The last thing you need after you’ve lost your job is to be forced to make a decision—that could be worth a lot of money—in just a few weeks.
And yet that’s what many of you face when you have stock options and you’re laid off. (To be clear, I’m talking about options in a private company, not public.)
(This isn’t the only circumstance under which you have to make this decision. You could voluntarily leave your job and be confronted with this decision. Or your company could foist this decision on all its employees while you’re still employed there.)
The details can vary, but usually it’s something like this:
- You were granted incentive stock options (ISOs) at your private-company employer.
- Some have vested and you may exercise them if you want (you’re not obligated to).
- If you stayed at the company, they would remain ISOs.
- But because you’re leaving, you have this choice: Exercise them as ISOs or let them convert to non-qualified stock options (NQSOs) in 90 days. If you do not exercise them, they will automatically convert to NQSOs after 90 days.
Now, despite this being a stressful decision, this is actually a pretty good deal. The fact that you get to keep your vested stock options in any form past that 90 days is nice. Many companies make you exercise or lose the options after 90 days.
At least with NQSOs, you’ll get to keep them until the expiration date, which you should be able to find in the stock-option grant document and in the stock plan portal (Shareworks, Carta, etc.)…if you can figure out how to navigate those usually unintuitive interfaces.
Note: 90 days isn’t always the timeframe. It can be shorter. But I’ll use 90 for the sake of simplicity.
How do you make this decision? Let’s walk through it:
The Difference Between ISOs or NQSOs
There are roughly a bajillion articles and blog posts out there about how each kind of option works. I’m going to highlight the differences that are most applicable to the question we’re entertaining in this blog post:
You need to understand two numbers first:
- Strike price (aka, exercise price): In order to exercise an option, be it Incentive Stock Option (ISO) or Non-Qualified Stock Option (NQSO), you have to pay the strike price. You should be able to find this number in your grant documentation and on the stock plan web portal.
If the strike price is $1, then in order to exercise one option, you pay $1 and voila! You now own a share of your company stock.
- 409(a) value: If you want to know the Fair Market Value of a share of Google (or any public company), you look it up on the internet. If you want to know the FMV of a share of stock in a private company, that is the 409(a) value.
Some private companies make this easy for employees to get. HR folks share it when asked; there’s an internal web page that records the 409(a) history, etc. Some companies make it really hard. And I’ve never encountered a professional who has a foolproof way of getting the 409(a) from a recalcitrant company.
When you exercise an NQSO, you instantly owe ordinary income tax (the kind you owe on your salary) on the difference between the strike price and the Fair Market Value (the 409(a) in this case).
- Strike price = $1
- 409(a) = $10.
- You owe ordinary income tax on that “spread” or “discount” of $9.
When you exercise an ISO, you might owe tax. That $9 spread is counted as an AMT (Alternative Minimum Tax) “preference item,” and only if your total amount of AMT preference items is pretty high (often $10,000s) do you owe AMT.
So, if the total amount of that spread is low, then you owe no tax on the exercise. You’ll want to work with a knowledgeable tax professional to help you figure out if the exercise would incur AMT. The simplest case is if the strike price equals the 409(a) value: the spread = $0, and that exercise won’t push you into AMT.
Regardless of the kind of option, once you exercise it, now you own a share of the company stock.
How That Difference Could Affect You (i.e., Why You Should Care)
Once you own a share of your company stock, the “long term capital gains clock” starts ticking. After you own a stock for a full year, if you sell it, any gains are taxed at the (lower) long-term capital gains tax rate. (I’m talking at the federal level. There is usually no advantage at the state-tax level.)
This is available to you if you exercise the ISOs now and then hold the resulting shares for at least a year.
By contrast, if you hold the options and let them convert to NQSOs, then two things happen:
- Taxes are definitely owed upon exercise: When you exercise them, you will shift from a “maybe there’ll be taxes on exercise” (ISOs) to “there will be taxes on exercise” (NQSOs).
