Early Exercise

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Early Exercise

What is Early Exercise?

Early exercise of an options contract is the process of buying or selling shares of stock under the terms of that option contract before its expiration date. For call options, the options holder can demand that the options seller sell shares of the underlying stock at the strike price. For put options, it is the converse, where the options holder may demand that the options seller buy shares of the underlying stock at the strike price.

Understanding Early Exercise

Early exercise is only possible with American-style option contracts, which the holder may exercise at any time up to expiration. With European-style option contracts, the holder may only exercise on the expiration date, making early exercise impossible.

Most traders do not use early exercise for options they hold. Traders will take profits by selling their options and closing the trade. Their goal is to realize a profit from the difference between the selling price and their original option purchase price.

For a long call or put, the owner closes a trade by selling, rather than exercising the option. This trade often results in more profit due to the amount of time value remaining in the long option lifespan. The more time there is before expiration, the greater the time value that remains in the option. Exercising that option results in an automatic loss of that time value.

Key Takeaways

  • Early exercise refers to buying or selling stock shares before the expiration of contract options.
  • It is only possible with American-style options.
  • Early exercise makes sense when an option is close to its strike price and close to expiration. Employees of startups and companies can also choose to exercise their options early to avoid the alternative minimum tax.

There are certain circumstances under which early exercise may be advantageous for a trader.

For example, a trader may choose to exercise a call option that is deeply in-the-money and is relatively near expiration. Because the option is in-the-money, it will typically have negligible time value.

Another reason for early exercise may be a pending ex-dividend date of the underlying stock. Since options holders are not entitled to either regular or special dividends paid by the underlying company, this will enable the investor to capture that dividend. It should more than offset the marginal time value lost due to an early exercise.

Employee Options

There is another type of early exercise that pertains to company awarded stock options (ESO) given to employees. If the particular plan allows, employees may exercise their awarded stock options before they become fully vested employees. A person may choose this option to obtain a more favorable tax treatment.

However, the employee will have to foot the cost to buy the shares before taking full vested ownership. Also, any purchased shares must still follow the vesting schedule of the company’s plan.

The money outlay of early exercise within a company plan is the same as waiting until after vesting, ignoring the time value of money. However, since the payment is shifted to the present, it may be possible to avoid short-term taxation and the alternative minimum tax (AMT). Of course, it does introduce the risk that the company may not be around when the shares are fully vested.

Example of Early Exercise

Suppose an employee is awarded 10,000 options to buy company ABC’s stock price at $10 per share. They vest after two years. She exercises 5,000 of those options to purchase ABC’s stock, which is valued at $15, after a year. Exercising those options will cost her $7,000 based on a federal AMT rate of 28%. However, she can reduce her federal tax percentage to 15% (based on 2020 rates) by holding onto the exercised options for another year to meet requirements for long term capital gains tax.

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Early Exercise

You’re working at an awesome company. You think it might Go Big. And they’ve given you a bunch of stock options that vest over several years.

You could wait until the options vest and exercise them then. But wait! You’ve heard talk of this “early exercise” thing. Should you do it? What is it? How can it help you?

Here are the three things I want you to walk (rather, click) away from this blog post thinking about:

  1. How long ago were my stock options granted?
  2. How will the rest of my financial situation be affected by using money right now to early exercise?
  3. Can I afford (both financially and psychologically) to lose every penny of the money I spend early exercising?

Yes, I know this is a tedious topic. And we’d all rather read about, well, anything else. But this is important, you know? It can make a difference of thousands of dollars for you, and I’ve had enough clients ask me about it to know that It’s On Your Mind, Don’t Deny It!

What Is Early Exercise?

Let’s say you’ve just been hired and your new employer grants you options that vest over the next 4 years.

The most straight-forward approach is to wait for an option to vest and, at that point, decide whether to exercise it. If you exercise a vested stock option, you now own that stock outright. Congratulations! You’re now the owner of an incredibly unpredictable and illiquid (that is, really hard to turn it into money) security that may bring you riches but probably won’t.

When you early exercise, you pay the exercise price now for options (maybe even all of them!) that have not yet vested , and own the stock in a restricted sense (you don’t outright own it until the vesting dates finally arrive).

Not all companies allow early exercise. So the first question you should answer is: Am I even allowed to early exercise? If not, well, at least your decision is simple.

Why Would You Early Exercise?

If the employment universe shines kindly on you, your company is going to grow (possibly a lot!) over the course of several years. If you have options that vest over those same years, then as the company grows, the value of stock grows, which means the value of your options grow, which means your tax liability grows .

First thing to do in this situation is: Thank your lucky stars that you hit gold. It’s rare (despite the media impression we get) and you’re lucky and it’s largely “found money” and be appreciative, dammit!

