Commonly Considered Option Program Enhancements: Part II – Early Exercisable Stock Options
In the first part of this four-part series, we provided a high-level summary of basics. In this second installment, we build on those basics and begin our exploration of program “enhancements” by considering early exercisable .
An early exercisable is an that allows the holder to exercise the before it is vested. Unlike a traditional , the holder of an early exercisable does not have to earn the right to exercise an early exercisable . Rather, the holder can exercise the at any time. However, if the holder exercises the before it is vested, he or she must then earn the right to keep the shares of received upon exercise of the unvested portion of the award. Put another way, when the holder early exercises an , the holder does not receive fully vested shares of (as the holder would upon exercise of a vested ) but instead receives that is generally subject to the same vesting schedule that applied to the unvested . If the holder of the leaves the company before those shares are fully vested, the company generally has the right to repurchase any unvested shares at the same price the holder paid for them.
Intended Benefits of Early Exercising
By taking advantage of an early exercise feature, an holder generally hopes to both:
- minimize any ordinary compensation income resulting from exercise of the ; and
- start the holding period for the underlying the before the would otherwise vest.
Where the Rubber meets the Road – Consequences of Early Exercising
Though the intended benefits of early exercising sound great in theory, depending on the type of being exercised, the point in time when it is exercised, and whether or not an election under Section 83(b) of the Internal Code (a “”) is timely and properly filed, early exercising an may not necessarily achieve the intended tax beneﬁts.
Early Exercising NSOs
If the is an nonstatutory (an NSO) and a is timely and properly filed within 30 days of the date of exercise of the NSO, (i) the difference between the fair market value of the on the date of exercise and the paid (also known as the “”), if any, will be ordinary compensation income to the holder and (ii) the holding period (and, incidentally, the five-year holding period for qualified small business purposes) will begin at the time of exercise. This is really the textbook example of why an holder may want to early exercise – if the holder exercises at a time when the fair market value is equal to the , then there will be no compensation income at the time the is made and the holder will have gotten to kickstart the holding period for the shares. So long as the holder holds the shares for more than one year, any appreciation above the fair market value of the at exercise would be subject to long-term rates.
Beware, however, that if the NSO is early exercised at a time when the fair market value of the underlying is higher than the ’s (that is, when there is a ), the compensation income recognized at the time the is made will be subject to all applicable income and withholding taxes and the company will have to ensure that the holder can pay those withholding taxes. Note too that if the is forfeited, the employee will not get a credit or refund of any taxes paid as a result of making the .
Worse still, if the is not properly or timely filed, then (i) instead of having income at the time of making the election, there will be compensation income to the holder of an early exercised NSO equal to the difference between the fair market value of the on each vesting date and the purchase price (i.e., the paid) and (ii) the holding period for the shares will begin only as and when those shares vest. Again, any compensation income would be subject to all applicable income and withholding taxes (and the company must ensure that withholding can be satisfied).
Early Exercising ISOs
Perhaps one of the most significant traps of all for the unwary is that, contrary to popular belief, early exercising an incentive (an ISO) and timely filing a will not cause the holding period to begin for the shares. Rather, the holding period will begin the day after the vests. While early exercising an ISO and timely and properly filing a may have the effect of minimizing (or even eliminating if there is no at exercise) any alternative minimum tax liability, if the purpose of early exercising a is to kickstart the holding period, early exercising an ISO just doesn’t work.
It is worth noting too that if an ISO is granted with an early exercise feature, less of the may be eligible for ISO treatment (even if the is not early exercised). This is because one of the rules applicable to ISOs provides that if the shares of underlying an ISO that ﬁrst become exercisable during any year have a fair market value of more than $100,000 (determined based on the fair market value of the on the date the was granted), the excess shares of will be treated as if they were subject to an NSO. If an is early exercisable, the entire award is “ﬁrst exercisable” in the year of and therefore more of the award may exceed the annual $100,000 limit than if the were only exercisable as and when the vested over a period of several years.
- Only granting early exercisable NSOs may avoid traps for the unwary but may not be the incentive most employees want. If a start-up is asked to issue early exercisable , then, to avoid the unintended tax consequences that apply to early exercisable ISOs, it may well make sense to early exercisable NSOs. However, taking it one step further and instituting a practice of only granting NSOs with an early exercise feature (instead of ISOs without an early exercise feature) may not be as attractive to employees who do not intend to (or cannot aﬀord to) early exercise their and would otherwise hope to beneﬁt from ISO treatment. When all is said and done, employees often don’t end up taking advantage of broad-based early exercise programs because they must pay the and any associated taxes, and many are unwilling or unable to put that cash at risk or don’t have the financial wherewithal to hold illiquid indefinitely. So, if the goal is to early exercisable to attract and retain qualified employees, only granting NSOs to avoid the negative tax outcomes of granting ISOs may undermine that goal.
- A holder of is still a for all corporate law purposes. Early exercisable could increase the number of employee in the company. When an holder early exercises a , the holder receives subject to vesting but becomes a for all corporate law purposes. If the company wants to limit the number of service-provider in the company’s , that goal is undermined each time an is early exercised.
- Administration matters. Permitting to be early exercised may also add administrative burdens for the company. The company must carefully track outstanding equity awards and, following a termination of service, must aﬃrmatively act to repurchase restricted shares or the holder will retain them even after ceasing to perform services. This is distinctly different from the treatment of , which must be aﬃrmatively exercised by the holder within a limited window after ceasing to perform services to avoid the being forfeited.
When All is Said and Done
It is certainly the case that providing the ability to early exercise a may give some employees a tax advantage. And it is possible that providing that potential tax advantage could be an important recruiting tool for an early-stage company. However, the tax considerations and practical implications of granting with (or amending outstanding to add) an early exercise feature are much more complex than would appear at ﬁrst blush.
It is also possible the same goals can be achieved more simply by granting an award of from the get-go. (And if the thought of making of is not palatable, then granting with an early exercise feature may not be for the company at all.)
We touch on some of the signiﬁcant issues of early exercising in this post, but any program or practice of granting that can be early exercised (whether on a case-by-case or across the board) should be carefully reviewed with tax counsel. Watch for part three of this four-part series in which we discuss the pros and cons of granting with extended post-termination exercise periods.