- Any growth in stock value between now and future exercise will now be taxed at a higher rate (your ordinary income tax rate).
Example: Exercising as an ISO
- The stock is worth $2 now and the strike price is $0.50.
- You exercise now (as an ISO). You might owe taxes (AMT) on that $1.50 spread. Or you might owe $0 in taxes.
- Fast forward a year or more, and the stock is worth $10.
- You sell it.
- That $9.50 gain is taxed at the lower long-term capital gains tax rate. (With a vague “yeah, talk to a CPA” nod to what happens if you paid AMT when you exercised. The tax rate is still lower.)
Beware: the stock increasing in value from $2 to $10 is our hope. You should not rely on it by any means!
Example: Holding and exercising later as an NQSO
- You hold on to the options and they convert to NQSOs.
- Fast forward some, and the stock is worth $8. The strike price is still $0.50.
- You exercise now (as an NQSO). You do owe taxes (ordinary income) on that $7.50 spread.
- You continue to hold the stock after exercising and the stock price reaches that $10.
- You sell it.
- That $2 gain from $8 to $10 is subject to tax. At what tax rate?
- If you have held it for > 1 year after, the lower long-term capital gains tax rate.
- If you haven’t, short-term capital gains tax rate (which is the same as the ordinary income tax rate).
So by exercising while they’re still ISOs, you could incur far lower overall taxes assuming your company stock price continues to go up.
I think we can all agree, at this point in time, that this doesn’t always happen. If I’d said this a year ago, everyone would be all “Yes, yes, I know intellectually stock prices can go down. But emotionally, I’m pretty sure they—and especially my company stock—will continue to go up.”
If stock prices go down, and worse yet, if your company fizzles out of existence, then who cares about the potential tax savings? You’ve just lost all your money.
Exercising ISOs gives you the chance to lower taxes over many years. Holding on to NQSOs protects you from losing money until you know you can make money off of your company stock.
Your company doesn’t necessarily need to go public for you to make money off of the stock. Here are other ways:
- Your company could be acquired.
- You could sell through a tender offer.
- You could sell on a private secondary market, like ForgeGlobal and EquityZen, where you might be able to sell your stock in private companies. They don’t traffic in all private-company stock, and their activity has definitely fallen during this tech downturn.
But if you can’t sell your stock now, and maybe not ever, then you have to consider any money you put into exercising the option (strike price plus any taxes) as a gamble. You should plan to never get it back.
Making the Decision: Exercise Now as ISOs or Hold and Let Convert to NQSOs?
There are several ways of framing this decision. I’m going to frame it in terms of “how much does it cost to exercise?”
We’re all about risk and reward when it comes to investing, right? The lower the cost, the lower the risk. If it cost $0 to exercise, obviously, you’d exercise: no risk, all potential upside. The higher the cost, the higher the risk. All in pursuit of that possible reward.
I’m also going to frame it in relative terms. Not “it costs $1000 or $10,000 or $100,000.” But “the cost is low for you” or “the cost is high for you.” Some of us can afford to light $1000 on fire (which you risk doing when you put money into private-company stock) and not have our financial strength or future imperiled. Some of us can afford $100,000.
This question cannot be answered in a vacuum, or following advice on Slack, or even a delightfully well-written blog post (cough). You have to know your own financial and life situation in order to make a reasonable choice.
If the cost of exercising the ISOs is really low (for you)
If your strike price is cheap, and the strike price = 409(a) (i.e., no taxable “spread”), then the total cost of the exercise is only the strike price (no taxes owed). Yes, you’re still gambling that money out of your own pocket, but as long as you “wouldn’t miss it” if it went away, then it’d be reasonable to exercise.
[Just as an aside that you might find interesting: as a Registered Investment Advisor, we at Flow cannot give personal investment advice in public forums like a blog. Which might explain two things you encounter when you’re reading financial advisor’s blog posts or articles:
- They can be uselessly vague. (We try to avoid this.)
