Early exercising NSOs

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orenesto
Posts: 2
Joined: Thu Aug 22, 2019 12:39 pm

Early exercising NSOs

Post by orenesto » Sat Sep 07, 2019 8:53 pm

Hi Bogleheads,

I am in a very small early stage startup (less than 10 people). I am thinking about leaving soon and wondering if I should early exercise the stock options I vested until now. It's been a year and a half so I have 3/8th of the total grant vested, which is about 1% of the company. The strike price is very low and the valuation hasn't changed since the grant time. Total exercise price as of now would be a few thousand dollars which is not a whole lot but I would rather not throw it away either if the company doesn't succeed in the end. I can exercise up to 7 years after leaving the company. As far as I understand, I should not be concerned with AMT in case of NSOs.

It seems the reasons to exercise now are:
  1. Make sure I can get the shares at a low price without paying any tax at the exercise time now (valuation equal to strike price). I'm not sure if it will be possible to sell in 7 years or more (if the company survives at all). If it's not possible to sell in 7 years but the company is doing well though then I will be forced to exercise if I want the shares, and pay the (possibly big) tax bill, but won't be able to sell. Seems like a stressful situation. If I exercise now, can I keep waiting forever to sell without paying anything in taxes until I sell?
  2. Pay only long term capital gains tax on the entire appreciation of the stock. Assuming that I'm lucky and it is possible to sell in 7 years, if I exercise then, I would be paying an ordinary income tax on the whole difference between the value then and now and losing a lot of potential gain, correct?
Am I missing anything else? Is this essentially a decision between a) spending a few thousands now and possibly (likely?) losing them, but having much less stress if the company succeeds and b) not spending anything now, but possibly having a much more difficult decision to make in the (unlikely?) event the startup succeeds?

I'd be grateful for any advice!

123
Posts: 4963
Joined: Fri Oct 12, 2012 3:55 pm

Re: Early exercising NSOs

Post by 123 » Sat Sep 07, 2019 10:36 pm

Depending on how you feel about the company you could go half way on each alternative. (Or maybe hold onto 10%.) Could they turn into a pets.com or an Amazon.com?
The closest helping hand is at the end of your own arm.

MotoTrojan
Posts: 5863
Joined: Wed Feb 01, 2017 8:39 pm

Re: Early exercising NSOs

Post by MotoTrojan » Sat Sep 07, 2019 10:41 pm

Very interesting that you have NSO and not ISO. Also I’m shocked you have 7 years to exercise after leaving; usually this is measured in days/weeks.

I’d consider exercising some/all of it’s a fraction of your annual retirement savings but there really isn’t a logical answer.

I’m not leaving my company but to date I’ve put >$15K into my ISOs since the AMT will slaughter me pretty soon based on current trajectory.

mountains
Posts: 39
Joined: Sun Jun 17, 2018 10:06 pm

Re: Early exercising NSOs

Post by mountains » Sat Sep 07, 2019 11:12 pm

7 years sounds very long too me. Make sure that you don't have another time frame to exercise after leaving. I had options that expired 10 year after grant *but* I also had to exercise 30 days after leaving the company or loose them (so the 10 years only applied if I was still employed).

I would say if you think the company has a decent chance of succeeding, exercise now even though you might loose all your money.

A couple of considerations:

If the company is quite successful but hasn't exited (IPO or acquisition) after 7 years you are stuck. If you exercise you need to pay taxes on the difference between strike price and FMV even though you can't sell so you might incur even larger losses if the company goes south. If you don't exercise you loose the options. These days many companies stay private for a long time before it exits.

Even if the company does have an exit within 7 years: if you exercise then you'll have to pay income tax instead of long term capital gains.

A final consideration: the 1% you own now will likely be a lot less (maybe 0.1%) in the future due to dilution from additional funding rounds.

NewMoneyMustBeSmart
Posts: 44
Joined: Sat Jun 01, 2019 10:28 pm

Re: Early exercising NSOs

Post by NewMoneyMustBeSmart » Sun Sep 08, 2019 9:13 am

orenesto wrote:
Sat Sep 07, 2019 8:53 pm
Hi Bogleheads,

I am in a very small early stage startup (less than 10 people). I am thinking about leaving soon and wondering if I should early exercise the stock options I vested until now. It's been a year and a half so I have 3/8th of the total grant vested, which is about 1% of the company. The strike price is very low and the valuation hasn't changed since the grant time. Total exercise price as of now would be a few thousand dollars which is not a whole lot but I would rather not throw it away either if the company doesn't succeed in the end. I can exercise up to 7 years after leaving the company. As far as I understand, I should not be concerned with AMT in case of NSOs.
Your logic is rational but I am not familiar w/ stock option compensation that allows you to exercise 7 years *after* leaving the company.

