When to Exercise ISOs
As you manage your equity compensation, knowing when to exercise incentive stock options (ISOs) is one of the toughest things to get right. ISOs have unique tax complexities and rules that make it tricky to know exactly the best time to exercise the ISOs you’ve been granted.
You’ve likely already done research to try to figure out when you should exercise your ISOs. In fact, that may be how you’ve ended up reading this article. By now, you’ve probably realized that getting the timing perfectly right when exercising your ISOs can be nearly impossible. (Sorry if you’re hearing this for the first time.)
That said, the purpose of this article is to provide some guidelines to help you determine when you should exercise your ISOs.
Below, we share 9 of our favorite tips to help you figure out when you should exercise your ISOs. Please note that although this list is a helpful start, if you have a lot of ISOs, it would be wise to consult with a professional. If you need assistance finding the right professional, we’d be happy to provide referrals to qualified CPAs.
9 Tips to Determine When you Should Exercise your ISOs
The decision to exercise ISOs will vary by individual and is based upon your current financial circumstances. One employee at a company may feel comfortable exercising every ISO available, while another may want to wait until an IPO is more certain. The following tips will help you determine if and when you should exercise the ISOs you’ve been granted.
#1 - Take Inventory of the ISOs You’ve Been Granted
The first thing you’ll want to do to determine when you should exercise ISOs is take inventory of the options you’ve been granted. If you’re comfortable with spreadsheets, you’re welcome to track there. Otherwise, your stock plan provider’s website will work just fine.
Here are the things you’ll want to take account of:
The number and value of all vested and unvested ISOs
Whether or not your company lets you early exercise (i.e. exercise before ISOs have vested)
The exercise price for your ISOs
The current market value of your ISOs (sometimes referred to as 409a valuation)
Determine the “spread” of each ISO grant. (You do this by taking the current market price minus your exercise price.)
All of the information in these bullet points is critical for determining when you should exercise your ISOs, so please do not skip this step! If you’re unfamiliar with a lot of the terms above, please read out ISO Basics article and come back.
Once you have all this information handy, you’ll be ready to further evaluate when you should exercise ISOs.
#2 - Evaluate Ability to Early Exercise and Complete an 83(b) Election
The ability to early exercise means that your company will let you exercise ISOs before they’ve vested.
This ability is important for two reasons: (1) if you don’t have the ability to early exercise then you’ll only be able to exercise vested ISOs, and (2) typically right after receiving a grant of ISOs, your spread will equal $0. This means that if you can exercise early, you can exercise without having to worry about Alternative Minimum Tax (AMT). (More on AMT later.)
The 83(b) election comes from the IRS code and it allows you to move the taxable event of your early-exercised ISOs up to the date in which you exercised. Meaning that if you early exercise your ISOs shortly after receiving them, you’ll likely owe zero taxes.
There are plenty of sample 83(b) election forms online, but here are two good options for you to look at: 83(b) election form #1 and 83(b) election form #2. Regardless of which 83(b) election form you choose, this is something that needs to be physically mailed to the IRS. And it needs to happen within 30 days of your early exercise.
A common mistake that people make is assuming that this 83(b) election needs to be made within 30 days of receiving a grant of ISOs. This is incorrect. An 83(b) election should be filed within 30 days of exercise.
Assuming all of this is doable for you, it helps reduce the risk of exercising ISOs because it lowers the odds of incurring a tax liability before you have access to liquidity. However, it doesn’t guarantee your ISOs will ever be worth more than what you paid for them.
#3 - Stay Aware of Each ISO Expiration
Each time you’re given an ISO grant, your employer will attach a date in which the grant expires. The most common expiration date is 10 years from the grant date, but we’ve seen shorter.
The length of time remaining on your ISO grant inevitably affects when you should exercise your ISOs. If you have a lot of time remaining on your ISO grant, you’ll feel less urgency. If you’re bumping right up against an ISO grant’s expiration, you probably won’t want the ISO to expire. The only time you’d consider letting an ISO grant expire is if the value of the company is less than your exercise price or if you have zero faith the company will ever be worth anything.
This seems like an easy thing to check on, but you’d be shocked at how often people lose track of when their ISOs expire. It’s okay if you want to bump up against the expiration, it’s just something you’ll want to stay aware of.
#4 - Know That Your ISO Spread is a Risk Multiplier
Determining the ISO spread per grant and the total ISO spread value of all your ISO grants is a major determinant of when you decide to exercise your ISOs.
The larger the spread of your ISOs, the more risk there will be. And the more ISOs you have, the more this risk accrues.
If you have a grant of ISOs that has a large spread, this means that the company has grown significantly since you were first granted the ISOs. This is a great thing!
The good news/bad news here is that when you start to exercise your ISOs, you’ll also begin to unlock the gains embedded in your ISOs, and you might be pushing yourself into what’s called Alternative Minimum Tax (AMT).
Anytime you exercise an ISO, the spread of your ISO is added to a separate tax calculation that runs alongside your normal tax calculation. This separate tax calculation is called Alternative Minimum Tax (AMT).
