If you’re an employee at a pre-IPO company, you’re probably asking yourself: should I exercise stock options before IPO and, if so, when should I exercise and how do I pay the cost?
Typically, employees only think about whether or not to exercise their options when they are leaving their company and they have to exercise before their options expire. But the most financially savvy employees know that, given the benefits of tax optimization and the need to manage the risk posed by over-concentration, the best time to consider exercising is as soon as your options vest.
When to exercise your options?
(1) When you no longer work for your company
First, let’s take the case where you’ve just separated from your company and you have the usual 60 to 90-day clock ticking down to the expiration of your options. Essentially, you have an investment decision to make. If you conclude the expected value of the shares underlying your options is greater than the cost to exercise them, then you should exercise your options. There’s two parts to that calculation: the cost to exercise versus the value of the shares.
The cost to exercise is comprised of the option exercise (or strike) price and the related taxes. You can find your exercise price in your option agreement or online in your company’s cap table management system (e.g., Carta, Shareworks, etc.). Determining the applicable taxes is a little bit more complicated. Your options will be characterized by your company as either Incentive Stock Options (ISOs”) or Non-Statutory Options (“NSOs”). As a simplified general rule, ISO shares trigger tax only when you sell them, but NSOs are taxed at the time of exercise based on the difference between your exercise price and the current value of the shares as determined by the company.
The current value of your shares can be hard to determine.
- For a venture-backed, pre-IPO company, a key indicator of share value is the price paid by investors in the company’s most recent primary financing. Note though that the shares underlying your option are common stock where the shares sold in the financing are very likely preferred stock. So, you should expect a roughly 30% to 40% discount to the preferred stock price for your common shares .
- You can also look at platforms like Collective Liquidity or one of the online secondary marketplaces that offer pricing on many venture-backed companies.
- Finally, if you are fortunate, your company has made it clear it plans to conduct its initial public offering in the near term or perhaps has already done so. In these cases, you can refer to anticipated IPO pricing or, if the IPO has already happened, actual public market trading prices.
(2) When you are still employed by your company
If you are still employed by your company and not facing the expiration of your options, there are still potentially two very good reasons to exercise: (1) to address the risk of over concentration, and (2) to minimize taxes.
- Over Concentration: Many employees have the bulk of their net worth tied up in their stock options. Fluctuations in the value of their company’s shares therefore have an enormous impact on their financial well-being – this is referred to as an “over-concentrated” position. Financial advisors generally recommend their clients diversify out of over-concentrated positions to create stability in their wealth and enable a smart long-term financial plan. Employees, however, can’t use stock options to diversify – they can only use the shares they receive when they exercise their options. So, an employee might wisely choose to exercise their options in order to sell their shares and purchase other assets to diversify or, even better, exchange the shares tax free for an interest in a diversified fund.
- Minimize Taxes: Even if an employee is sufficiently diversified, they may consider exercising their options today to potentially minimize future tax liability on their eventual sale , subject to IRS rules regarding holding periods and gain classification.. If an employee is confident their company’s shares will be publicly traded or otherwise saleable within a year or two, they might want to exercise their options a year before their expected sale in order to have the proceeds taxed as long-term capital gains rates (currently 20%) versus as ordinary income (currently 37%). Depending on the amount of gain that will be recognized on a sale of the shares, this tax savings can be significant and justify the option exercise in advance of the sale.
Stock option financing: how to pay the option exercise cost?
The easiest way to pay the option exercise price and related taxes is of course just to write a check. The funds needed though can be considerable and more than many employees have available. Even where the employee has the cash, they should see paying to exercise options on illiquid shares as a risky investment. If the company’s shares never become saleable, the money paid to exercise has a zero return. For this reason, most employees prefer to keep their cash and find someone else for option exercise financing.
The most obvious candidate to pay the exercise cost is a buyer of the underlying shares. There is, however, a catch-22 of sorts though. You can only sell shares to a buyer once the options have been exercised and the shares issued. But you generally can’t get a buyer to fund their purchase until the shares are transfer ready. Some may be willing to solve for this on a deal by deal basis by funding option exercise, but this typically involves more complex legal arrangements and the active support of the company.
There are also a handful of specialized lenders that offer loans to exercise stock options of private companies. This is a loan against stock options: The shares received upon exercise are security for the loan. The loan matures when the company’s shares become liquid (e.g., upon an IPO). Note though that a loan to exercise startup stock options often involve complex legal agreement and come with steep interest rates and cash and stock fees.
How can Collective Liquidity help?
At Collective Liquidity, we can provide access to liquidity solutions for pre-IPO stock that will help you navigate the exercise of your options. At Collective, we:
- Provide you with a clear process: with limited time to act, you need timely access to resources that can help you evaluate your options and understand the potential liquidity path based on current market data.
- Talk with you about the pros and cons of exercising your options today and compare your different liquidity options.
- Provide you with indicative pricing for your shares based on recent secondary data, subject to availability and applicable transfer restrictions– check out our Liquidity Estimator.
- Offer potential access to liquidity solutions that may provide favorable tax treatment, depending on your individual tax situation and applicable IRS rules enabling you to avoid lengthy negotiations with multiple buyers - helping you in getting liquidity from startup equity.
- Can provide diversification strategies for qualified investors that defer or mitigate capital gains tax recognition, depending on transaction structure and compliance with federal tax requirements, at long-term venture capital rates of return.
Have questions about Collective? Schedule a call with a Collective Customer Service Representative today – we’re here to help.
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