Exercising stock options can offer significant benefits, but it’s important to know the factors involved before doing so. An IPO or acquisition can substantially affect your payout and even impact your tax situation.
If you’re considering working for a startup, or you’re a seasoned veteran, knowing the ins and outs of equity can help you determine the best time to exercise. Here are some things to consider as you make your decision.
Understand How to Value Your Equity
One of the toughest parts of deciding what to do with your equity is understanding what’s included in your package. If you’re new to working for a startup, looking at your equity agreement may seem confusing. However, knowing a few key terms can help you figure out the specifics.
- Your Vesting Schedule: This is the amount of time your options need to vest before you own them. Most startups have a four-year vesting schedule with a one-year cliff. This means that you get 25% of your options after the first year and more every month thereafter. Once you hit the four-year mark, your options will be fully vested.
- The Number of Options: This number will likely vary depending on your role, your level of seniority, and how early you joined the company. To get a complete picture of your equity you’ll also need to have some idea of the total number of options issued. For example, if you have 1,000 stock options and the company has issued 100,000 in total, that amounts to a 1% stake in the company. However, if the company has issued 200,000, your options amount to a 0.5% stake.
- The Strike Price: The strike price is the price you’ll pay when you exercise your options and purchase your shares. Based on the company’s fair market value (FMV), this price is set at the time you join the company and will remain the same until you exercise.
- 409A Valuation: Third-party valuations are one of the most important assessments startups go through. These typically take place annually, or after major events such as a new investment round. When the 409A valuation goes up, the cost of exercising your options does too. You’ll need to pay additional taxes to cover the difference between the strike price of your shares and their current fair market value.
- ISO vs. NSO: There are two main types of stock options—Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). While ISOs can only be issued to employees, NSOs can be issued to anyone. Although both have benefits, ISOs generally come with more tax advantages.
Once you have a clear understanding of your equity, it’s time to think about some other factors. This is where taxes and exit expectations come into play.
Consider Your Tax Situation
Taxes can play a big role when it comes to exercising options. This is because your tax rate can vary significantly depending on when you decide to exercise. If you wait until your company goes public or gets acquired, the situation is often more straightforward and your payout will be taxed as income.
If you choose to exercise before there is an exit, things can get a bit more complicated. While you’ll be required to make two separate tax payments (when exercising your options and when selling your shares), your overall tax liability could actually be lower. In fact, exercising early means you could earn up to 26% more through tax savings in the event of an IPO.*
Weigh Out Exit Expectations
The possibility of an exit is another important consideration and one you should weigh carefully before making a decision. Without an exit, your options won’t carry any value.
If your company seems poised for an IPO or an acquisition, exercising early could help you land a higher payout. If you’re not sure about the company’s long-term prospects, or there are no signs of an imminent exit, you may decide to wait and see how things pan out.
If you do decide to exercise your options, the right expertise can make all the difference. With unparalleled experience in startup equity, Secfi can help you gain a better understanding of how stock options work and how to make the most of them.
Secfi’s tools also allow you to learn more about profits, taxes, and other equity insights. And if you’re looking for a way to finance the purchase of your options, their non-recourse financing gives you access to the funds you need without paying out of pocket.
Deciding whether to exercise your stock options can be a significant step in your startup journey. With a clear understanding of the factors involved, you can find a solution that works best for you.
* Based on potential tax savings upon sale of the shares upon exit.