As a founder, you’ve probably tied up a lot of your energy, time, and resources in your startup. Ideally, that’s going to pay some serious dividends through the years. In fact, if you’re thinking about that future payoff, you might be dreaming about the day you can turn company shares into dollars in your pocket.
To get that ball rolling, you might consider exercising some stock options. Reminder: stock options aren’t shares, but they give you the right to purchase shares at a set price. Once you exercise those options, you convert them into shares of stock. And if your startup IPOs or gets acquired, those shares give you a way to make money.
You might think, then, that it makes sense to exercise now to be poised for that payoff. And in some cases, it does. But there are some things to consider before you take this step.
Types of stock options and their tax implications
Different types of stock options come with different ramifications for their exercise. The two types of options are:
Incentive stock options (ISOs)
Also called a qualified stock option, this type of option can only be granted to employees within the company. You don’t need to pay any taxes on ISOs at the time of exercise.
Plus, provided you handle them correctly, ISOs can qualify for preferential tax treatment. That’s because an alternative minimum tax (AMT) gets applied to any profit you make when you sell ISOs. So if you exercise an ISO for $10, then your company IPOs and you sell that share for $15, the $5 of profit is subject to the AMT.
If you hold ISOs for two years after their grant date and one year after you exercise them, that profit is subject to long-term capital gains. If you don’t hit those time milestones, the AMT for your profit on ISOs is the short-term capital gains rate.
The short-term capital gains rate is usually equal to your current income tax rate, which is almost always higher than the long-term capital gains rate. The latter comes in at 0%, 15%, or 20% depending on your income bracket. Since, in 2024, a salary of $47,151 gives you an income tax bracket of 22%, you’ll almost always pay less with long-term capital gains.
Long story short, if you have ISOs, you want to hold them for two years after the grant date and one year after exercise to pay less in taxes. And that may mean it makes sense to exercise them now to get that clock ticking.
Nonstatutory options (NSOs)
Also called nonqualified stock options, NSOs can go to employees as well as outside parties like consultants. They get taxed twice, once when you exercise and again when you sell.
When you exercise an NSO, the spread between your strike price (i.e., your price to exercise) and the fair market value (FMV) of the stock option becomes a tax liability. If your strike price was $8 but the FMV of the share is $12, for example, you need to pay taxes on the $4 spread. That spread is taxed as income, meaning you’ll pay your income tax rate on it.
With NSOs, you’re also subject to the one-year holding period for preferable tax treatment. They don’t come with the two-year requirement to hold them after the grant date.
If you hold your exercised NSOs for one year, they get taxed at the lower long-term capital gains tax rate. If you sell within a year of exercising the stock option, any profit gets taxed at the short-term capital gains tax rate, which is usually your current income tax rate.
A reason to exercise fast: 83(b) elections
If you exercise either ISOs or NSOs at the grant date, the FMV should be equal to the strike price. And this can save you from owing taxes at the time of exercise.
Specifically, if you file an 83(b) election, you inform the IRS that there’s no spread between your exercise price and FMV. And that means the amount you would potentially owe income taxes on is $0.
This effectively eliminates the first round of taxation for NSOs.
This election can also benefit folks with ISOs. If you don’t file for an 83(b), you could be subject to the AMT on the spread between your strike price and FMV.
Note that if you want to take advantage of this way to minimize the taxation on your shares, you need to act fast. To capitalize on this tax savings opportunity, you need to file the 83(b) within 30 days of exercising those stock options.
The out-of-pocket cost
If you held shares in a publicly traded company, you could sell some of them to cover the cost of exercising. But since your startup probably hasn’t made it to an IPO yet, you don’t have that option.
Instead, you’ll need to come up with the cash to cover the cost of exercising those shares another way. Yes, that does mean that in a liquidity event, you’ll be poised to pocket money straight away instead of needing to cover the cost of exercising at that time. But it could take a while for your startup to reach the point where it gets publicly traded or acquired. And that means you could spend money to exercise your stock options now, only to sit on those illiquid shares for a while.
Many startup founders are bootstrapping to at least some extent. And that doesn’t leave a lot of money left over to tie up in stock you won’t be able to profit on for a while. As a result, it may be better to wait to exercise shares.
Deciding what’s right for you
On the other hand, there could be a good reason for parting with some cash for a while to exercise now. Specifically, if your strike price is low, it might not sting much to exercise your stock options. And this starts the clock ticking so they’re subject to the lower long-term capital gains rate if/when you do sell.
Be smart about how you approach this. Every founder wants their startup to grow and thrive. But realistically speaking, is yours on track to do so? Even if your strike price is low, it doesn’t make sense to spend money on exercising stock that will never turn a profit. And if your startup doesn’t make it to an IPO or an acquisition, it won’t matter how many stock options you exercise or how much (or little) you paid for them. You won’t have a way to convert them into cash.
Between the trajectory of your startup, the tax implications, and the out-of-pocket cost, there’s a lot to consider when it comes to exercising your stock options. To talk with an accountant about the best way to approach this, contact our team.