Need help thinking through exercising options

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Topic Author
Ancal
Posts: 51
Joined: Wed Jan 23, 2013 12:37 pm

Need help thinking through exercising options

Post by Ancal »

***Updated: I've exercised all the options and am now considering what to do next. If interested, see post on July 23 below.***

Hi folks! I have a financial issue that's doing my head in, and I would greatly appreciate any advice or suggestions.

I recently left a company and have a short window in which to exercise vested options - mainly Incentive Stock Options. The company's stock is illiquid: there is no public or secondary market for its shares. The current Fair Market Value of the company stock is far higher than the exercise price.

Exercising my options would trigger an immediate payment (for the purchasing of the stock) plus a very large Alternative Minimum Tax bill. The total check I'd have to write by the end of the year, mostly to the government, would be more than five times my annual salary. It would wipe out my emergency fund, cash holdings, and taxable investments - and also put me deeply in debt (assuming I could get the money from somewhere).

The potential upside of exercising these options is that were the company's stock to become tradeable at or above the current Fair Market Value, I could cash in the shares for a considerable sum - upwards of 15 times my annual salary.

Part of me says that exercising the options for such a vast upside is a no-brainer, and that I'd be throwing away money not to exercise. Another part of me says that I'd be taking a huge risk by paying money for an investment that is not realizable and may never be (if the company stock never becomes liquid OR if the Fair Market Value drops precipitously). This leaves me paralyzed.

Does anyone have any suggestions on how to go about thinking through the problem?

Thanks so much in advance.
Last edited by Ancal on Wed Jul 23, 2014 3:32 pm, edited 1 time in total.
ccieemeritus
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Re: Need help thinking through exercising options

Post by ccieemeritus »

Ouch. Rough situation.

It's hard to evaluate without knowing the company, since the company's probability of success is a critical factor.
But that would probably risk your privacy.

I heard stories about people at Cisco who exercised options in 2000/2001 who ended up owing more in tax than the stock was worth after the bottom fell out.

Keep in mind it's not an all or nothing thing. You can exercise a percentage of the options. You get some of the possible upside in exchange for the risk of some of the downside.

Depending on where you live, a stock exercise could result in a 40% federal+state tax bill you have to pay immediately. Meaning every $1 you spend on taxes now MIGHT get you $2.5 someday in the future (that doesn't even count the strike price), plus possible gains or losses from the current fair market value. Profitable but not worth risking it all in my opinion.

In your situation I'd consider getting my job back (if possible) or buy what I can without debt (as long as I've already got a new income in the bag). That's risky but not going to bankrupt me.

Hopefully I won't have to post this in a future "worst financial advice I've given" thread. Good luck.
Topic Author
Ancal
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Joined: Wed Jan 23, 2013 12:37 pm

Re: Need help thinking through exercising options

Post by Ancal »

Thanks so much for the advice! Exercising to the point of no debt seems to make sense, although there will always be part of me that thinks, "What if?" Really appreciate your thoughts.
ccieemeritus
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Re: Need help thinking through exercising options

Post by ccieemeritus »

You'll note that it's several hours since you posted your question and I'm the only one who has responded so far.

I suspect that's because most people here want to "do no harm" with advice. They are happy to recommend diversifying between stocks and bonds, using low expense index funds, dollar cost averaging, and so on. I think they are wise to "do no harm". I should adopt that plan. Too late for today.

Your decision is so risky that no matter what you do serious harm may result. Invest nothing and you could lose out on a big gain. Invest a lot and you could lose it all. For perspective the stock my wife has in her old startup is worth.....zero. But we didn't bet the farm so we're fine.

Back to analyzing your situation. Most startups fail. Most companies never IPO. Without knowing the name of your company we can't evaluate the probability of it being sold or going IPO. But for a generic non-public company the odds are against success.

Lets say your option strike price is $1. Assume current fair market value is $10. Assume current federal+state tax rate (including the new brackets and investment taxes which became effective in 2013) is 40% (a substantial option exercise will put you in a higher bracket than you are used to).

If you buy 1000 shares then your expenses are:

$1000 exercise price
$9000 income x 40% = $3600 immediate tax.
$10000 asset which cannot be sold, with a $10000 cost basis.

