Should a company allow early exercise of stock options?

January 11, 2009

Some companies allow employees to exercise their unvested stock options, or “early exercise.”  Once purchased, the unvested stock is subject to a right of repurchase by the company upon termination of services.  The repurchase price is the exercise price of the option.  Please note that a stock option is typically not early exercisable unless the board of directors of the company approves an option grant as early exercisable and the company issues the stock option pursuant to an option agreement that permits early exercise.

Allowing early exercise of unvested shares can provide employees with a potential tax advantage by allowing the employee to start their long-term capital gains holding period with respect to all of their shares and minimize the potential for alternative minimum tax (AMT) liability.  If an employee knows that he/she will early exercise a stock option immediately upon the grant of an option (when there is no difference between the exercise price and the fair market value of the common stock), the employee typically should want an NSO as opposed to an ISO, because long-term capital gain treatment for stock issued upon exercise of an NSO occurs after one year.  In contrast, shares issued upon exercise of an ISO must be held for more than one year after the date of exercise and more than two years after the date of grant, in order to qualify for favorable tax treatment.

There are several disadvantages to allowing early exercise, however, including:

  • Risk to employee.  By exercising a stock purchase right or immediately exercisable option the employee is taking the risk that the value of the stock may decrease. In other words, the exercising employee places his or her own capital (the money used to purchase the stock) at risk. Even if a promissory note is used to purchase the stock (future post to come), the note must be full recourse for the IRS to respect the purchase. In addition, if the employee purchases the shares with a promissory note, the note will continue to accrue interest until it is repaid, and a market rate of interest must be paid in order to satisfy accounting requirements. Depending on the number of shares purchased, the expected tax benefit from early exercise may not justify these increased risks to the stockholder.
  • Tax upon spread. If there is a “spread” at the time of exercise, the employee will trigger ordinary income (in the case of an NSO exercise equal to the difference between the exercise price and fair market value of the common stock on the date of exercise) and may trigger AMT liability (in the case of an ISO exercise, with the difference between the exercise price and fair market value of the common stock on the date of exercise being an AMT preference item). Any taxes paid will not be refunded if unvested shares are later repurchased at cost. (Please see the post “What’s the difference between an ISO and an NSO?” for a summary of the tax implications of exercising an ISO or an NSO.)
  • “Back door” public company.  Allowing employees to early exercise may increase the number of stockholders.  If the company ever reaches 500 stockholders, Section12(g) of the Securities Exchange Act of 1934 will require the company to register as a publicly reporting company.
  • Securities law issues upon a sale.  If the company has more than 35 unaccredited stockholders at a time when it has agreed to be acquired in a stock for stock transaction, the acquisition will likely be more complex and take longer to complete.
  • Administrative hassles.  A significant increase in the number of stockholders can place a tremendous administrative burden on the company. This is especially true when employees purchase shares subject to repurchase and when they purchase shares with promissory notes. The forms that the employee must complete and sign are much longer and more complicated. 83(b) elections must be filed with the IRS within 30 days of the purchase. Stock certificates for unvested shares must be kept by the company so that they can be easily repurchased if the employee leaves the company, which increases the risk that the stock certificates are lost or misplaced. Interest on promissory notes must be tracked.
  • Stockholder rights. Optionees have no rights as stockholders until they exercise their stock options.  If optionees exercise stock options, whether vested or unvested, they have the same voting rights as any other stockholder. Certain actions, such as amendment of the certificate of incorporation, which typically occurs in connection with every venture financing, require stockholder approval.  This requires certain information to be provided to the stockholder in order to make an informed decision.  Stockholders also have more statutory rights than optionees, including inspection rights. Stockholder information requirements may also be triggered under Rule 701.

Comments

  • http://venturehacks.com nivi

    Some suggestions for clarification:

    * Tax upon spread: Is there ordinary income taxation in the case of an ISO? Is there AMT liability in the case of an NSO?

    * “Back door” public company: How does this effect my decision to exercise my shares early in either the NSO or ISO case? How does this effect the company's decision to offer early exercise in either the NSO or ISO case?

    * Administrative hassles: What do you mean by “unvested shares must be kept by the company”? Do holders of exercised but unvested stock also have more voting rights than holders of unexercised but vested options? Does exercised but unvested stock have the same voting rights as exercised vested stock?

  • http://www.startupcompanylawyer.com Yokum

    @Nivi – Thanks for the feedback. I've tried to deal with most of the suggestions with changes in the text of the post. With respect to the “back door” public company issue, this is a company issue and is not relevant to the individual employee's decision to exercise.

  • DavidSF

    As a startup employee, founder, two time acquisitionee.. these points, especially for a startup, lie somewhere between inconsequential and false.

