-break issue. For example, most startups with significant numbers of “friends and family” investors will pass this threshold.
At the end of the day, while this issue may present some challenges, most potential acquirers won’t base their acquisition decision on this issue.
One of the risks of offering early-exercise option grants is the potential increased burden in equity accounting and record-keeping. Companies need to track things like:
- Grant dates
- Early-exercisability of options
- Amount of shares exercised at different dates
- Exercise proceeds
- Ongoing vesting on both options and restricted stock
- Associated paperwork, signatures, and legal docs
- Terminations, cancellations, transfers, and sales of stock can further complicate the record keeping for these transactions
Until recently, tracking these details could become a real time sink for many larger companies. However, given the increased availability of equity management systems like Shareworks Startup Edition, this has become a very low and manageable risk.
When employees exercise their option grants, they become legal company shareholders. This is true for employees with both early-exercise options and traditional options.
Before option holders exercise, they hold a derivative instrument and are not legal shareholders. The distinction is technical, and many startups treat option holders just like they treat other important shareholders–especially if a particular option holder owns the right to buy a large percentage of the company.
However, shareholders have a legal right to access some sensitive company information. A shareholder could use information rights in ways that might cause controversy. Examples include:
- Gathering information prior to filing a stockholder derivative suit
- Communication with other stockholders regarding a stockholder class action against the company
- Communication with other stockholders for the purpose of influencing management to change its policies
- Valuation of one’s stockholdings
Because granting early-exercise options could lead to slightly greater numbers of legal shareholders earlier in a company’s life, it may be a risk worth considering. But remember, traditional stock options can create this risk as well. However, since fewer traditional stock option holders ever exercise, and many exercise later in a company’s life, the risk may be somewhat lower for traditional stock options.
Most companies mitigate these risks by making it very difficult for any shareholder, legal or otherwise, to gain access to corporate information. Shareholders are allowed very limited information, and they are often required to sign nondisclosure or confidentiality agreements.
There are legitimate reasons to proceed with a healthy dose of caution when considering early-exercise programs for your employees. However, smart companies can mitigate many, if not all, of the risks associated with early-exercise programs.
One option is to experiment with early-exercise grants gradually to see if it works well for your company. Our experience indicates that this can become a major recruiting and retention tool for your employees.
Even if you decide to grant early-exercise options to your employees, when should they exercise? What if they don’t feel that they can afford to exercise their options immediately after grant? Should they exercise if they aren’t 100% convinced that the company will succeed?
We’ll explore these questions more thoroughly in Part 3. Feel free to reach out to us with any questions or comments. We’d love to hear from you.