Want To Exercise Your Stock Options? Read This First.

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Equity remains one of the hallmarks of working at a startup. But while it’s something most employees receive, it’s not something that all take advantage of.

Factors abound when considering if and when to exercise your stock options. In the spirit of tax season and a pent-up IPO pipeline, we talked to some equity experts about what employees should keep in mind when making decisions around their equity.

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But while it’s a benefit some employees receive, it carries with it a cloud of mystery, and everyone’s situation differs. One factor seems clear: You should think about equity early.

When employees typically start to think about exercising their options

Platforms like Secfi, a startup focused on equity planning and stock option planning, generally see a “huge influx” of people to the platform when there’s any sort of financial announcement concerning their company, such as news of a funding round or IPO paperwork being filed, according to Vieje Piauwasdy, Secfi’s senior director of equity strategy.

But the optimal time to exercise options is “usually before that,” he said.

“What I always tell people is that it’s hard to predict the future … but if you assume your company is going to continue to grow, earlier is better,” Piauwasdy said.

The main reason earlier is better? Taxes.

Generally speaking, a startup’s valuation goes up as time goes on, as well as with each funding round. Of course the exceptions are “down rounds” or situations like that of Instacart, which lowered its own valuation after taking public market conditions into consideration. 

Startups must get what’s known as a 409A, or “fair market value” at minimum once a year, per IRS rules. A big funding round, acquisition or another significant event triggers another 409A reevaluation. With each passing funding round, a company’s fair market value typically goes up, and that will increase a person’s tax bill quite a bit. 

For incentive stock options—popular among startups—in addition to paying the strike price to buy those stock options, employees face taxes based on the difference in a company’s fair market value, and could potentially be exposed to alternative minimum tax as well.

Startup employees paid $11 billion in avoidable taxes last year by exercising their stock options post-exit, rather than pre-exit, according to a report by Secfi.  

What the pros say

Babylon Wealth Management provides financial planning and wealth management services to tech professionals and  other employee stock options owners. The majority of people come to Babylon when there’s some sort of liquidity event coming up, such as a tender offer, acquisition, or IPO, according to the firm’s founder, Stoyan Panayotov.

“The people who start planning early and start exercising early tend to have some advantages in terms of paying taxes, making sure they’re making more informed decisions, and having more flexibility when that payday comes,” Panayotov said.

It gets more cost-prohibitive to exercise your options as your company’s fair market value goes up, Piauwasdy said, and many people have found themselves in the situation where a big funding round happens and suddenly their equity is unaffordable.

When you can’t exercise your options

A company in the middle of fundraising that’s expecting to sign a term sheet soon will enter into what’s known as a “blackout period.” That means employees can’t exercise their options at that time.

“Really, the goal is to get ahead of that,” Piauwasdy said. “If you have some knowledge that your company is fundraising and you know it’s going to be a significant increase in valuation, of course it might be a good idea to exercise at that time.”

Secfi usually sees a big uptick in people visiting its platform when headlines and rumors about a company fundraising or going public swirl, Piauwasdy said. 

Planning early and considering your options well before a big event, such as an IPO, comes with many advantages, according to Panayotov.

By exercising early and paying taxes earlier, employees could save money down the line when they sell their shares. That’s because some of their gains could convert into long-term capital gains, which are taxed at a lower rate. Many companies now also offer the option to exercise early, or before shares have vested.

“Try to exercise them as early as possible, especially if you believe in your company,” Panayotov said. “If you believe your company has a bright future, exercise as early as possible.”

Illustration: Dom Guzman

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