If I could afford the few thousand dollars of cost, I absolutely would exercise now. You avoid ordinary income tax as the valuation = the strike. You avoid AMT because they are not ISOs (and the valuation = strike/exercise price).

The only puzzling thing is it is odd for a company to not have an increase in valuation for 18 months .

Unless you think the company is likely doomed, the possible upside is great.

Recognize you'll likely be diluted.

Assume your company has a pre-money valuation of $10M with $3M from series-A. If they go to $50M valuation and includes $10M, you'll be diluted 10%. If they go to $100M and raise 20M that's another 20%. Go to $200M and raise $40M that's another 20%.

(1-.1)*(1-.2)*(1-.2)=.576 so your 1% will be diluted down to just over 1/2 of one percent. But that's .576 of $200M in the above example, or $1.15M.

Who knows what will happen. But do you have enough inside knowledge about the company to invest a few thousand dollars to buy an option on future increase?
It seems the reasons to exercise now are:
orenesto wrote:
Sat Sep 07, 2019 8:53 pm
  1. Make sure I can get the shares at a low price without paying any tax at the exercise time now (valuation equal to strike price). I'm not sure if it will be possible to sell in 7 years or more (if the company survives at all). If it's not possible to sell in 7 years but the company is doing well though then I will be forced to exercise if I want the shares, and pay the (possibly big) tax bill, but won't be able to sell. Seems like a stressful situation. If I exercise now, can I keep waiting forever to sell without paying anything in taxes until I sell?
I believe if you exercise now and fmv=exercise price, and are in the USA and taxes don't change tremendously, you'll never pay a penny of tax until you sell.
orenesto wrote:
Sat Sep 07, 2019 8:53 pm

[*] Pay only long term capital gains tax on the entire appreciation of the stock. Assuming that I'm lucky and it is possible to sell in 7 years, if I exercise then, I would be paying an ordinary income tax on the whole difference between the value then and now and losing a lot of potential gain, correct?[/list]
Yes, you could pay ordinary income. I'm still doubtful you really have 7 years to exercise after you leave.
orenesto wrote:
Sat Sep 07, 2019 8:53 pm

Am I missing anything else? Is this essentially a decision between a) spending a few thousands now and possibly (likely?) losing them, but having much less stress if the company succeeds and b) not spending anything now, but possibly having a much more difficult decision to make in the (unlikely?) event the startup succeeds?

I'd be grateful for any advice!
If you're putting this much time into, if I were you I'd buy them and move on.

random_walker_77
Posts: 788
Joined: Tue May 21, 2013 8:49 pm

Re: Early exercising NSOs

Post by random_walker_77 » Sun Sep 08, 2019 9:50 am

Sounds like the "bargain" element here isn't all that high. Really, what you have is the chance to be a VC and invest in this early-stage company. Most startups don't make it, but there is that chance of very high returns. So this is entirely up to your judgement. Note that it's not all-or-nothing; you could buy 1/4 of the amount offered to you, 1/2, or all of it. How much do you want to put into this "lottery ticket"? How strongly do you believe in this company, and most especially, how strongly do you believe in the people?

After putting in 1.5 years of my life into a company, I'd hate to walk away and miss out on a payoff. Rational or not, I'd probably kick in at least a bit to ensure participation in future gains. But the textbook answer is to compare your upfront cost vs the expected value: sum((probability of payoff_i) * (amount of payoff_i))

i.e. present value of $1000 worth of company ownership is something like
sum of (
40% times $0, (lose everything)
30% times $100, (lose most of it)
10% times $1000, (break even)
10% times $3000, (triple your money)
9% times $10K, (10x on your money)
0.9% times $100K, (100x return)
0.1% times $300K, (300x return)
)

= 0 + $30 + $100 + $300 + $900 + $900 + $300 = "theoretical value"
Insert your own guesses, and keep in mind the maxim "garbage in -> garbage out"

daektr
Posts: 22
Joined: Sat Apr 07, 2018 6:18 pm

Re: Early exercising NSOs

Post by daektr » Sun Sep 08, 2019 10:54 am

Almost certainly, you only have 7 years left to exercise if you stay a ‘service provider’ for the company. Suggest you read the fine print more closely.

I’ve seen 30 days to exercise once you leave, but I think I’ve also heard of cases where you have to exercise before leaving, basically.

