Early- to mid-stage startup employees are vesting Incentive Stock Options (ISOs) but often struggle deciding what to do with their options. Uncertainty around time horizon for liquidity and the future value of any exercised shares often causes people not to exercise.
When a startup runs a Tender Offer, employees have the right to sell a specified percent of their vested stock at a set price by a stated date. Although this provides the certainty to cash out of otherwise illiquid private stock, most employees who participate with unexercised ISOs do not optimize their participation.
We get a lot of questions about whether it is smart to participate in a Tender and if so, what is the best strategy. So, this essay is a case study to help you make the most of your Tender Offer liquidity with ISOs.
Your ISOs & Tender Offer
To make this case study applicable, we need to be on the same page with terminology and set the hypothetical numbers this essay is built on.
Stock options are simply the right to purchase shares of company stock at a set price on a future date. Here are the important terms you’ll see throughout:
- Grant Date: Date the equity offer is implemented after signing the Option Agreement.
- Exercise Price: The fixed price at which one can exercise the right to buy a share of the company until the option expires - also called strike price or grant price.
- Vest Date: The date a chunk of options becomes exercisable.
- Exercise: The purchase of shares, triggering a taxable event that also begins the long-term capital gains clock. Exercised shares are owned and receive voting rights.
- Expiration Date: The last day one can elect to exercise their right to purchase an option.
Let’s assume your ISO grants have a 4-year vesting schedule, so all the new hire grant has vested, 75% of the next grant has vested, and 25% of the most recent grant has vested.
Your company does a Tender Offer allowing you to sell up to 20% of your vested stock (23,750 shares) at $16 per share. At the time of the Offer, the company’s 409A Valuation is $8. This is great news because an independent third party determined the company stock to be worth $8 but a buyer (investors or the company) is willing to pay $16.
Tendering Your ISOs
At a high level, this means you can exercise your right to buy shares for $1, $2, or $5 and then immediately sell them for $16!
As exciting as this Tender Offer is, not holding the ISOs for at least 12 months from exercise date and 24 months from grant date means the sale is considered a “disqualifying disposition”. When ISOs are sold in a disqualifying disposition the spread (difference between the sale price and the purchase price) is taxed at ordinary income rates. So, depending on which grant you sell from, you will increase your income by $15, $14, or $11 per share.
Without exercised options, you have two choices to participate.
- Send the custodian enough cash to cover the cost to exercise options and then subsequently sell the held shares in the Tender.
- Electing a “cashless exercise” by exercising and selling at the same time. Simultaneously doing both covers the cost to exercise with proceeds from the sale of the stock.
Irrespective of which path you choose, the tax implications are the same. Unfortunately, deciding whether to pay the exercise price and then sell or elect a cashless exercise is where the strategy ends. The rest of this essay walks through a framework that is designed to help clients optimize their Tender Offer, which will vary based on an individual’s specific needs and priorities.
Your Tender Framework
No decision should be made in isolation, which is why participating in a Tender should begin with how much liquidity you want and need.
1. Ballpark your target liquidity.
What will the additional liquidity do for you? By nature, access to liquidity of private company stock is not common. When the sale price is significantly above the exercise price, it could be worth capturing those gains to use the net proceeds for other goals. The downside, beyond paying tax at ordinary income rates, is that selling shares reduces the number of shares that can participate in future appreciation assuming the price continues to increase.
It’s important to ballpark your net liquidity figure in this step because fully optimizing the Tender gets into a bit of an if-then loop, and the clarity this process provides will influence your decisions.
2. Think about which shares to exercise and sell.
Because the spread on any disqualifying dispositions is taxed at ordinary income rates, the grants from which you choose to sell will determine the tax you pay for liquidity. To illustrate the impact of each decision, we’re using numbers from tax projections we ran in our tax software specifically for this case study. Let’s assume:
You are single, your $150,000 salary is your only taxable income, and you take the standard deduction. We will ignore state tax for simplicity.
Before participating in the Tender Offer your Federal tax obligation for 2020 is $27,247. To get a feel for the implications of participating relative to the baseline, here are illustrations for selling 20%, 10%, and 5% of vested shares beginning with the oldest grants and then beginning with the newest grants.
The Net Proceeds in each iteration are the Gross Proceeds reduced by the Cost of Exercise and the Additional Tax from Sale. Because the oldest shares have an exercise price of $1, the cost to exercise is low and the spread (Taxable Income from Sale) is high. But if we consider selling the newest grants first, the Net Proceeds changes significantly.
Although the Gross Proceeds don’t change, the higher exercise price on the newest grants cost more than the tax savings from a lower spread (sale price minus exercise price). This is because exercise cost is dollar for dollar and spread is taxed at a rate lower than 100%. It’s also important to note that because the newest grant only has 11,250 vested shares, the 10% and 20% scenario exercise and sell from the grant with the $2 exercise price as well.
You’ve made it far enough to participate in the Tender while optimizing for proceeds net-of-tax. However, stopping here would still fall short of a full optimization.
