Early exercise stock options accounting

Employee Stock Options: Early Or Premature Exercise.

As a way to reduce risk and lock in gains, early or premature exercise of Employee Stock Options (ESOs) must be carefully considered, since there is a large potential tax hit and big opportunity cost in the form of forfeited time value. In this section, we discuss the process of early exercise and explain financial objectives and risks.

When an ESO is granted, it has a hypothetical value that – because it an at-the-money option – is pure time value. This time value decays at a rate known as theta (Related: Using the “Greeks” to understand options), which is a square root function of time remaining.

Assume you hold ESOs that are worth $35,000 upon grant, as discussed in the earlier sections. You believe in the long-term prospects of your company and plan to hold your ESOs until expiration. Figure 3 shows the value composition – intrinsic value plus time value – for ITM, ATM and OTM options.

Even if you begin to gain intrinsic value as the price of the underlying stock rises, you will be shedding time value along the way (although not proportionately). For example, for an in-the-money ESO with a $50 exercise price and a stock price of $75, there will be less time value and more intrinsic value, for more value overall (top bars in Figure 3). (Related: The Importance Of Time Value In Options Trading)

The out-of-the-money options (bottom set of bars) show only pure time value of $17,500, while the at-the-money options have time value of $35,000. The further out of the money that an option is, the less time value it has, because the odds of it becoming profitable are increasingly slim. As an option gets more in the money and acquires more intrinsic value, this forms a greater proportion of the total option value. In fact for deeply in-the-money option, time value is an insignificant component of its value, compared with intrinsic value. When intrinsic value becomes value at risk, many option holders look to lock in this all or part of this gain, but in doing so, they not only give up time value but also incur a hefty tax bill.

Tax Liabilities for ESOs.

We cannot emphasize this point enough – the biggest downsides of premature exercise are the big tax event it induces, and the loss of time value. You are taxed at ordinary income tax rates on the ESO spread or intrinsic value gain, at rates as high as 40%. What’s more, it is all due in the same tax year and paid upon exercise, with another likely tax hit at the sale or disposition of the acquired stock. Even if you have capital losses elsewhere in your portfolio, you can only apply $3,000 per year of these losses against your compensation gains to offset the tax liability.

After you have acquired stock that presumably has appreciated in value, you are faced with the choice of liquidating the stock or holding it. If you sell immediately upon exercise, you have locked in your compensation “gains” (the difference between the exercise price and stock market price).

But if you hold the stock, and then sell later on after it appreciates, you may more taxes to pay. Remember that the stock price on the day you exercised your ESOs is now your “basis price.” If you sell the stock less than a year after exercise, you will have to pay short-term capital gains tax. To get the lower, long-term capital gains rate, you would have to hold the shares for more than a year. You thus end up paying two taxes – compensation and capital gains.

An Example.

Many ESO holders may also find themselves in the unfortunate position of holding on to shares that reverse their initial gains after exercise, as the following example demonstrates. Let’s say you have ESOs that give you the right to buy 1,000 shares at $50, and the stock is trading at $75 with five more years to expiration. As you are worried about the market outlook or the company’s prospects, you exercise your ESOs to lock in the spread of $25.

You now decide to sell one-half your holdings (of 1,000 shares) and keep the other half for potential future gains. Here’s how the math stacks up –

Exercised at $75 and paid compensation tax on the full spread of $25 x 1,000 shares 40% = $10,000. Sold 500 shares at $75 for a gain of $12,500. Your after-tax gains at this point = $12,500 – $10,000 = $2,500 You are now holding 500 shares with a basis price of $75, with $12,500 in unrealized gains (but already tax paid for). Let’s assume the stock now declines to $50 before year-end. Your holding of 500 shares has now lost $25 per share or $12,500, since you acquired the shares through exercise (and already paid tax at $75). If you now sell these 500 shares at $50, you can only apply $3,000 of these losses in the same tax year, with the rest to be applied in future years with the same limit. To summarize: You paid $10,000 in compensation tax at exercise Locked in $2,500 in after-tax gains on 500 shares Broke even on 500 shares, but have losses of $12,500 that you can write off per year by $3,000.

Note that this does not count the time value lost from early exercise, which could be quite significant with five years left for expiration. Having sold your holdings, you also no longer have the potential to gain from an upward move in the stock.

