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.