Early exercise is a means of investing in the company earlier, with the expectation that the stock's value will increase in the future, and you will be able to sell it for far more than you paid for it originally. The flip side of the coin is that the option holder risks losing all or part of the investment if the company's common stock value decreases. Before becoming a stockholder, stock options allow holders to lock in a price and wait to see if the company's stock value increases before being required to pay the exercise price. As the aggregate cost to exercise the options increases relative to the option holder's financial means, the decision to early exercise the options could become more difficult for the option holder.
If the company is a corporation, incentive stock options ISOs and nonqualified stock options NSOs can include early exercise stock options. If the company knows that an employee will immediately exercise her options, they should grant the employee his or her option as an NSO to avoid a two-year ISO holding period rule. The option holder is eligible to vote to the extent the shares are voting shares, receive dividends, and request company financial information.
By filing a Section 83 b election, the option holder agrees to immediately include in gross income any spread associated with the option's exercise, based on the stock's fair market value on the exercise date. To be effective, 83 b elections must be filed 30 days after the exercise date. Unfortunately, the company can face disputes with option holders who neglect to make this filing. These option holders might fault the company for not giving notice of the deadline or might expect the company to handle the filing for them. If the option holder early exercises, the company can repurchase the unvested stock when the option holder terminates service.
The repurchase price tends to lower the exercise price or the previous, current fair market value of the stock. This repurchase right will end as the stock vests, as companies ordinarily do not have the right to repurchase vested stock. Usually, the company holds the unvested stock in escrow for the repurchase in case the person leaves the company, and collects all signed documents that would be required to re-sell the unvested shares back. The content of this article is intended to provide a general guide to the subject matter.
Specialist advice should be sought about your specific circumstances.
#1: All About ISOs
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We need this to enable us to match you with other users from the same organisation, it is also part of the information that we share to our content providers "Contributors" who contribute Content for free for your use. Learn More Accept. Your LinkedIn Connections with the authors. One meaningful downside to the company of allowing optionholders to early exercise is that the company can face disputes with optionholders who neglect to make this filing.
Such optionholders might fault the company for not giving adequate notice of the deadline, or of the consequences of failing to file, or might even expect the company to handle the filing for them. The time and cost of educating optionholders about the 83 b election, coupled with the potential for disputes with people who might not complete their filing in time is enough for many companies to steer away from allowing early exercise.
If the optionholder early exercises, the company will retain the right to repurchase the stock that is unvested when the optionholder terminates service. The repurchase price is generally the lower of the exercise price or the then-current fair market value of the stock. This repurchase right will lapse as the stock vests. Companies generally would not have the right to repurchase any of the vested stock.
The company generally holds the unvested stock in escrow to facilitate the repurchase in the event the person leaves the company, and also collects from the optionholder at the time of exercise all of the signed documents that would be required to re-sell the unvested shares back to the company. The company only uses those documents if and when the person leaves the company while holding unvested shares. Document Generator.
Thank you. Thank you for reaching out to us. A reload option is a nice provision to take advantage of.
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We now arrive at the ESO spread. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread. The following points need to be borne in mind with regard to ESO taxation:. This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares. This aspect can give rise to the risk of a huge tax liability, if you continue to hold the stock and it plummets in value.
The ability to buy shares at a significant discount to the current market price a bargain price, in other words is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate. Thus, even if you do not sell the shares acquired pursuant to your ESO exercise, you trigger a tax liability at the time of exercise. The value of an option consists of intrinsic value and time value. Time value depends on the amount of time remaining until expiration the date when the ESOs expire and several other variables.
Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, their time value can be quite significant. While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them. To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model to compute the fair value of your ESOs.
You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO. From there, it is a simple exercise to calculate time value, as can be seen below. The exercise of an ESO will capture intrinsic value but usually gives up time value assuming there is any left , resulting in a potentially large hidden opportunity cost.
Immediately Exercisable ISOs: The Problems - The Startup Law Blog
The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and above all, volatility. Consider a situation where your ESOs are out of the money i. It would be illogical to exercise your ESOs in this scenario for two reasons. The biggest and most obvious difference between ESOs and listed options is that ESOs are not traded on an exchange, and hence do not have the many benefits of exchange-traded options. Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an option portfolio.