That said, while it seldom makes sense to exercise listed options early, the non-tradable nature and other limitations of ESOs may make their early exercise necessary in the following situations –

Need for cashflow : Oftentimes, the need for immediate cashflow may offset the opportunity cost of time value lost and justify the tax impact. Portfolio diversification : As mentioned earlier, an overly concentrated position in the company’s stock would necessitate early exercise and liquidation in order to achieve portfolio diversification. Stock or market outlook : Rather than see all gains dissipate and turn into losses on account of a deteriorating outlook for the stock or equity market in general, it may be preferable to lock in gains through early exercise. Delivery for a hedging strategy : Writing calls to gain premium income may require the delivery of stock (discussed in next section).

ESOs: Accounting For Employee Stock Options.

Relevance above Reliability.

We will not revisit the heated debate over whether companies should "expense" employee stock options. However, we should establish two things. First, the experts at the Financial Accounting Standards Board (FASB) have wanted to require options expensing since around the early 1990s. Despite political pressure, expensing became more or less inevitable when the International Accounting Board (IASB) required it because of the deliberate push for convergence between U. S. and international accounting standards. (For related reading, see The Controversy Over Option Expensing .)

As of March 2004, the current rule (FAS 123) requires "disclosure but not recognition". This means that options cost estimates must be disclosed as a footnote, but they do not have to be recognized as an expense on the income statement, where they would reduce reported profit (earnings or net income). This means that most companies actually report four earnings per share (EPS) numbers - unless they voluntarily elect to recognize options as hundreds have already done:

2. Pro Forma Diluted EPS.

A key challenge in computing EPS is potential dilution. Specifically, what do we do with outstanding but un-exercised options, "old" options granted in previous years that can easily be converted into common shares at any time? (This applies to not only stock options, but also convertible debt and some derivatives.) Diluted EPS tries to capture this potential dilution by use of the treasury-stock method illustrated below. Our hypothetical company has 100,000 common shares outstanding, but also has 10,000 outstanding options that are all in the money. That is, they were granted with a $7 exercise price but the stock has since risen to $20:

Basic EPS (net income / common shares) is simple: $300,000 / 100,000 = $3 per share. Diluted EPS uses the treasury-stock method to answer the following question: hypothetically, how many common shares would be outstanding if all in-the-money options were exercised today? In the example discussed above, the exercise alone would add 10,000 common shares to the base. However, the simulated exercise would provide the company with extra cash: exercise proceeds of $7 per option, plus a tax benefit. The tax benefit is real cash because the company gets to reduce its taxable income by the options gain - in this case, $13 per option exercised. Why? Because the IRS is going to collect taxes from the options holders who will pay ordinary income tax on the same gain. (Please note the tax benefit refers to non-qualified stock options. So-called incentive stock options (ISOs) may not be tax deductible for the company, but fewer than 20% of options granted are ISOs.)

Pro Forma EPS Captures the "New" Options Granted During the Year.

First, we can see that we still have common shares and diluted shares, where diluted shares simulate the exercise of previously granted options. Second, we have further assumed that 5,000 options have been granted in the current year. Let's assume our model estimates that they are worth 40% of the $20 stock price, or $8 per option. The total expense is therefore $40,000. Third, since our options happen to cliff vest in four years, we will amortize the expense over the next four years. This is accounting's matching principle in action: the idea is that our employee will be providing services over the vesting period, so the expense can be spread over that period. (Although we have not illustrated it, companies are allowed to reduce the expense in anticipation of option forfeitures due to employee terminations. For example, a company could predict that 20% of options granted will be forfeited and reduce the expense accordingly.)

Our current annual expense for the options grant is $10,000, the first 25% of the $40,000 expense. Our adjusted net income is therefore $290,000. We divide this into both common shares and diluted shares to produce the second set of pro forma EPS numbers. These must be disclosed in a footnote, and will very likely require recognition (in the body of the income statement) for fiscal years that start after Dec 15, 2004.

There is a technicality that deserves some mention: we used the same diluted share base for both diluted EPS calculations (reported diluted EPS and pro forma diluted EPS). Technically, under pro forma diluted ESP (item iv on the above financial report), the share base is further increased by the number of shares that could be purchased with the "un-amortized compensation expense" (that is, in addition to exercise proceeds and the tax benefit). Therefore, in the first year, as only $10,000 of the $40,000 option expense has been charged, the other $30,000 hypothetically could repurchase an additional 1,500 shares ($30,000 / $20). This - in the first year - produces a total number of diluted shares of 105,400 and diluted EPS of $2.75. But in the forth year, all else being equal, the $2.79 above would be correct as we would have already finished expensing the $40,000. Remember, this only applies to the pro forma diluted EPS where we are expensing options in the numerator!