Assume worst case, which is it fails. in 2016 value drops to $0.

At that point you can claim a $10000 long term capital loss, which can be offset versus capital gains and rolled over from year to year. $3k of that loss can be offset against income each year. You are also out $4600. Assuming a 30% long term tax rate (including state) that $10k loss might save you $3k of taxes...eventually. But you'll need enough gains to offset, or live a long time offsetting $3k/year of income.

Assume a great case, which is it IPO's for $10.

You sell for $10000. The cost basis was already $10000, so you keep all $10000. But you already paid $4600.

So you took a big risk, and more than doubled your money. That's great, but not great enough to go into debt for.

Depending on the probability of success of the company, I'm back to "exercise some options to give you some upside, but not enough to make your finances dependent on that stock going IPO". An exercise price of $1 and a value of $10 looks like a 10x gain, but it's really a 2.17x gain after taxes and extreme risk.

You will, of course, have to recalculate based on your tax rates, strike price, and current market value.
HornedToad
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Re: Need help thinking through exercising options

Post by HornedToad »

Here's a few articles on this to think through. I've been pleasantly impressed with Wealthfront's career advice for Equity in the Silicon valley so it's possible you might be able to do a consultation with them or one of the other articles will help more. From what I've read, you have ISO's, not RSU's/NSO's so there was probably never an option to file an 83(b). But make sure you are aware of it for the future. (Link included below)

I agree with the advice that it's not an all or nothing proposition and you might find a balance where both the risk and rewards are lower than an all or nothing approach. Depending on the percent stake of company you might find a loan/partner who would go in on it for a cut (i.e. SVB or rich individual investors)

https://blog.wealthfront.com/risk-with-stock-options/
http://www.naffziger.net/blog/2007/11/1 ... r-options/

https://blog.wealthfront.com/always-file-your-83b/

Best of luck in your decision.
Topic Author
Ancal
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Joined: Wed Jan 23, 2013 12:37 pm

Re: Need help thinking through exercising options

Post by Ancal »

Thanks once more, to both of you!

I think I've narrowed down the infinite spectrum of choices down to a few alternatives:

a. Do nothing (let the options expire) and just live my life knowing it'll be ok.
b. Spend as much (purchase + taxes) as I can comfortably afford, gaining potential upside but keeping emergency funds/a reserve intact.
c. Spend all my family's wealth but avoid debt.
d. Go whole hog but see if I can find someone to share the risk/reward with me.
e. Put it all on red, go deep into debt, and pray it all pays off in the end.

Really appreciate y'all helping me clarify my thinking.
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ogd
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Re: Need help thinking through exercising options

Post by ogd »

Tough situation to be in. It's a ton of money to leave on the table so I'd make sure I'd exhausted all my options.
HornedToad wrote:I agree with the advice that it's not an all or nothing proposition and you might find a balance where both the risk and rewards are lower than an all or nothing approach. Depending on the percent stake of company you might find a loan/partner who would go in on it for a cut (i.e. SVB or rich individual investors)
I'd really explore this. There's gotta be some kind of secondary market or arrangement that you could find for someone to take out risk. I wish I had some pointers, but you might just wish to find and pay for a consultation with a financial guy specializing in employee options strategies. Actually, I remember hearing from these guys at one point (not thru AARP), but not much since. http://content.schwab.com/m/schwab_aarp ... vices.html . Won't hurt to give them a call.
Jack FFR1846
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Re: Need help thinking through exercising options

Post by Jack FFR1846 »

Let's say that your strike price is $3. Let's say that you think the value is $10. Let's say that the majority shareholders get together to "steal" the company from the rest of the shareholders and put fourth an offer of $1 a share. These majority shareholders easily pass a resolution at the shareholder meeting to do exactly that. So you get paid $1.33 for your $3 shares.