    For startups, providing early-exercise weakens employee retention. Thus, the biggest reason not to offer it is to increase retention.

    Consider an employee who joins a startup when early-exercising their shares costs $200. Five years later, their shares are valued at $800,000+ but still illiquid. The spread at this later point creates an inconvenient situation for the employee, where exercising them may have expensive tax consequences even though the shares can not be sold to produce profit. The employee has become an indentured servant. It's not a reasonable financial choice to leave and give up the profit, but it's also not necessarily possible for them to afford purchasing the shares and pay the taxes. They are stuck, with no leverage, and no information about when the shares may be liquid and able to be sold. The company is happy, because the employee has the greatest incentive to stay with the company.

    Let's talk about how the article misrepresents some of the points.

    Risk to employee. ALLOWING early exercise does not create risk to the employee. The only risk is created when the employee actually decides to early exercise. Allowing it simply creates more flexibility for the employee. Further, early-exercise minimizes risk to the employee by allowing them to exercise the stock at the lowest possible price. Even without early exercise, the employee is free to exercise option as they vest. At that point, the exercise creates increased risk, in the form of tax upon spread.

    Tax upon spread. If tax upon spread is bad, then early exercise is good. There are only two times a stock has no tax-spread-risk. At the beginning, when the purchase price is the same as the value, as in an early-exercise; and at the end, during a same-day sale when the stock is liquid. All the time in the middle involves spreads which are potentially dangerous for the employee from a tax perspective. More importantly, these tax consequences don't effect the company at all.

    “Back door” public company. Disallowing early exercise does not disallow exercise. In order for preventing early exercise to be an effective means to stave off being forced to file public financial reports, employees must choose not to exercise options as they vest. The primary reason they would avoid exercising as they vest is the increased risk or tax-on-spread risk. These reasons put them further and further into indentured servitude, but don't reliably help the company prevent being forced to file public financial reports. If this is the company goal, a better means would be avoiding employee ownership of either stock or options. This issue is only applicable to startups, as large public companies are already filing publicly.

    Securities law issues upon a sale. This is a red herring. This is not a real reason that acquisitions don't complete, or even the major issue in legal bills or costs in handling an acquisition. It simply doesn't matter.

    Administrative hassles. Again, red herring. This is not a significant burden or cost. Startups can offer early exercise with ease. As employee count grows, it's true the administrative burden grows. However, there are much larger risks in a company than this minor clerical issue. Stock certificates? They don't need to be issued at all in private companies. It can simply be a paper or electronic ledger. Some of these points seem relevant if we were talking about a large public company, but we were not just talking about preventing 'back door' public financial filings?

    Stockholder rights. Again, false and red herring. Every venture financing does not require amendment of the certificate of incorporation. At least not if the incorporating lawyers did their job correctly. Further, incorporation bylaws don't need to require minor shareholders to 'vote' to approve a financing event as long as they receive a majority of votes in support. This is simply a non-issue for financing.

    Spread is a reason to allow early-exercise not disallow it. The minimum spread occurs when the options are originally issued, which requires early-exercise to take advantage of. Without early-exercise, an employee is forced to wait until

  • http://www.startupcompanylawyer.com Yokum

    @David,

    Thanks for taking the time to comment.

    Risk to employee. The point here is that when exercise prices become non-trivial (i.e. the cost of a new car), early-exercise no longer seems like a good idea.

    Tax upon spread. Employees often do not early exercise their shares until they have been at the company for some period of time (and realize whether the risk to purchasing the shares is warranted). In that situation, there may be spread.

    “Back door” public company. You're right, employees can always exercise their vested shares. The point is where a company sets up a culture of early exercise, things get dicey with the '34 Act.

    Securities law issues. Having to do a CA fairness hearing or an S-4 will add at least a month and a half of time until closing and I'd guess about $75K in extra legal/accounting fees for a fairness hearing and significantly more for an S-4.

    Administrative hassles. Almost all venture backed private companies issue stock certificates. They have a tendency to get lost, which is a pain to deal with.

    Stockholder rights. You're flat out wrong here. The certificate of incorporation needs to be amended to create the new series of preferred stock in a typical venture financing. Stockholders of the company need to approve an amendment — and even if all stockholders are not solicited if their votes are not needed, they need to be give notice of the action (at least post-facto). There is always a sensitivity to sending out notices/info to employee stockholders.

  • itjobs1

    Administrative hassles: What do you mean by “unvested shares must be kept by the company”? Do holders of exercised but unvested stock also have more voting rights than holders of unexercised but vested options? Does exercised but unvested stock have the same voting rights as exercised vested stock?
    http://www.staffingpower.com