Part 3 of the Employee Stock Options series.
Disclaimer: I have regrets. The following is for entertainment purposes only, this is what I do for fun. I am not a finance or tax professional, seek the advice of a professional for your unique situation. Ok, now read my opinions.
I remember the morning Google went public. I was home for summer break and my dad asked me if he should buy some of their stock. I said something like, “Yeah, they are the best search engine and I use them all the time.” I had no idea if they made money and had no formal idea of what good product or tech was.
Some time later, my dad asked me if I had invested in any companies lately. I said, “Yeah, Apple. They are starting to make really good computers and the iPod is great.”
My dad laughed as he usually did when I gave a hot take on a stock and I don’t think he acted on any of them. My dad was right not to invest based on a college kid’s intuition, but I wonder if he has any regrets when looking back. Of course, you can always look back and think, “If only I had bought Amazon back then!” The inverse is also true, “Argh, I shouldn’t have put all of my 401k in Pets.com!”
If you have employee stock options, you are faced with the same dilemma. There are two possible decisions and sources of regret:
Do you exercise your options at all?
- If you don’t exercise and the shares end up being worth a lot, you will regret not exercising.
- If you exercise and the shares end up being worth less than you paid for them, you will regret exercising.
If you do exercise and there’s an IPO, when do you sell your shares?
- If you sell early and the price goes up afterward, you will regret selling early.
- If you hold and the price goes down, you will regret not selling earlier.
Should you play the lottery?
This is a very personal question that depends on your appetite for risk and your confidence in success, but I’m going to give some prescriptive advice anyway.
After reading to the end, if you are unsure in any way, and you have not yet left the company, you probably should not exercise your options using your own money. That uncomfortable feeling is your aversion to risk and you should listen to it. If you are sure you want to exercise your options, then you should probably exercise as much as you can per year to avoid or reduce AMT.
When deciding whether you want to exercise your options, there are three factors to consider:
- The chances you will get your money back.
- The amount of money you are risking.
- The timing.
What are your chances to get your money back
The first factor is covered in my previous post on valuing employee stock options (lottery tickets), and it also explains how to understand this calculator that estimates your chances of getting your money back.
How much money to risk
This will depend on your chances (see above) and how much you depend on the money you currently have.
Put your money on the table and light it on fire
Every time I risk money, I use a mental exercise to calibrate my sense of risk. I imagine what my life would look like if I took the money and burned it. Imagining the money in a burning pile gives you a more tangible feeling of loss.
If your life looks very bad without the money, you should consider some alternatives.
- Exercise up to the amount of money that you feel is ok to burn.
- Burn someone else’s money.
Put someone else’s money on the table and light it on fire
By burning someone else’s money, I don’t mean to borrow from friends and family or the bank: you would still owe the money as debt or emotional baggage. There are organizations that will give you the money to exercise, risk free. That means they are putting their money on the table and potentially burning it and your financial life is unchanged. Even if the shares go to $0, you won’t owe them anything.
If this sounds too good to be true, that’s because it comes at a potentially heavy cost: they usually take a significant portion (30% or more) of any proceeds from the sale of your shares, in addition to the money they gave you. That means they get their money back first in the event of a sale, which makes sense because they risked their money, not yours. They usually ask for confidential information (growth, valuation, etc), so it’s up to you whether or not you are willing to give that info. I’ll leave the due diligence of terms and legality per your contract up to you.
I only recommend this option as a last resort, if you know you will not exercise your options either due to risk or just don’t have the money, in which case you have nothing to lose. There are a few organizations that offer similar services:
- ESO Fund (oldest fund, since 2012)
- Employee Capital Partners
- SecFi (nice tools too, but I’m wary of giving away confidential info)
- Section Partners
I know people have used these services (particularly ESO Fund) and have not heard any horror stories yet. If you have experience with these funds, I’d love to hear how it went.
Remember, only use this option as a last resort if you cannot/will not exercise any other way.
You know you want to exercise your options, when do you exercise?
