|February 16th, 2017|
|money, startup, taxes|
Update 2017-03-07: Ben Kuhn has a much better post, Stock options are really complicated. Go read that instead.
Update 2017-02-17: The modelling in this post is wrong to the point of not being useful. I had thought that the reason to exercise early was to get capital gains treatment on options, but ISOs already have this if you're careful with them. The reason to exercise early is the alternative minumum tax.
I recently started at a startup, and as is typical part of my compensation is in the form of stock options vesting over four years. I have two choices about how to handle this:
The default option is to do nothing. When I want to sell, I pay the strike price to convert the options into stock ("exercise them"), and pay taxes on their growth.
Alternately I pay the strike price now to convert the options into stock (even thought they haven't vested yet) and file an 83b election. When I want to sell, I pay taxes on their growth.
On the other hand, the company might not succeed. Then I'll have paid thousands of dollars to buy shares that aren't worth anything. Or I might leave the company before four years have passed, giving up thousands of dollars of stock that I've paid for but hasn't vested. I don't expect either of these to happen, but the outside view suggests something like a 50% chance.
So, what does this look like financially? Let's say there's a 25% chance of the company doing really well and exiting for $1B in five years, a 25% chance of $300M, and a 50% chance of failure. How much money do I have in five years?
Early exercise: I pay $25k in strike price now, which if borrowed at 5% is comparable to $30k five years out. In five years I have a 25% chance of my stock being worth $1.5M, a 25% chance of it being worth $0.5M, and a 50% chance of it being worth $0. IRS says I have long term capital gains of $475k, I pay $95k in taxes. After taxes I have $375k.
Default: I do nothing now. If the company fails I also do nothing. If it succeeds, five years from now I pay the $25k strike price, immediately sell the stock, and have regular income of $975 taxed at 35%. After taxes I have (50%) $0 or ($50%) $634k, which is $317k.
So, with that model I should early-exerise. But this ignores donations! Donations do two things:
If I early exercise, I would be donating appreciated stock, which has very good tax treatment. I donate the stock, but don't ever pay tax on it. Additionally, I can deduct it from my federal income taxes (up to 30% of AGI). So if I slowly donated off the stock, taking a deduction as I went, I not only wouldn't ever pay tax on the gains, but I would reduce my regular taxes. This is complicated and extends the time horizon, so I'm just going to model this as if I donate all the stock. So I donate (50%) $0 or (50%) $1M, which after accounting for the strike price with interest is $470k.
If I do nothing, then if the company succeeds I'm donating some of the proceeds and so not taxed on them. I take in $975k, donate 50%, so $488k, pay 35% taxes on the rest leaving me with $316k. Ignoring the donated-kept distinction, and accounting for the strike price, this is $779. So this is either (50%) $0 or (50%) $779k, which is $390k.
Ignoring donations, I come out ahead by $58k by early exercising, while counting donations I'm ahead by $80k.
Of course, the real tricky part here is the model of how much the company is going to be worth. The company might be more likely than 50% to fail, but it also might be worth as much as, say, Western Union, at $10B. I'm not great at handling tax details, but I'm really not good at valuing companies! Not early exercising is in some sense the 'safer' choice, but of course so would have been staying at Google.
 The options have a ten-year exercise period, so there's nothing that would push me to exercise the options without immediately selling them.