- There are often a lot of wiggle words: maybe, consider, possibly, probably, likely, may, etc. (We do not avoid this.)]
If the cost of exercising the ISO is really big (for you)
Like, no way is that a responsible choice for you to make with your own money. Maybe you simply don’t have the money. Or you’d be putting your current financial safety or future goals at risk by doing this.
You actually have several choices available to you. (I don’t know whether this provides relief or anxiety.)
#1: Don’t exercise any ISOs and let them all convert to NQSOs.
This can be a very good choice. You are putting no money at risk while still allowing yourself to participate fully in the possible future growth in company stock value.
The downside is that all possible future gains will be subject to the higher ordinary income tax rate instead of long-term capital gains rate. So, you’re basically paying for your “downside protection” with an increased tax rate if, and I repeat if, your company stock ends up doing well in the future.
I know most of us chafe at paying taxes. But seriously, please run the numbers on what the difference in tax rate is, how many saved tax dollars that could equate to…and whether it feels right to you to put your money at definite risk for the sake or possible tax savings in the future.
#2: Exercise some ISOs with your own money and let the rest convert to NQSOs.
This isn’t an all-or-nothing decision. Could you “split the difference,” as it were? Compromise?
Can you identify how much money you feel comfortable putting at (true, real) risk of complete loss, exercise ISOs (with taxes!) with that money, and then let the remainder convert to NQSOs?
Now, whatever happens to the company stock, you can reassure yourself that you made the right decision at least with some of your options. 🙂 Might sound glib, but honestly, this sort of emotional management is important.
#3: Finance the exercise of some or all, and let any remainder convert to NQSOs.
Yes, you can always scrounge about in your proverbial couch cushions and beg/borrow/steal money from your family in order to exercise all these options yourself. We’ve certainly had clients do this. You don’t have to give away any possible future upside…but every cent of your and your loved ones’ money is at risk.
An alternative to this is to get help financing the exercise of your ISOs from companies like ESO Fund, Vested, Secfi, and EquityBee—in exchange for giving up some part of the possible stock gain in the future.
These deals can take some time to finalize, so don’t wait until the last minute. You might not make the deadline.
I hiiiiiighly recommend using a lawyer to review the contracts, especially if we’re talking dollar amounts that are very big for you. These contracts are complicated and tricky and you likely can’t anticipate all the possible outcomes.
For example, let’s say a financing company lends you the money to exercise your options. Your company doesn’t go public, so the company can’t get repaid from the sale of the stock. Now let’s say that the financing company forgives the loan (you don’t have to pay it back).
Sounds great, right? Well, the amount of that forgiven loan is now taxable as ordinary income. If this loan was worth $100,000, now you owe an extra maybe $40,000 in taxes that year. You prepared for that? Here’s a Twitter thread about this very thing that went viral.
If the cost of exercising is middlin’ (for you)
I have to put this in here for completeness’ sake, but I don’t really have any new logic or framing to add. It still comes down to:
- How much money can you afford to lose? (which is both a math and an emotions question)
- Are you a “bird in the hand” (holding onto the options) or “two in the bush” (exercising the options) type of person?
Work with a Tax Professional. No Really.
We encourage all our clients to work with tax professionals in general. It saves you time (yes, even if you still have to collect and submit all your documentation) and stress, and tax professionals simply know more than you do about taxes, so why are you trying to DIY?
Once we start talking about exercising options, my advice turns into, “What do you mean, you’re exercising options without consulting your tax professional? That’s insane.” But, like, nicely.
I have seen too many stories (going back to the Dot Com Boom and Bust, and certainly over the last few years) of people who exercise options without paying proper attention to the tax impact, and April 15 is a sad, sad, sometimes terrifying, day for them.
Sign up for Flow’s weekly-ish blog email to stay on top of our blog posts and videos.
Disclaimer: This article is provided for educational, general information, and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. We encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Flow Financial Planning, LLC, and all rights are reserved. Read the full Disclaimer.