We read somewhere that Facebook's IPO helped 1,000 employees become millionaires overnight because they were owners of the company. Without being investors or the founders of the company, how were they able to become owners in the business?
Options represent a contract to buy shares that could be potentially valuable in the future. It’s holding the common stock in the company that will make us owners. To receive common stock in the company, we have to exercise our rights stated in the options agreement to buy common stock for the strike price.
If we plan to sell our shares, we must exercise our options.
To exercise our option to buy shares in the company, we need to notify the company (legal counsel or HR) and pay the company the total exercise cost. The cost is calculated by multiplying the strike price, or the price we need to pay for each share, and the total share count.
In addition to the exercise cost, we need to have enough money set aside to cover the potential taxes. However, before we make the decision to exercise, we should understand the risks involved.
Risks to exercising
Exercising stock options can be risky depending on when we decide to exercise. Exercising early puts our money at risk in case the company does poorly. Exercising late puts us at risk of a big tax bill. Let's step through a few of these situations.
Owing significant taxes
When the business we work for grows rapidly, so does the valuation assigned by investors. Each new round of fundraising raises the FMV and our tax liability.
Depending on when we choose to exercise, we could be golden handcuffed and owe hundreds of thousands of dollars in taxes for shares we can't sell yet. Not properly implementing an exercise strategy exposes us to this risk.
Losing our money
Exercising in advance carries the risk of losing our exercise cost.
We have to pay to buy shares in the company, and this money will not be refunded in case the company shuts down in the future. To make matters worse, we also would have lost any taxes paid to exercise. The IRS will not refund us if our shares end up becoming worthless. This is a real risk for every employee and while there is nothing to be done to remove this risk completely, early exercise helps keep our exercise costs low and reduces our tax liability to $0.
We can always decide the previously mentioned risks are too high and forgo exercising completely. However, if the company ends up being successful, and the shares in the company become very valuable.
We would be kicking ourselves because of an opportunity cost of potentially millions of dollars.
When we are forced to decide
While these scenarios mentioned above may seem far off in the distance for us, we can be caught in a scenario where all of a sudden we need to make a decision. If we are resigning from a startup and haven't exercised early or filed an 83(b), we will need to choose to exercise our options. Already a potentially stressful decision, most companies only provide a post-termination exercise window of 30-60 days to decide. Starting early to think through the risks can help us feel much more at ease when the day comes to make the decision—the outcomes can be life-changing in either direction.
When we exercise our options, we are making an investment in the company. As prudent investors, we should only invest when we are confident the company will do well. This also doesn't mean we need to invest in the full amount. Instead, we should invest an amount we are comfortable with possibly losing. If we are confident in the business and make a decision to invest by exercising our options, we should always consider early exercising—the benefits greatly outweigh waiting. And if the future of the business is uncertain, we can exercise only a portion of our shares.
It’s helpful to consult a tax accountant especially if we fall under AMT threshold.