When Should You Not Exercise Your Options?
Jun 26th, 2019
This guest post was written by our friends at Harness Wealth. See below for more info.
In many cases, stock options are valuable because they allow employees to acquire equity in a company at a lower price than a previous financing round. In hit cases like Google, Amazon, or Zoom, employees were able to acquire shares and see a big pay day. There are situations, though, where not exercising stock options may make sense for an individual. Primarily, as the name implies, stock options give employees optionality, and unless the options are expiring, it may be prudent to hold off on exercising to maximize value and reduce risk. Below are some situations that demonstrate the value of not exercising options.
1) When you can’t afford to exercise your options
Exercising stock options costs money, albeit at a price point potentially lower than a future equity raise or public offering price. If you can’t afford to buy the shares, it may be best to hold off. Borrowing money—in other words, leveraging your assets—can significantly increase the cost and the risks of exercising your options. In the event the value of your company’s shares decreases, you will still be contractually obligated to pay the loan interest and loan principal. If you’re unable to, you may be required to forfeit the shares to the loan holder or liquidate other assets to repay the loan.
Additionally, there are a number of tax implications regarding exercising options. For a deeper dive into the potential tax implications of exercising stock options, check out Tax Reform: What it Means for Your Startup Equity (Part I) and (Part II).
2) Limitations on selling shares post-exercise
Companies have different policies regarding equity ownership for employees and non-employees. Oftentimes, employees have strict restrictions on the sale of their equity, either requiring them to hold the shares for a certain period before they’re eligible to sell or only allowing the sale of part of their equity.
Prior to exercising options, inquire about your company’s policies regarding the sale of equity. If you exercise your options and aren’t allowed to sell enough to at least cover the purchase price, commissions and fees, you’re taking on a risk. You’ll be stuck with the stock, which could decline, and your investment could lose substantial value.
3) The importance of portfolio diversification
Portfolio diversification is an important strategy that aims to minimize risk and maximize returns by balancing the various risk profiles of various investments. Purchasing equity in a startup through stock options is one part of your investment portfolio, and, as a result, you should balance your portfolio accordingly. You don’t want the success of your entire portfolio to depend upon your company doing well. If you exercise your options and don’t sell your stock immediately, you could end up with your whole portfolio riding on the stock price going up. If things go poorly, this could mean you end up out of a job and your investments tank at the same time– which is hardly a good position to be in.
You can avoid this by selling at least some of the shares you exercise right away – but only if you’re allowed to do so and can afford to sell and make enough of a profit to pay any capital gains taxes and other taxes you’ll owe.
As such, your risk appetite and desired portfolio diversification may warrant holding off on exercising options granted by your startup.
4) Stock option and equity value is dependent on the success of the company
It’s important to keep in mind that the value of stock options and equity are wholly dependent on the success of the startup. As noted above, in ultra success stories like Google and Amazon, employees were handsomely rewarded for buying into the company. In reality, not all startups are Cinderella stories. By exercising stock options, you are betting on the company having a successful exit, either through an IPO or acquisition, but in the case where the company folds, the equity value goes to zero along with your investment. As a result, it can be prudent to wait until the startup has proven itself and has a clear path to an exit.
This is also dependent on your ability to sell your stock shares after exercising. If you can’t, and you think the price of shares will fall, it would make no sense to exercise your options and pay a lot of money for an investment you believe will lose value.
5) Talk to a Financial or Tax Advisor
Consult with a financial and/or tax advisor to discuss the best course of action regarding your stock options. A financial advisor can help you understand the risks and benefits of exercising stock options in the context of your financial situation, risk profile, and long-term plans. Additionally, a tax advisor can help you understand the tax implications regarding your financial decisions.
This post was sponsored by Harness Wealth. Harness Wealth is dedicated to helping clients unlock financial opportunity to achieve their best financial future through a holistic and personalized approach. They provide a unified data platform that enables clients to manage their financial picture. Harness then pairs clients with a highly curated set of top tax, financial and legal advisers, and power those ongoing relationship with their proprietary technology.
Note: EquityZen is not tax or financial advisors or professionals. Please consult financial and tax professionals prior to making any investment decisions, including whether to exercise options.