Early Exercise for your Company’s Stock Option Plan

I’m often asked if an early exercise provision should be included in a company's stock option plan.  Many tax advisors recommend an early exercise provision.  Many legal advisors are against it.  My experience has led me to this conclusion: early exercise can be valuable to a company’s optionees, but usually only at the very early stage of a start up.

What is Early Exercise? An early exercise provision works as follows. Let's say a key employee or consultant is granted 100,000 options with an exercise price of $1 per share, vesting 25% at the end of each year for 4 years.  An early exercise provision in the option plan would allow the optionee to buy all 100,000 shares immediately, even though the optionee will only vest in 25,000 shares per year. 

The company retains the right to repurchase the optionee’s unvested shares pursuant to the optionee’s vesting schedule. Usually the company will repurchase shares if the optionee severs his or her relationship with the company before the shares vest.  This means that, by the prior example, the company could repurchase 100% of the stock if the relationship ends before the end of year 1, 75% before the end of year 2, and so on. 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.

Employee or Consultant’s Perspective.  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.

• For an employee with an incentive stock option (ISO), to exercise early when the spread is minimal can reduce the employee's exposure to the alternative minimum tax (AMT).  If the employee exercises the option after the stock goes public (we should all be so lucky) the spread will have gone sky high and the employee’s AMT may be a significant tax burden.

• 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.

But be Careful.  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. At initial startup, there is a better chance of success, because then the company’s value is minimal.  Recent events, however, give us reason to be wary of such investment risk.

The Company’s Perspective.  So why do legal advisors have reservations about early exercise?  Because early exercise adds complexity to the company’s stock option plan and increases the company’s administrative burdens.  In general, my experience has been that most companies have difficulty keeping up with the administrative burdens of even the simplest of option plans.  Increasing the complexity of the option plan only increases the risk of more company slip-ups.

• 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.

• 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.

If an employee wants to take advantage of early exercise, it seems logical that with their own money at stake, there's more of a commitment.  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.

Conclusion.  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.

Call me to schedule a legal consultation: 510-796-9144