(I worked for a company that did exactly this)
Bogle: Smart Beta is stupid
Topic Author
Ancal
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Joined: Wed Jan 23, 2013 12:37 pm

Re: Need help thinking through exercising options

Post by Ancal »

ogd wrote: I'd really explore this. There's gotta be some kind of secondary market or arrangement that you could find for someone to take out risk.
Smart advice. Thanks.
Jack FFR1846 wrote:Let's say that your strike price is $3. Let's say that you think the value is $10. Let's say that the majority shareholders get together to "steal" the company from the rest of the shareholders and put fourth an offer of $1 a share. These majority shareholders easily pass a resolution at the shareholder meeting to do exactly that. So you get paid $1.33 for your $3 shares.
Man, that sucks. I feel for you. I don't think that is likely in this situation, as there is far too much external investment and the board wouldn't allow this to happen. But it's a great reminder that nothing is certain. (To clarify, the FMV is determined by a third party, so it's very unlikely for a lowball bid to even be a possibility unless things change dramatically.)
Buffetologist
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Re: Need help thinking through exercising options

Post by Buffetologist »

Can you find someone, maybe one of the other employees or venture capitalists who can buy your shares for less than fair market value, but enough to make exercising worth it to you. If you find someone, it might be worth talking to a tax attorney. Perhaps there is justification in saying that what you sell it for IS the fair market value. Often the company has right of first refusal if you try to sell restricted stock to a qualified investor. Again, an attorney might be able to help you figure out what your rights are.

It does seem painful to leave all of those in-the-money options on the table. I feel your pain.

If it were me, I'd try to find a qualified buyer to purchase my holdings without waiting for the IPO.
Valuethinker
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Re: Need help thinking through exercising options

Post by Valuethinker »

Ancal wrote:Thanks once more, to both of you!

I think I've narrowed down the infinite spectrum of choices down to a few alternatives:

a. Do nothing (let the options expire) and just live my life knowing it'll be ok.
I wouldn't be comfortable doing this unless I thought my ex employer was really unlikely to be successful.
b. Spend as much (purchase + taxes) as I can comfortably afford, gaining potential upside but keeping emergency funds/a reserve intact.
That's close to the right answer, psychologically, for me. I still have some skin in the game, but if I lose it I haven't ruined my life. Think of it as an esoteric investment. We tend here to limit that to 10% of our portfolio of 'play' money, but if you are confident of the prospects of the company and you feel that you will make enough money in your career to be able to recoup a total loss, then you could go with more. (a 30 year old is naturally a lot less risk averse than a 50 year old in these matters).
c. Spend all my family's wealth but avoid debt.
Way too risky for me to go whole hog. But see my last point.
d. Go whole hog but see if I can find someone to share the risk/reward with me.
A very creative idea. I don't know how the legals of that would work. It may be given that this is not an unusual problem and so there are well worked out arrangements in your area/ industry. Half a loaf (or even 1/3rd) is better than no loaf.
e. Put it all on red, go deep into debt, and pray it all pays off in the end.

Really appreciate y'all helping me clarify my thinking.
I'd rule that one (e) out immediately. Unless you think that even if you lose all this money, you are going to be so well compensated in your career that you can afford to rebuild from scratch.

Your choice really does boil down to 'how important is this money to me, if I invest it, and lose it?'
brogrammer
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Re: Need help thinking through exercising options

Post by brogrammer »

Recast the situation like this: you're someone who never worked for this company, but through your sweet connections you have the opportunity to buy into a private placement and get some shares for $x, that are allegedly worth n*x right now if you could sell them (but you can't), and may be worth N*x if there is an exit. But the opportunity closes next Friday, so hurry!

Do you wipe out your emergency fund, taxable investments, and go into debt to buy in? If the answer is no, I wouldn't do that to exercise all your options, either. If you really believe they can succeed, buy some... if it's relatively late stage, I'd consider it even if it crunches your liquidity for now or tilts your asset allocation out of whack for a few years until you have time to amass more savings. It sounds like you have good earning potential and discipline for saving, so you'll recover the short-term hit. But 5x salary seems it would be a pretty big hole to dig yourself to buy one smallcap stock.

