In the first part of this four-part series, we provided a high-level summary of stock option basics. In this second installment, we build on those basics and begin our exploration of stock option program “enhancements” by considering early exercisable stock options.
An early exercisable option is an option that allows the option holder to exercise the option before it is vested. Unlike a traditional option, the holder of an early exercisable option does not have to earn the right to exercise an early exercisable option. Rather, the option holder can exercise the option at any time. However, if the option holder exercises the option before it is vested, he or she must then earn the right to keep the shares of stock received upon exercise of the unvested portion of the award. Put another way, when the option holder early exercises an option, the option holder does not receive fully vested shares of stock (as the option holder would upon exercise of a vested option) but instead receives restricted stock that is generally subject to the same vesting schedule that applied to the unvested option. If the holder of the restricted stock leaves the company before those shares are fully vested, the company generally has the right to repurchase any unvested shares at the same price the holder paid for them.
Intended Benefits of Early Exercising
By taking advantage of an early exercise feature, an option holder generally hopes to both:
- minimize any ordinary compensation income resulting from exercise of the option; and
- start the capital gains holding period for the stock underlying the option before the option would otherwise vest.
Where the Rubber meets the Road – Consequences of Early Exercising
Though the intended benefits of early exercising options sound great in theory, depending on the type of option being exercised, the point in time when it is exercised, and whether or not an election under Section 83(b) of the Internal Revenue Code (a “Section 83(b) election”) is timely and properly filed, early exercising an option may not necessarily achieve the intended tax beneﬁts.
Early Exercising NSOs
If the option is an nonstatutory stock option (an NSO) and a Section 83(b) election is timely and properly filed within 30 days of the date of exercise of the NSO, (i) the difference between the fair market value of the stock on the date of exercise and the exercise price paid (also known as the “spread”), if any, will be ordinary compensation income to the option holder and (ii) the capital gains holding period (and, incidentally, the five-year holding period for qualified small business stock purposes) will begin at the time of exercise. This is really the textbook example of why an option holder may want to early exercise – if the option holder exercises at a time when the fair market value is equal to the exercise price, then there will be no compensation income at the time the Section 83(b) election is made and the option holder will have gotten to kickstart the capital gains holding period for the shares. So long as the option holder holds the shares for more than one year, any appreciation above the fair market value of the stock at exercise would be subject to long-term capital gains rates.
Beware, however, that if the NSO is early exercised at a time when the fair market value of the underlying stock is higher than the option’s exercise price (that is, when there is a spread), the compensation income recognized at the time the Section 83(b) election is made will be subject to all applicable income and withholding taxes and the company will have to ensure that the option holder can pay those withholding taxes. Note too that if the restricted stock is forfeited, the employee will not get a credit or refund of any taxes paid as a result of making the Section 83(b) election.
Worse still, if the Section 83(b) election is not properly or timely filed, then (i) instead of having income at the time of making the election, there will be compensation income to the holder of an early exercised NSO equal to the difference between the fair market value of the stock on each vesting date and the purchase price (i.e., the exercise price paid) and (ii) the capital gains holding period for the shares will begin only as and when those shares vest. Again, any compensation income would be subject to all applicable income and withholding taxes (and the company must ensure that withholding can be satisfied).
Early Exercising ISOs
Perhaps one of the most significant traps of all for the unwary is that, contrary to popular belief, early exercising an incentive stock option (an ISO) and timely filing a Section 83(b) election will not cause the capital gains holding period to begin for the shares. Rather, the capital gains holding period will begin the day after the restricted stock vests. While early exercising an ISO and timely and properly filing a Section 83(b) election may have the effect of minimizing (or even eliminating if there is no spread at exercise) any alternative minimum tax liability, if the purpose of early exercising a stock option is to kickstart the capital gains holding period, early exercising an ISO just doesn’t work.
It is worth noting too that if an ISO is granted with an early exercise feature, less of the option may be eligible for ISO treatment (even if the option is not early exercised). This is because one of the rules applicable to ISOs provides that if the shares of stock underlying an ISO that ﬁrst become exercisable during any calendar year have a fair market value of more than $100,000 (determined based on the fair market value of the stock on the date the option was granted), the excess shares of stock will be treated as if they were subject to an NSO. If an option is early exercisable, the entire award is “ﬁrst exercisable” in the year of grant and therefore more of the award may exceed the annual $100,000 limit than if the option were only exercisable as and when the option vested over a period of several years.
- Only granting early exercisable NSOs may avoid traps for the unwary but may not be the incentive most employees want. If a start-up is asked to issue early exercisable options, then, to avoid the unintended tax consequences that apply to early exercisable ISOs, it may well make sense to grant early exercisable NSOs. However, taking it one step further and instituting a practice of only granting NSOs with an early exercise feature (instead of ISOs without an early exercise feature) may not be as attractive to employees who do not intend to (or cannot aﬀord to) early exercise their options and would otherwise hope to beneﬁt from ISO treatment. When all is said and done, employees often don’t end up taking advantage of broad-based early exercise programs because they must pay the exercise price and any associated taxes, and many are unwilling or unable to put that cash at risk or don’t have the financial wherewithal to hold illiquid stock indefinitely. So, if the goal is to offer early exercisable options to attract and retain qualified employees, only granting NSOs to avoid the negative tax outcomes of granting ISOs may undermine that goal.
- A holder of restricted stock is still a stockholder for all corporate law purposes. Early exercisable options could increase the number of employee stockholders in the company. When an option holder early exercises a stock option, the option holder receives stock subject to vesting but becomes a stockholder for all corporate law purposes. If the company wants to limit the number of service-provider stockholders in the company’s cap table, that goal is undermined each time an option is early exercised.
- Administration matters. Permitting options to be early exercised may also add administrative burdens for the company. The company must carefully track outstanding equity awards and, following a termination of service, must aﬃrmatively act to repurchase restricted shares or the holder will retain them even after ceasing to perform services. This is distinctly different from the treatment of options, which must be aﬃrmatively exercised by the option holder within a limited window after ceasing to perform services to avoid the options being forfeited.
When All is Said and Done
It is certainly the case that providing the ability to early exercise a stock option may give some employees a tax advantage. And it is possible that providing that potential tax advantage could be an important recruiting tool for an early-stage company. However, the tax considerations and practical implications of granting options with (or amending outstanding options to add) an early exercise feature are much more complex than would appear at ﬁrst blush.
It is also possible the same goals can be achieved more simply by granting an award of restricted stock from the get-go. (And if the thought of making grants of restricted stock is not palatable, then granting options with an early exercise feature may not be for the company at all.)
We touch on some of the signiﬁcant issues of early exercising options in this post, but any program or practice of granting options that can be early exercised (whether on a case-by-case basis or across the board) should be carefully reviewed with tax counsel. Watch for part three of this four-part series in which we discuss the pros and cons of granting options with extended post-termination exercise periods.