Expensing options is merely a best-efforts attempt to estimate options cost. Proponents are right to say that options are a cost, and counting something is better than counting nothing. But they cannot claim expense estimates are accurate. Consider our company above. What if the stock dove to $6 next year and stayed there? Then the options would be entirely worthless, and our expense estimates would turn out to be significantly overstated while our EPS would be understated. Conversely, if the stock did better than expected, our EPS numbers would've been overstated because our expense would've turned out to be understated.

Should a company allow early exercise of stock options?

Some companies allow employees to exercise their unvested stock options, or “early exercise.” Once purchased, the unvested stock is subject to a right of repurchase by the company upon termination of services. The repurchase price is the exercise price of the option. Please note that a stock option is typically not early exercisable unless the board of directors of the company approves an option grant as early exercisable and the company issues the stock option pursuant to an option agreement that permits early exercise.

Allowing early exercise of unvested shares can provide employees with a potential tax advantage by allowing the employee to start their long-term capital gains holding period with respect to all of their shares and minimize the potential for alternative minimum tax (AMT) liability. If an employee knows that he/she will early exercise a stock option immediately upon the grant of an option (when there is no difference between the exercise price and the fair market value of the common stock), the employee typically should want an NSO as opposed to an ISO, because long-term capital gain treatment for stock issued upon exercise of an NSO occurs after one year. In contrast, shares issued upon exercise of an ISO must be held for more than one year after the date of exercise and more than two years after the date of grant, in order to qualify for favorable tax treatment.

There are several disadvantages to allowing early exercise, however, including:

Risk to employee . By exercising a stock purchase right or immediately exercisable option the employee is taking the risk that the value of the stock may decrease. In other words, the exercising employee places his or her own capital (the money used to purchase the stock) at risk. Even if a promissory note is used to purchase the stock (future post to come), the note must be full recourse for the IRS to respect the purchase. In addition, if the employee purchases the shares with a promissory note, the note will continue to accrue interest until it is repaid, and a market rate of interest must be paid in order to satisfy accounting requirements. Depending on the number of shares purchased, the expected tax benefit from early exercise may not justify these increased risks to the stockholder. Tax upon spread. If there is a “spread” at the time of exercise, the employee will trigger ordinary income (in the case of an NSO exercise equal to the difference between the exercise price and fair market value of the common stock on the date of exercise) and may trigger AMT liability (in the case of an ISO exercise, with the difference between the exercise price and fair market value of the common stock on the date of exercise being an AMT preference item). Any taxes paid will not be refunded if unvested shares are later repurchased at cost. (Please see the post “What’s the difference between an ISO and an NSO?” for a summary of the tax implications of exercising an ISO or an NSO.) “Back door” public company . Allowing employees to early exercise may increase the number of stockholders. If the company ever reaches 500 stockholders, Section12(g) of the Securities Exchange Act of 1934 will require the company to register as a publicly reporting company. Securities law issues upon a sale . If the company has more than 35 unaccredited stockholders at a time when it has agreed to be acquired in a stock for stock transaction, the acquisition will likely be more complex and take longer to complete. Administrative hassles . A significant increase in the number of stockholders can place a tremendous administrative burden on the company. This is especially true when employees purchase shares subject to repurchase and when they purchase shares with promissory notes. The forms that the employee must complete and sign are much longer and more complicated. 83(b) elections must be filed with the IRS within 30 days of the purchase. Stock certificates for unvested shares must be kept by the company so that they can be easily repurchased if the employee leaves the company, which increases the risk that the stock certificates are lost or misplaced. Interest on promissory notes must be tracked. Stockholder rights . Optionees have no rights as stockholders until they exercise their stock options. If optionees exercise stock options, whether vested or unvested, they have the same voting rights as any other stockholder. Certain actions, such as amendment of the certificate of incorporation, which typically occurs in connection with every venture financing, require stockholder approval. This requires certain information to be provided to the stockholder in order to make an informed decision. Stockholders also have more statutory rights than optionees, including inspection rights. Stockholder information requirements may also be triggered under Rule 701.

