There are a number of reasons someone at a private company would consider exercising their options early. Most of them fall into the tax optimization (long-term capital gains) or career freedom (portability) categories. There are, however, some other lesser-known reasons to consider exercising your stock options. Before pursuing any of these routes, we strongly recommend consulting with a financial or tax advisor.
Estate Planning – Generally not a favorite topic, but not exercising options before something tragic happens can put your economic rewards at risk or put a substantial burden on your estate. If an option holder passes away, the ability of estate representatives or beneficiaries to exercise options, and the time-frame in which they’re able to do so, will depend on the terms of the company’s equity incentive plan, which could mean a limited time to exercise before the options expire or the loss of potential tax benefits associated with exercising incentive stock options as opposed to non-qualified stock options1. In addition, it can be difficult to transfer options if proper estate planning has not been completed. If you have an underlying health condition or are close to retirement, it may be worth looking into exercising your options for estate planning purposes alone.
Dividends – With companies staying private longer, dividend payments prior to an exit event could become more common (for example, dividends paid by Squarespace2 and Juul Labs come to mind). Why does this matter for options? Because option holders do not receive dividends, only shareholders do. This could make the difference between getting a cash distribution and receiving nothing. A substantial dividend payout could help an employee recoup the cost of the option exercise or provide needed liquidity. Something to consider if your company is profitable or is considering returning cash to shareholders.
Voting Rights – If you are a founder with substantial equity ownership in the form of options, you may want to solidify your ownership position by exercising the remainder of your options. When it comes to governance matters that require a vote, options do not factor into your ownership percentage, which could put your job or company at risk. An example of this came to light at ZocDoc, a cautionary tale for founders holding unexercised options. Regardless of the current environment at your company, it could be better to be safe than sorry.
280G – Section 280G and related provisions of the Internal Revenue Code can result in a 20% excise tax on the recipient of “excess parachute payments,” in addition to any income and employment taxes owed with respect to the payments. This applies during a change of control transaction and may be triggered by a large payout from accelerated options vesting or just substantial option holdings. This Internal Revenue Code Section has limited application to most option holders, but it can make a big difference if it applies to you. Those who could be ensnared by 280G include certain officers, highly compensated individuals, and greater than 1% shareholders. With the IPO window seemingly closed for now, private companies may be more open to being acquired than they have been for the last several years. There are ways to mitigate, or even eliminate, taxes related to 280G that are beyond the scope of this blog, but considering and planning for the effect of this code provision ahead of time is important, as compensation or equity grants paid, granted, or accelerated within 12 months of an acquisition will be factored into the 280G analysis.
While you may not recognize all the potential benefits of exercising your options early, it’s wise to start planning. There are many factors to keep in mind, aside from the most obvious advantages, when considering when and how to exercise options. At Liquid Stock, we provide solutions that are tailored to meet your specific financial goals and needs. Reach out to our team to learn more about our solutions.
1Upon death, the ability of an administrator to exercise is often lengthened to 1-year post-death, while after 90 days following the death the incentive stock options are statutorily recharacterized as non-qualified stock options.
2On December 7, 2020 Squarespace declared an extraordinary dividend payable to all stockholders.
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