But, to gild that lily, wouldn’t it be nice if you could pay fewer taxes on these new-found riches?

Here’s the real meat of the matter: If you early exercise, you should also file what’s called an 83(b) election with the IRS . This means:

  1. Now: When your company is ideally valued at very little, you pay income taxes on the accordingly small value of all your options.
  2. Later: When your company stock (hopefully) is worth much more, you only have to pay the lower capital-gains taxes on the increased value. That can be the difference between paying 25%, 28%, 33% or more on the stock gain versus paying 15%, 18.3%, 20%, or 20.3% on the stock gain.

To recap: The point of this 83(b) election is that you pay a higher tax rate now on a small amount of income, and a lower tax rate later on hopefully a large amount of income.

This excellent blog post goes through specific numbers in a way that I don’t want to, and would be redundant, to boot, because hey! He already did it.

Should You Early Exercise?

If early exercise is available to you, ask yourself these questions:

#1: How much money will it take to 83(b) early exercise?

If you’re a very early employee, then the 83(b) tax bill might be very small, because the fair market value (FMV) of the stock is very low. Which means this maneuver carries little financial risk.

But if you’re a later employee, and the company has raised a few rounds of funding, then the FMV might be significant, which means your tax bill would be significant, which dramatically increases your risk. Ask your HR department what the fair market value (FMV) of company shares is. It’ll likely be tied to a fundraising or a third-party valuation.

You’ll owe income tax on the difference between your exercise price and the FMV, and you’ll also need cash to exercise the options in the first place.

#2 Can I afford to front and eventually lose this money?
I f the cost of early exercising (both the cost to exercise and the 83(b) tax liability) will deplete your emergency fund or crimp your ability to save for you retirement or use all the cash you were going to spend on a professional-improvement course, then you probably want to leave the gambling to Las Vegas (because that’s what it is).

Note that if you leave the company before some of your exercised stock vests, the company will likely repurchase the stock at the exercise price you paid for it (look for “right of repurchase” in your stock option grant document).

#3: How confident am I that the company is going to be a big success?
Oh, I’m sorry. I’m fresh out of crystal balls.

We’re all enthused about our start-up employers. It’s practically a requirement of employment to think you’re going to “change the world!” and “hit it big!” But much like working with “the smartest people I’ve ever known,” everyone in every start-up thinks the same thing. And you’re not all right!

[Edited 1/3/2020] For this reason, I like Wealthfront’s advice: the best time to exercise is when your company files for an IPO . If your company has gotten to the IPO stage, that’s a much more reliable predictor of success than employee enthusiasm or even prior funding successes.

Does all this sound like Charlie Brown’s teacher to you? Well, then, I have lovingly crafted this simplified decision process for you:

  • Is early exercise available, and will it cost you vanishingly little to early exercise and pay the 83(b) tax liability? Do it.
  • Will the cost to early exercise change your life at all significantly? Don’t do it.

Gotchas

Not paying attention to that 30-day deadline! [Edited 1/3/2020] If you early exercise, you must (double triple underscore, bright red flashing lights, no do-overs) file the 83(b) election within 30 days of the tax event, which basically means within 30 days of exercising the stock options, because that’s when taxes are assessed: either Alternative Minimum Tax for Incentive Stock Options, or ordinary income tax for Non-Qualified Stock Options.

Getting caught up in the company enthusiasm and not thinking objectively about the risk to your personal finances. Investing in individual companies is risky enough. Investing in an individual start-up takes that risk to a whole new level. Nine out of 10 start-ups fail . And that remaining one doesn’t always go the way of Facebook. It can get acquired at a reasonable but not astronomical valuation. (Been there, done that. Twice.)

The likelihood that your start-up will hit it big is very small. Sorry, but ‘tis the truth.

When I left my first start-up, I had outstanding options to exercise. I decided that I’d be mad at myself if the company hit it big and I didn’t get any piece of that action, but I’m too conservative to risk a lot of money. So, I exercised all my cheapest shares, for a grand total of $300. Lo’ and behold, 5 years later, that $300 got me an 800% return. Which is say,about $2500. I would have been better off, in retrospect, exercising all my options, but that 20-20 hindsight doesn’t mean I made the wrong choice back then.

My point here is, well, two-fold: One, I am no judge of company success and two, it’s not all or nothing: you can bet on your company to the extent it doesn’t risk the rest of your financial success.

There’s no friggin’ 83(b) form! True enough. The 83(b) election is not accompanied by a lovely, Google-able 83(b) form from the IRS. But either your HR department can provide one (companies often facilitate early exercise), of you can use this sample letter from the IRS.

Is it just me, or does the phrase “early exercise” just sound funny after you’ve read it a bunch of times?