Some suggestions for clarification:

* Tax upon spread: Is there ordinary income taxation in the case of an ISO? Is there AMT liability in the case of an NSO?

* “Back door” public company: How does this effect my decision to exercise my shares early in either the NSO or ISO case? How does this effect the company's decision to offer early exercise in either the NSO or ISO case?

* Administrative hassles: What do you mean by “unvested shares must be kept by the company”? Do holders of exercised but unvested stock also have more voting rights than holders of unexercised but vested options? Does exercised but unvested stock have the same voting rights as exercised vested stock?

Nivi – Thanks for the feedback. I've tried to deal with most of the suggestions with changes in the text of the post. With respect to the “back door” public company issue, this is a company issue and is not relevant to the individual employee's decision to exercise.

As a startup employee, founder, two time acquisitionee.. these points, especially for a startup, lie somewhere between inconsequential and false.

For startups, providing early-exercise weakens employee retention. Thus, the biggest reason not to offer it is to increase retention.

Consider an employee who joins a startup when early-exercising their shares costs $200. Five years later, their shares are valued at $800,000+ but still illiquid. The spread at this later point creates an inconvenient situation for the employee, where exercising them may have expensive tax consequences even though the shares can not be sold to produce profit. The employee has become an indentured servant. It's not a reasonable financial choice to leave and give up the profit, but it's also not necessarily possible for them to afford purchasing the shares and pay the taxes. They are stuck, with no leverage, and no information about when the shares may be liquid and able to be sold. The company is happy, because the employee has the greatest incentive to stay with the company.

Let's talk about how the article misrepresents some of the points.

Risk to employee. ALLOWING early exercise does not create risk to the employee. The only risk is created when the employee actually decides to early exercise. Allowing it simply creates more flexibility for the employee. Further, early-exercise minimizes risk to the employee by allowing them to exercise the stock at the lowest possible price. Even without early exercise, the employee is free to exercise option as they vest. At that point, the exercise creates increased risk, in the form of tax upon spread.

Tax upon spread. If tax upon spread is bad, then early exercise is good. There are only two times a stock has no tax-spread-risk. At the beginning, when the purchase price is the same as the value, as in an early-exercise; and at the end, during a same-day sale when the stock is liquid. All the time in the middle involves spreads which are potentially dangerous for the employee from a tax perspective. More importantly, these tax consequences don't effect the company at all.

“Back door” public company. Disallowing early exercise does not disallow exercise. In order for preventing early exercise to be an effective means to stave off being forced to file public financial reports, employees must choose not to exercise options as they vest. The primary reason they would avoid exercising as they vest is the increased risk or tax-on-spread risk. These reasons put them further and further into indentured servitude, but don't reliably help the company prevent being forced to file public financial reports. If this is the company goal, a better means would be avoiding employee ownership of either stock or options. This issue is only applicable to startups, as large public companies are already filing publicly.

Securities law issues upon a sale. This is a red herring. This is not a real reason that acquisitions don't complete, or even the major issue in legal bills or costs in handling an acquisition. It simply doesn't matter.

Administrative hassles. Again, red herring. This is not a significant burden or cost. Startups can offer early exercise with ease. As employee count grows, it's true the administrative burden grows. However, there are much larger risks in a company than this minor clerical issue. Stock certificates? They don't need to be issued at all in private companies. It can simply be a paper or electronic ledger. Some of these points seem relevant if we were talking about a large public company, but we were not just talking about preventing 'back door' public financial filings?

Stockholder rights. Again, false and red herring. Every venture financing does not require amendment of the certificate of incorporation. At least not if the incorporating lawyers did their job correctly. Further, incorporation bylaws don't need to require minor shareholders to 'vote' to approve a financing event as long as they receive a majority of votes in support. This is simply a non-issue for financing.

Spread is a reason to allow early-exercise not disallow it. The minimum spread occurs when the options are originally issued, which requires early-exercise to take advantage of. Without early-exercise, an employee is forced to wait until.

Thanks for taking the time to comment.

Risk to employee. The point here is that when exercise prices become non-trivial (i. e. the cost of a new car), early-exercise no longer seems like a good idea.

Tax upon spread. Employees often do not early exercise their shares until they have been at the company for some period of time (and realize whether the risk to purchasing the shares is warranted). In that situation, there may be spread.