The big perk of ISOs is that you usually don’t owe taxes when you exercise. However, if you exercise a lot of ISOs and/or have a large spread on each exercise, you’ll eventually add so much to the AMT calculation that you’ll owe taxes even though you haven’t actually sold any ISOs.
Getting pushed into AMT isn’t necessarily a bad thing, but it happens a lot more quickly than people expect - especially if your ISOs have a very large spread. Just because you might have a lot of ISOs or ISOs with a large spread, doesn’t mean you should avoid exercising, it just means you’ll want to pay more attention.
Tip #5 - Private Companies May Stay Private
Your start-up is the best. It’s reached unicorn status and your ISOs have made you rich…at least on paper.
Wealth from ISOs on paper is great, and it has a great chance of translating to significant wealth. But in order for your ISOs to translate into true wealth, you will need to eventually sell your exercised ISOs.
Even if you time your ISO exercises well and do all the right things with your ISOs, there’s still the possibility that your company never IPOs/goes public - which makes it hard to sell your ISOs.
For this reason, you should only put into your ISOs what you’re willing to lose.
If it’s going to cost $3k to exercise your ISOs, are you okay waiting 5+ years for the opportunity to sell? Are you okay with never having the ability to sell and with losing that money?
The semi-good news is that if your company ends up going bankrupt, at least you’ll be able to write off what you paid to exercise your ISOs as a capital loss.
#6 - The Current Status of your Company
The next thing you’ll want to do to help you determine when you should exercise your ISOs is to try to get a glimpse into your company’s future. While it’s impossible to know the future, it’s helpful to be on the lookout for a couple of signs.
Is There an IPO in the Future?
One of the biggest determinants of when to exercise your ISOs is dependent on your company’s plans to go public/IPO (which means they’ll be listed on the stock market).
If an IPO is rumored to be in the works and your company is doing well, it means there could be an opportunity to sell ISOs you’ve exercised. If your company has filed what’s called an S-1 or has explicitly stated that they’ll IPO at some point very soon, this is great news.
The goal of exercising ISOs is to exercise before the value of your ISOs goes up dramatically, so if there’s an IPO in the future, it’s likely the value of your company is going to go up.
Are Valuations Increasing Quickly?
Even if there’s not an IPO in the immediate future, if the company you work for is completing new rounds of funding and is receiving larger and larger valuations, it’s important to get a sense of this growth sooner than later.
If you’re able to exercise before an updated valuation, you’ll be able to exercise at a potentially smaller spread and you’ll instantly have a larger embedded gain within your ISOs following the new valuation.
To get an idea of the next valuation on the horizon, you’ll want to ask around at work. Sometimes it’s hard to get much reliable information, but you should at least be able to get some pretty reliable rumors.
#7 - Evaluate Your Appetite for Risk/Reward
We all have different things going on in our lives and our financial pictures are each different. Because exercising ISOs involves a pretty substantial level of risk, there’s a wide spectrum of the appropriate level of risk to take on.
The cost of the ISOs, the spread of the ISOs, the company, and your current financial state all play major roles in determining how much risk you want to take on.
We’ve written an article to help people determine how much company stock is too much, and it’s worth a read if you’re not sure where you fall on the risk/reward spectrum.
#8 - Know the Tax Consequences of Exercising your ISOs Before Exercising
Hopefully you’ve made it this far in this article, because tip #8 is probably the single most important tip for determining when you should exercise your ISOs.
Before you exercise your ISOs, you should know the impact that they will have on your tax situation. We’ve come across plenty of people who exercise ISOs with a large spread and unknowingly end up with a tax bill in the hundreds of thousands of dollars.
And it can get even worse than just owing taxes. We’ve seen cases where people exercise ISOs, incur a large tax bill, and then the price of their company stock drops 70% before they’ve sold their ISOs. Obviously, you can’t predict what your company’s stock price is going to do, but this is definitely a situation you want to avoid.
If there’s no spread on your ISOs, you don’t have to worry about taxes. However, if there’s a spread and you’ll be receiving more than $5k-$10k worth of value, it’d be worth running your situation through Carta’s AMT Calculator.
If you want help from a CPA, we’re happy to provide referrals, and we do so for free as a courtesy to you.
#9 - Final Thoughts on When You Should Exercise ISOs
The final tip to help you determine when to exercise your ISOs is to encourage you to not stress too much about getting the timing absolutely perfect. No matter how many scenarios you run, chances are pretty good that you’ll have at least some regret - for not exercising sooner, for not waiting to exercise, for not exercising more, for exercising too much, for selling too soon, or for selling too late, etc. Try not to allow yourself to go there.
No matter what you do, you’ll never have fully optimized your profit-making ability from exercising ISOs. And we’re here to tell you that that’s okay.
In fact, being able to live with your decisions after you eventually sell your shares of ISOs is going to be very important to eventually diversifying any wealth you’ve generated.
You should go in with the expectation that although you may not get it perfect, you can at least ensure that you don’t completely torpedo your financial situation.
We hope you’ve found these 9 tips helpful as you make decisions about when to exercise your ISOs. Please reach out to us with any questions you have. We’re happy to be a resource to you.