You are not planning on leaving the company
You should probably exercise as early as you can using as much money as you are willing to burn. This will decrease the amount of AMT you will owe by exercising before the fair market value rises much higher than your strike price.
You are planning on leaving the company
This is a little trickier because there are many factors that come into play.
If you have not already exercised your options, ask the options plan administrator at your company how long you have to exercise after you leave. The standard is 90 days, but if they give you longer than that, you should probably take it!
Downside of a longer exercise window:
- After 90 days, your ISO are converted to NSO, which are treated like normal income when you exercise.
Benefits of a longer exercise window:
- You can wait until the the shares are liquid and you can decide if it’s worth exercising, reducing or eliminating any risk and upfront cost.
- If you don’t have the money to exercise, you will have more than 90 days to save up or find money.
If you have a standard 90 day exercise window and you will owe AMT if you exercise all your options, try timing your last day to be within 90 days of January 1st of the next year (or January 15th if you don’t want to cut it close). That way you can exercise enough options in the current year up to the point where you would owe AMT, then exercise the rest at the start of the new year. This should reduce any AMT you might owe.
You shouldn’t stay in a job you hate just to optimize for taxes. On the other hand, it might be worth staying a few extra weeks if you’re on the bubble.
You don’t know if you want to exercise your options, when should you consider exercising?
As late as you possibly can. You can either wait until you are forced to (leaving the company) or when there is a liquidation event (IPO or acquisition).
If you win the lottery, when do you cash out?
Before you win
There are markets where people will buy your lottery tickets before they are confirmed winners. These are called secondary markets, and your company must agree to you selling on these platforms. If you need the money, or are unwilling to take on the risk, it may be worth exploring EquityZen, SharesPost, or Equidate. Keep in mind that sales on secondary markets usually come with fees and a lower price than you would probably get if your company is headed for an IPO.
Take the money and run
Let’s say you exercised your options using your own or someone else’s money… and you win! Your company has an IPO and your shares are worth more than you bought them for. What do you do now?
Wealthfront has a good explanation on why the best time to sell your shares after an IPO is usually as soon as you possibly can. Their criteria for “best” is calculating the regret score of different selling strategies: “for every one of the 258 IPO stocks in our sample of tech company IPOs between 1999 and 2010, for which pricing information was available, and calculated the mean annualized regret realized for each of the 18 selling strategies.” They recommend you get out of a single stock and into a diversified portfolio which, as luck would have it, you can pay them to manage for you.
On average, selling all of your shares as soon as possible is the best way to minimize regret. But if you strongly believe in the future success of your company, you may want to keep a small number of lottery tickets.
Take the money and… buy more lottery tickets?
It’s tempting to hold on to winning lottery tickets, hoping for even more wins. Historical outcomes and averages aside, this may not be the best strategy.
Say your company’s shares are worth $101 and you bought them for $1, so you would have a profit of $100 per share. You bought 1,000 of them, so your total gain would be $100 x 1,000 = $100,000. Now, imagine instead of owning shares, you had $100,000 in cash. Would you immediately buy $100,000 worth of shares in your company?
If your answer is “no,” yet you were planning on holding the shares, you have discovered a form of cognitive dissonance (and/or cognitive bias). In both cases you are risking $100,000, yet you may feel more comfortable leaving it at risk vs putting it at risk1.
Living with regret
I have regrets. These shoes, for instance. To not have regrets is to be incredibly lucky or to avoid all risk (and never fall in love). I cited some studies on averages because statistics can reveal the best choice in the face of uncertainty, but the best choice on average can be the wrong choice for you. Don’t be afraid of a little regret and minimize big regret.
Despite the incredible complexity and risk of employee stock options, it boils down to this:
- If you believe in your company, you should probably exercise at least some of your options with your own money if you can, or other people’s money if you can’t.
- If you are unsure if you are going to exercise, wait until an IPO/acquisition if you have a longer exercise window, or use other people’s money to exercise.
- If you are able to sell your shares after exercising, you should probably sell as soon as you can (or keep a little bit if you like to gamble).