“Back door” public company. You're right, employees can always exercise their vested shares. The point is where a company sets up a culture of early exercise, things get dicey with the '34 Act.

Securities law issues. Having to do a CA fairness hearing or an S-4 will add at least a month and a half of time until closing and I'd guess about $75K in extra legal/accounting fees for a fairness hearing and significantly more for an S-4.

Administrative hassles. Almost all venture backed private companies issue stock certificates. They have a tendency to get lost, which is a pain to deal with.

Stockholder rights. You're flat out wrong here. The certificate of incorporation needs to be amended to create the new series of preferred stock in a typical venture financing. Stockholders of the company need to approve an amendment — and even if all stockholders are not solicited if their votes are not needed, they need to be give notice of the action (at least post-facto). There is always a sensitivity to sending out notices/info to employee stockholders.

Administrative hassles: What do you mean by “unvested shares must be kept by the company”? Do holders of exercised but unvested stock also have more voting rights than holders of unexercised but vested options? Does exercised but unvested stock have the same voting rights as exercised vested stock?

Pre-IPO: Early-Exercise Options.

Some companies grant stock options that are immediately exercisable, but you receive shares that still need to vest before you own them outright. Until then, the stock is still subject to a repurchase right if your employment ends before vesting. Check your grant agreement for whether your options are immediately exercisable at grant before vesting, and check the repurchase details. At some companies this is called a restricted stock purchase plan or early-exercise stock options .

Early-exercise options with a repurchase right let employees who wish to make an early investment decision about the company start their capital gains holding period sooner. If you hold the stock, not just the options, for at least 12 months, you will pay lower taxes on the later sale. In a private company, the downside is that the shares have no liquidity (i. e. are not tradable even when vested). You may be holding the shares for an indefinite period until any IPO or acquisition or until the shares become worthless.

When the spread is zero or negligible, early exercise also minimizes the chance of any alternative minimum tax on ISOs, and ordinary income for NQSOs on the spread at exercise. The plan needs to allow you to exercise your options immediately into stock, which the company can buy back at your exercise price (or another price your plan specifies) if you leave within the original vesting period. See, for example, Uber's Notice of Stock Option Grant (filed as an exhibit in a lawsuit), which makes all options exercisable six months after grant.

What Happens At Early Exercise.

At exercise, you have essentially purchased restricted stock. (This should not be confused with an acquisition of restricted securities which, under the securities laws, cannot be immediately resold. For more on the difference, see a related FAQ.) You should make a Section 83(b) election and file it within 30 days of exercise with the Internal Revenue Service and with your next tax return.

Alert: In this situation, you make a Section 83(b) election even when you have paid the fair market value for the restricted stock and there is no discount or spread. You report that you have zero income for the value of the property received. Otherwise, you will owe ordinary income later on the stock's appreciation in value between purchase and vesting (see the case Alves v. IRS Commissioner , decided in 1984).

Tax Treatment For Early Exercise.

The election essentially says that you agree to recognize as ordinary income for NQSOs, and as an AMT item for ISOs, any spread between the stock's fair market value and your exercise price. In this way, the future appreciation on the NQSO stock can be taxed at favorable long-term capital gains rates at the sale of the underlying stock. Without the timely Section 83(b) filing at exercise, you recognize the income on the spread at vesting for both ISOs and NQSOs.

As explained in another FAQ, the ISO taxation is more complex for early-exercise options with an 83(b) election. For this special type of ISO, the one-year ISO holding period begins at exercise. But in a sale before the ISO holding periods are met (i. e. disqualifying disposition in a sale within two years from grant), the ordinary income is the lower of either the spread at vesting (remainder is capital gain) or the actual sale gain.

Status Of Your Shares After Exercise.

The period for the company's repurchase right is similar to the cliff or graduated vesting schedules for traditional stock options. In exchange for the potentially lower tax on sale of the stock, you do commit money to your company's stock earlier. Although the unvested shares you receive upon purchase/exercise may be held in an escrow account until they vest, they are outstanding shares that confer voting rights and eligibility for dividends. Occasionally, when permitted by law, companies offer loans to employees to encourage this early exercise.

Alert: You do not need to make this filing for standard stock options that you can exercise only after vesting. The stock you receive at the exercise of vested stock options is not subject to a substantial risk of forfeiture that triggers the ability and need to make a Section 83(b) election.