Not so with your ESOs, whose value is not as easy to ascertain, because there is no market price reference point. Many ESOs are granted with a term of 10 years, but there are virtually no options that trade for that length of time. LEAPs long-term equity anticipation securities are among the longest-dated options available, but even they only go two years out, which would only help if your ESOs have two years or less to expiration.
Option pricing models are therefore crucial for you to know the value of your ESOs. Your employer is required—on the options grant date—to specify a theoretical price of your ESOs in your options agreement. Be sure to request this information from your company, and also find out how the value of your ESOs has been determined. Option prices can vary widely, depending on the assumptions made in the input variables. For example, your employer may make certain assumptions about expected length of employment and estimated holding period before exercise, which could shorten the time to expiration.
With listed options, on the other hand, the time to expiration is specified and cannot be arbitrarily changed. Assumptions about volatility can also have a significant impact on option prices. If your company assumes lower than normal levels of volatility, your ESOs would be priced lower. Listed options have standardized contract terms with regard to number of shares underlying an option contract, expiration date, etc.
This uniformity makes it easy to trade options on any optionable stock, whether it is Apple or Google or Qualcomm.
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If you trade a call option contract, for instance, you have the right to buy shares of the underlying stock at the specified strike price until expiration. Similarly, a put option contract gives you the right to sell shares of the underlying stock until expiration. While ESOs do have similar rights to listed options, the right to buy stock is not standardized and is spelled out in the options agreement. For all listed options in the U. If the third Friday happens to fall on an exchange holiday, the expiration date moves up by a day to that Thursday.
Thus, if you owned one call option contract and at expiration, the market price of the underlying stock was higher than the strike price by one cent or more, you would own shares through the automatic exercise feature.
Likewise, if you owned a put option and at expiration, the market price of the underlying stock was lower than the strike price by one cent or more, you would be short shares through the automatic exercise feature. Note that despite the term "automatic exercise," you still have control over the eventual outcome, by providing alternate instructions to your broker that take precedence over any automatic exercise procedures, or by closing out the position prior to expiration.
With ESOs, the exact details about when they expire may differ from one company to the next. Also, as there is no automatic exercise feature with ESOs, you have to notify your employer if you wish to exercise your options.
When Should You Exercise Your Stock Options?
With ESOs, since the strike price is typically the stock's closing price on a particular day, there are no standardized strike prices. In the mids, an options backdating scandal in the U. This practice involved granting an option at a previous date instead of the current date, thus setting the strike price at a lower price than the market price on the grant date and giving an instant gain to the option holder.
Options backdating has become much more difficult since the introduction of Sarbanes-Oxley as companies are now required to report option grants to the SEC within two business days. Vesting gives rise to control issues that are not present in listed options. ESOs may require the employee to attain a level of seniority or meet certain performance targets before they vest. If the vesting criteria are not crystal clear, it may create a murky legal situation, especially if relations sour between the employee and employer. As well, with listed options, once you exercise your calls and obtain the stock you can dispose of it as soon as you wish without any restrictions.
However, with acquired stock through an exercise of ESOs, there may be restrictions that prevent you from selling the stock. Even if your ESOs have vested and you can exercise them, the acquired stock may not be vested. This can pose a dilemma, since you may have already paid tax on the ESO Spread as discussed earlier and now hold a stock that you cannot sell or that is declining.
As scores of employees discovered in the aftermath of the s dot-com bust when numerous technology companies went bankrupt, counterparty risk is a valid issue that is hardly ever considered by those who receive ESOs. With listed options in the U. S, the Options Clearing Corporation serves as the clearinghouse for options contracts and guarantees their performance. But as the counterparty to your ESOs is your company, with no intermediary in between, it would be prudent to monitor its financial situation to ensure that you are not left holding valueless unexercised options, or even worse, worthless acquired stock.
You can assemble a diversified options portfolio using listed options but with ESOs, you have concentration risk, since all your options have the same underlying stock. In addition to your ESOs, if you also have a significant amount of company stock in your employee stock ownership plan ESOP , you may unwittingly have too much exposure to your company, a concentration risk that has been highlighted by FINRA. Understanding the interplay of these variables—especially volatility and time to expiration—is crucial for making informed decisions about the value of your ESOs.
The first table below uses the Black-Scholes option pricing model to isolate the impact of time decay while keeping volatility constant, while the second illustrates the impact of higher volatility on option prices. You can generate option prices yourself using this nifty options calculator at the CBOE website.