Unexpected Risks of Early Exercise ISOs | News & Resources | Dorsey

Many tax advisors recommend an early exercise provision. Many legal advisors are against it.

My experience has led me to this conclusion: What is Early Exercise? An early exercise provision works as follows.

An early exercise provision in the option plan would allow the optionee to buy all , shares immediately, even though the optionee will only vest in 25, shares per year. Usually the company will repurchase shares if the optionee severs his or her relationship with the company before the shares vest. The repurchase price for unvested shares is equal to the original exercise price, so the optionee has no opportunity to realize a gain on the unvested shares. For employee or consultant, it may be smart to take advantage of an early exercise provision.

The basic reason is that, if the company is growing, then the value of its stock will increase over the vesting period, and therefore the spread fair market value less exercise price will also increase.

Employees and consultants look to exercise early when the spread is low, that is, the fair market value of the shares is about equal to their exercise price. For early exercise, the spread could be as low as zero.

If the employee or consultant waits and the value of the company increases, then the spread will also increase. Early exercise only works if the optionee makes his or her 83 b election within 30 days of exercising the option.

If the optionee forgets to make the 83 b election which often happens , then the optionee loses most of the tax advantages mentioned above. In addition, for both employees and consultants, early exercise is a gamble that the company will increase in value.

Recent events, however, give us reason to be wary of such investment risk. So why do legal advisors have reservations about early exercise? In general, my experience has been that most companies have difficulty keeping up with the administrative burdens of even the simplest of option plans.

Final IRS Regulations Complicate Use of "Early Exercise" Incentive Stock Options | isycihe.web.fc2.com

Increasing the complexity of the option plan only increases the risk of more company slip-ups. Investment has a way of motivating people. Our view is that a win-win occurs with the early exercise opportunity.

ISO plans are all about tax breaks, and an early exercise provision substantially increases the tax benefit when compared to exercising later, when the high stock price makes the economics and tax issues very complex.

In many instances, the initial exercise price is very low and taking advantage of the early exercise provision place only a slight burden on the company as compared to the tax benefit to the employees. Whether or not to permit early exercise is obviously a complex issue. Needless to say, the company should consult its legal and tax advisors before doing anything. Matt Dickstein Business Attorney Making legal matters easy and economical for your business.

Business Law Attorney for Businesses, Corporations, LLCs. A consultant with a nonstatutory stock option NSO , upon exercising his or her option, will recognize ordinary income on the spread.

The advantage of early exercise, then, is that by exercising when the spread is minimal, the consultant recognizes a minimal amount of ordinary income. The spread is later taxed at the capital gains rates when the consultant ultimately sells the stock.

The company usually will hold unvested shares in escrow, and will release them only upon vesting. This creates more work for the HR and payroll departments.

Stock Options and the Alternative Minimum Tax (AMT)

Companies frequently forget to repurchase unvested shares upon termination of an employee or consultant. Those persons carry a grudge, and reappear later to claim their rights in the shares — especially if the company has increased in value.

Upon early exercise, each optionee becomes a shareholder and has full voting rights as a shareholder. The increase in shareholders can be inconvenient and sometimes unworkable for the company. Many optionees simply do not understand the tax implications of early exercise, for example, optionees often fail to timely make their 83 b election see above.

Option plans can be complex enough without adding early exercise. The key is to have a well-documented and well-administered plan.

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