I don’t know the company’s prospect, but $1000 for 1% of a 10 person company sounds like it could be a good deal to me.

engin33r
Posts: 49
Joined: Thu Apr 07, 2011 3:45 pm
Location: North ATL

Re: Early exercising NSOs

Post by engin33r » Sun Sep 08, 2019 12:19 pm

Lots of Silicon Valley companies are extending the duration that employees can exercise options after terminating employment. 90 days is still standard but there are dozens that now offer 3, 5, 7, or 10 years to exercise after leaving the company. As a worker bee, this change in how the handcuffs work is a welcome one.

milo minderbinder
Posts: 30
Joined: Fri Apr 20, 2018 12:57 pm

Re: Early exercising NSOs

Post by milo minderbinder » Mon Sep 09, 2019 11:19 am

If you really have 7 years left to exercise you should let it ride. Most of the value off an option is the time value. With 7 years of volatility to go you would be sacrificing a lot in terms of black scholes or lattice binomial valuation if you exercised now. But read the option agreement and plan carefully!

random_walker_77
Posts: 788
Joined: Tue May 21, 2013 8:49 pm

Re: Early exercising NSOs

Post by random_walker_77 » Tue Sep 10, 2019 11:07 pm

milo minderbinder wrote:
Mon Sep 09, 2019 11:19 am
If you really have 7 years left to exercise you should let it ride. Most of the value off an option is the time value. With 7 years of volatility to go you would be sacrificing a lot in terms of black scholes or lattice binomial valuation if you exercised now. But read the option agreement and plan carefully!
That's if you go by option value, but it has issues, which were laid out in the original post. The dream is for the company to do really well and for these to be worth a lot. Let's say it goes up 1000x and now they're worth millions. Taxation as ordinary income would hurt, as compared to long-term capital gains, but that's secondary to the possibility of immense taxation risk if there's no liquid market for its shares b/c the company remains private. Then OP could exercise, let's say $3M of options for the strike price of ~$3K, but then would owe $1M in taxes. How'd they pay the IRS? They can't sell the stock received from exercising the options, and w/ no liquidity, there's still the risk that the stock value plummets back to 0. Borrowing to pay the IRS would seem to be awfully risky... whereas if the OP pays the few thousand to exercise now, then the dream scenario won't have this nightmare scenario attached to it. On the other hand, if OP pays the few thousand now, there's a decent chance that money is toast. So I think OP has the opportunity to invest as a VC, but under arguably worse terms.

As historical background, while OP has non-qualified options, a similar problem scenario occurs (occurred?) w/ qualified options under AMT, and some tech workers did get badly burned after the dot.com crash. The only thing worse than a bad year where all your previously-valuable stock became worthless is to find out the following year that you're bankrupt because you owe hundreds of thousands to the IRS. Here's a news article from 2001... those were the days :twisted:
https://www.chicagotribune.com/sns-tech ... story.html

milo minderbinder
Posts: 30
Joined: Fri Apr 20, 2018 12:57 pm

Re: Early exercising NSOs

Post by milo minderbinder » Wed Sep 11, 2019 11:50 am

random_walker_77 wrote:
Tue Sep 10, 2019 11:07 pm
milo minderbinder wrote:
Mon Sep 09, 2019 11:19 am
If you really have 7 years left to exercise you should let it ride. Most of the value off an option is the time value. With 7 years of volatility to go you would be sacrificing a lot in terms of black scholes or lattice binomial valuation if you exercised now. But read the option agreement and plan carefully!
That's if you go by option value, but it has issues, which were laid out in the original post. The dream is for the company to do really well and for these to be worth a lot. Let's say it goes up 1000x and now they're worth millions. Taxation as ordinary income would hurt, as compared to long-term capital gains, but that's secondary to the possibility of immense taxation risk if there's no liquid market for its shares b/c the company remains private. Then OP could exercise, let's say $3M of options for the strike price of ~$3K, but then would owe $1M in taxes. How'd they pay the IRS? They can't sell the stock received from exercising the options, and w/ no liquidity, there's still the risk that the stock value plummets back to 0. Borrowing to pay the IRS would seem to be awfully risky... whereas if the OP pays the few thousand to exercise now, then the dream scenario won't have this nightmare scenario attached to it. On the other hand, if OP pays the few thousand now, there's a decent chance that money is toast. So I think OP has the opportunity to invest as a VC, but under arguably worse terms.

As historical background, while OP has non-qualified options, a similar problem scenario occurs (occurred?) w/ qualified options under AMT, and some tech workers did get badly burned after the dot.com crash. The only thing worse than a bad year where all your previously-valuable stock became worthless is to find out the following year that you're bankrupt because you owe hundreds of thousands to the IRS. Here's a news article from 2001... those were the days :twisted:
https://www.chicagotribune.com/sns-tech ... story.html
True, but I think this is a largely theoretical risk. If the company succeeds on this scale it is likely there will be a public market, or at least a robust private market, for the shares.

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