(I've been through this before, though the numbers were smaller in magnitude-- not multiples of my salary, but still meaningful to me giving my circumstances at the time. I didn't buy the ISOs. The company still exists but has never really gone anywhere.)
kevinpet
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Re: Need help thinking through exercising options

Post by kevinpet »

If your exercise price + AMT tax bill is several times your annual salary, you're talking about at least a couple million in options. That might not be "never work again", but that is "retirement is taken care of" money. This is well worth talking to an accounting firm even if it costs a few thousand dollars.

One possibility, as someone mentioned, is to arrange a private sale. The company would probably be more cooperative if you were selling to someone who was already an investor. If you exercise ISO and then sell within the first year, it's a disqualifying disposition, which means you pay tax as ordinary income, but if you sell at less than the supposed FMV, the sale price is what you actually use.

There are also "exchange funds" which may let you reduce your risk and increase the chance of seeing liquidity. In these, you buy into a private equity fund with your illiquid private company shares. These wouldn't solve your problem of raising the cash to exercise and pay the taxes.

I've seen a new fund http://www.esofund.com/index.html that is attempting to solve this problem. They offer loans that only need to be repaid in the event of liquidity. I know nothing about who's behind it. I think I perceive them as a little bit sleazy since the business model is similar to the "we buy your structured settlement" companies, but it really does seem a perfectly logical approach to the problem.

All of these are complicated and I wouldn't attempt one of these without an accountant and/or tax lawyer assisting.
Topic Author
Ancal
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Joined: Wed Jan 23, 2013 12:37 pm

Re: Need help thinking through exercising options

Post by Ancal »

@ValueThinker - thank you, that's very helpful context.

@brogrammer - i like your way of framing the scenario. It involves the irrational "it's mine already, i just have to pay for it" mindset.

@kevinpet - yes, I'll get help. It's potential a large amount of wealth forgone.
engin33r
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Re: Need help thinking through exercising options

Post by engin33r »

You may want to check out esofund.com. They'll provide money to cover the exercise and the taxes in exchange for a reasonable percentage of the upside from any eventual gains.

Edit: I now see someone already mentioned it. Anyway, I second that suggestion :-)

Also, esofund is not a loan. They give you the money in exchange for a percentage of eventual proceeds. In my circle of friends, there are a couple of people who have had positive experiences with them.
freebeer
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Re: Need help thinking through exercising options

Post by freebeer »

If there is no public or secondary market for a stock, so no "market maker", how can a Fair Market Value so much in excess of the strike price of options be determined?

If it's based on a recent VC funding valuation... well VCs receive preferred stock not common stock, which comes along with various liquidation preferences, participation rights, antidilution provisions and so so it's conventional and accepted (and true) to give a FMV to common stock at a massive discount to the preferred shares (I was part of a startup VC financing where preexisting common stock was washed out with a 1000-1 reverse split so I've seen it in action).

This may be a consideration both for your exercise decision and for your tax liability.

OTOH if there is a market-maker of some kind... then that would imply you could somehow dispose of your shares, so why not do so and get the 15x return?
Topic Author
Ancal
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Joined: Wed Jan 23, 2013 12:37 pm

Re: Need help thinking through exercising options

Post by Ancal »

engin33r wrote: Also, esofund is not a loan. They give you the money in exchange for a percentage of eventual proceeds. In my circle of friends, there are a couple of people who have had positive experiences with them.
Thanks! I will definitely check them out.
freebeer wrote:If there is no public or secondary market for a stock, so no "market maker", how can a Fair Market Value so much in excess of the strike price of options be determined?

If it's based on a recent VC funding valuation... well VCs receive preferred stock not common stock, which comes along with various liquidation preferences, participation rights, antidilution provisions and so so it's conventional and accepted (and true) to give a FMV to common stock at a massive discount to the preferred shares (I was part of a startup VC financing where preexisting common stock was washed out with a 1000-1 reverse split so I've seen it in action).
OK, a massive dilution like that is scary and would suck. A lot.

From time to time, a company's shares have to have their FMV assessed by independent third-party valuers. This is for accounting purposes (for example, when a nonqualified option is exercised, the difference between the FMV and strike price is immediately taxed as income). So the FMV should refer the current value of the common stock, with the knowledge that it's illiquid and last in line for cashing out. This FMV is generally lower than the price of a preferred stock.
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