Exercising your stock options early could provide you with enormous tax benefits, but if you get it wrong you could lose a lot of money. To do it right, you will need to carefully consider a range of factors. Doing so will allow you to optimize your chances of success. Here we provide you with a set of tools to help you succeed.
As a reminder, this post is the third in a series of three 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
Here we take a look at the employee’s perspective and provide you with some basic tools to help you decide if and when you should early exercise.
Before we begin, we need to emphasize a disclaimer: You should always consult with a licensed tax advisor if you have any questions. This post and the tools we are providing do not constitute tax advice. Please use them at your own risk.
Part 3: Evaluating If and When to Early Exercise
Exercising early can yield enormous tax benefits to option holders, but you need to consider all the risks as well. In the last post, we talked about the risks of early exercise for employees and their companies. Understanding the risks is important, but how do you know if you should exercise or when to exercise?
Deciding if and when to exercise early should be based on two primary factors: 1) knowing how much you really stand to benefit; and 2) understanding the potential costs and risks. To better help you navigate these concerns, we have created a couple tools:
- A spreadsheet model that will help you understand how much money you could save by achieving capital gains treatment on your stock options, and
- A decision tree that can be useful to you as you consider the pros and cons of early exercise at different times
Early-Exercise Spreadsheet Model
In this model, you can enter some basic information about your option grant, and the model will estimate the tax savings of exercising early.
The model has only a few key inputs that you can customize to your specific situation. Here’s a brief explanation of the inputs:
- Shares exercised–the number of shares you plan to exercise early
- Strike price–the strike price of these shares (you may need to model each grant separately if you have many grants at different strike prices)
- Grant / exercise date — the date you received your shares and the assumed date of early exercise*
- Company liquidity date–the date you sell your shares
- Assumed individual discount rate–the annual percentage return that you can personally achieve on saved or invested capital. This is used to create a net present value of tax savings. Feel free to leave the assumption as it is if you don’t understand this.
- Value per share at exit–this is the amount you will sell your shares for in the liquidity event
- Long-term capital gains tax rate–this is your personal long-term capital gains tax rate
- Ordinary income tax rate–this your personal income tax rate
* In this model, we assume that you exercise your shares as soon as you receive them. This may not be the case, but as long as you exercise them 12 months before you sell them (and 24 months after grant if they are ISOs), you will achieve capital gains treatment. There are more complicated issues that arise surrounding AMT tax if you exercise after your grant date and after the stock has appreciated, but we will cover that in a separate article.
Go ahead and enter these specifics using the link to the model below.
Once you enter in your option details, there are two particularly important output cells which we have highlighted for you in yellow:
- After-tax return. This cell will show you the difference in your after-tax return between early-exercising and not early-exercising.
- Net present value of after-tax return. This cell will show you your after-tax return difference adjusted for the time value of money.
Based on this model, you should be able to get a good sense of just how much tax money you could save yourself based on a successful early-exercise strategy. I built a similar model for a friend, and his decision to early-exercise ultimately saved him approximately $800,000 in taxes.
The model will give you a good sense of how much you could save. However, it will not tell you the likelihood that you will achieve these savings. This is because the tax savings are dependent on several factors outside of your control. For example, the probability that company will reach a liquidity event, or the probability of reaching the liquidity event at least 12 months after you exercise, etc.
Calculating your potential tax savings is only part of the equation. Even if you know that you could save on taxes by exercising your options early, you still need to consider the risks. Knowing if and when to exercise turns out to be a bit more complicated than a simple yes or no decision.
Here are some risks you should consider when making the decisions:
- Losing the money you paid to exercise
- The possibility you might not achieve long-term capital gains
- Potential adverse tax implications upon exercise due to certain kinds of taxable gains
- The likelihood that your company will not succeed
Below is a basic decision tree to help you think about these risk factors:
While this decision tree is not comprehensive, it provides a basic framework for deciding if you should exercise your options early.
Through careful planning and thorough analysis of potential risks and rewards, you might be able to benefit enormously from exercising your options early. Many employees have achieved 20% tax savings by using these strategies.
Remember to always consult with your tax advisor when contemplating these types of decisions. Also, please don’t hesitate to contact us for questions about this article.