How many of your unsold and unexercised ISOs do you want to exercise?
3. Consider tender proceeds to exercise & hold ISOs.
Remember how the spread on the sale was a disqualifying disposition resulting in ordinary income tax? The only way to have a “qualifying disposition” and pay tax on the spread at the lower, capital gains rates is to meet the 24-month and 12-month thresholds mentioned earlier. To do this, you must exercise shares!
The decision to exercise and hold ISOs comes down to three main factors.
Investment Risk on an ISO exercise is the total cost – exercise price plus any tax due on the spread. Not immediately selling means you could pay for something that eventually becomes worth less than what you paid. You should also consider the risk you’re comfortable taking on given how much cash you have on the sidelines, your existing concentrated stock risk, and your ability to manage your cash flow.
Expiration Date on the ISOs is also important. Within the context of how much investment risk you’re willing to take on, it’s important to understand how many shares will expire before they can be exercised. Usually the earliest grants will expire first, so not acting on those first will increase the odds of expiring options. Because option grants are a major aspect of startup job offers, allowing options to expire forgoes that aspect of your total comp package.
Tax Implications of the exercise are the trickiest of these factors. The exercise and hold strategy does not necessarily increase tax due in the year of exercise. The spread on ISOs when exercised and held feeds into the Alternative Minimum Tax (AMT) calculation instead of the normal tax calculation like a disqualifying disposition.
AMT is a separate tax calculation that parallels the usual tax calculation to ensure high income earners are not using advanced tax strategies to avoid paying their share of tax. If the tax calculation shows an AMT liability of $10,000 more than the traditional tax calculation, then one must pay the traditional tax amount plus $10,000 of Alternative Minimum Tax. Similarly, the higher the ordinary income tax due, the less likely it is that one will trigger paying any AMT at all.
Another caveat is the AMT spread on an ISO exercise is the difference between the 409A ($8) and the exercise price, not the difference between the Tender price ($16) and the exercise price, because the shares are not being sold!
Understanding the principles of the exercise and hold strategy sets the stage for the final optimization of participating in a Tender Offer.
4. Determine which shares should be exercised & held.
Because the AMT bill is a function of the standard tax calculation, different levels of taxable income have different limits before AMT is triggered. Now we re-integrate illustrations from Step 2 with the tax impact of selling different amounts of shares based on whether the oldest or newest grants were sold. Knowing the tax implications in each scenario we can solve for the “AMT Spread” or how many shares can be exercised and held without paying AMT.
Finally, the choice architecture can be narrowed to 2 main approaches – Minimizing Investment Risk or Maximizing Spread.
Minimizing Investment Risk
Minimizing Investment Risk requires exercising and holding ISOs with the lowest exercise price.
Because there are enough unsold ISOs in the oldest grant with a $1 exercise price to fill the Spread to AMT in each iteration, the Cost to Exercise and Hold equals the number of shares being exercised. The lower the exercise price per share, the greater the spread per share. The greater the spread per share, the fewer shares can be exercised. Exercising the fewest number of shares at the lowest exercise price per share limits overall investment risk on the exercise and hold strategy.
You’ll notice the Spread to AMT figure is the same when selling 20% whether you choose to sell the oldest or newest. This is because the amount of ordinary income realized in the “sell oldest” example exceeds the AMT exemption threshold, which reduces the Spread to AMT by phasing out part of the exemption. It’s not worth getting into the weeds about this here, just something to be aware can happen and could influence your approach to a Tender Offer.
Maximizing Spread
Maximizing the Spread to AMT involves exercising and holding ISOs with the highest exercise price.
Whether selling the oldest or newest first, exercising and holding the newest shares is more expensive but also allows you to exercise many more shares in each scenario. If the goal is maximizing spread to exercise and hold as many ISOs as possible, selling the oldest shares and exercising the newest is the strategy on which to focus.
This happens because selling the newest 20% and 10% of vested shares eliminates all 11,250 of the newest ISOs. The next newest grant to exercise from has a $6 spread per share instead of a $3 spread per share, which reduces the efficiency of the Spread to AMT even when trying to optimize for it.
No Right Answers
Although there are many more rabbit holes to explore in these calculations, there are no right answers because this is a subjective optimization problem. Optimization depends on context – your needs, your risk appetite. Each choice also involves risk. Sell now and the price may go up. Exercise now and the price may go down.
If your company runs Tender Offers more regularly, there is less pressure to “get it right” this time. You have multiple opportunities to implement whatever optimization strategy works best for you during when the Tender is available.
DISCLAIMER: This essay is purely for educational purposes and is not intended to be exclusively relied upon for any investment, tax, financial, or other ISO-related decisions. The hypothetical examples used throughout do not consider all of your specific investment objectives, your risk appetite, or other facts that may influence your ISO exercise strategy. It is highly recommended that you consult with investment, tax, and other professionals before making any ISO-related decisions.