Resources

As you might imagine, taxes weave their little fingers through much of your financial life in ways it’s hard to anticipate, and you can bet this issue is no exception. So, for anything but the most basic of decisions on this issue, I highly encourage you to work with an accountant or lawyer who specializes in stock options (they exist!).

This firm’s blog is great for understanding how stock options work, in particular early exercise and the 83(b) election.

Question: How do you feel about betting on your company? You can leave a comment below.

Do you want a financial planner who can not only help you invest in a low-cost way, but who focuses on your larger financial picture, including your career opportunities? R each out to me at [email protected] or schedule a free 30-minute consultation.

Sign up for Flow’s Monthly Newsletter to effortlessly stay on top of my blog posts and extra goodies, and also receive my Guide to Optimizing Your Stock Compensation for free!

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner and/or an accountant for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer .

What’s the Best Time to Exercise?

Experts offer tips on finding the best time of day for your workout.

Some people swear by a 6 a.m. jog to get their hearts racing and get them psyched up for the day. Others wouldn’t dream of breaking a sweat before noon, preferring a walk around the neighborhood after dinner. But is any one time of day the best time to exercise?

The truth is that there’s no reliable evidence to suggest that calories are burned more efficiently at certain times of day. But the time of day can influence how you feel when exercising.

The most important thing, experts say, is to choose a time of day you can stick with, so that exercise becomes a habit.

Your Body Clock

Your body’s circadian rhythm determines whether you’re a night owl or an early bird, and there’s not much you can do to alter it.

Circadian rhythm is governed by the 24-hour pattern of the earth’s rotation. These rhythms influence body functions such as blood pressure, body temperature, hormone levels, and heart rate, all of which play a role in your body’s readiness for exercise.

Using your body clock as a guide to when to go for a walk or hit the gym might seem like a good idea. But, of course, there are other important considerations, such as family and work schedules, or a friend’s availability to walk with you.

The Perks of Morning Exercise

If you have trouble with consistency, morning may be your best time to exercise, experts say.

“Research suggests in terms of performing a consistent exercise habit, individuals who exercise in the morning tend to do better,” says Cedric Bryant, PhD, chief science officer with the American Council on Exercise in San Diego.

“The thinking is that they get their exercise in before other time pressures interfere,” Bryant says. “I usually exercise at 6 a.m., because no matter how well-intentioned I am, if I don’t exercise in the morning, other things will squeeze it out.”

He recommends that if you exercise in the morning, when body temperature is lower, you should allow more time to warm up than you would later in the day.

Continued

When Insomnia Interferes

Unfortunately, hitting the snooze button repeatedly isn’t exercise. But, if you’ve suffered insomnia the night before, it can seem a lot more appealing than jumping out of bed and hitting the treadmill.

Good, regular bedtime habits can help you beat insomnia. They include winding down before bedtime.

“Your body needs to get ready for sleep,” says Sally A. White, PhD, dean and professor in the College of Education at Lehigh University in Bethlehem, Pa.”You want your heart rate and body temperature in a rest zone. It starts the body getting into a habit of sleep.”

Exercising or eating too late sabotages your body’s urge to sleep.

“Both exercise and eating raise your heart rate and temperature,” White tells WebMD. “That’s not conducive to sleeping.”

When Later Is Better

White, who studies achievement motivation in exercise and other areas, says that in spite of good intentions to get up early and get her exercise over with, she is more likely to exercise after work.

“It’s easier to get my body into a rhythm because I’m not fighting my body the way I do in the morning,” she says.

For some people, lunchtime is the best time to exercise, especially if co-workers keep you company. Just be sure to eat after you work out, not before.

“Don’t exercise immediately following a meal,” says Bryant, who lectures internationally on exercise, fitness and nutrition. “The blood that needs to go to your muscles is going to your digestive tract. Give yourself 90 minutes after a heavy meal.”

Finding Your Own Best Time to Exercise

You don’t have to be an expert on circadian rhythms to determine the best time to exercise. Steven Aldana, PhD, advises trying different times of the day.

Work out in the morning for a few weeks, then try noon, then early evening. Which do you enjoy most and which makes you feel best afterward? Also, consider the type of exercise, and other daily commitments.

“Most of all, find a time that helps you make your exercise a regular, consistent part of your life,” says Aldana, a professor of lifestyle medicine in the department of exercise sciences at Brigham Young University in Provo, Utah. “This is more important than the time of day.”

Continued

Establishing the Exercise Habit

One day, you’ll reach a point where daily exercise comes as naturally as breathing. At that point, you may want variety.

“In an effort to stay regularly active, some people change the type of exercise they do and the time of day they do it,” says Aldana, author of The Stop & Go Fast Food Nutrition Guide. “Keeping it fresh makes it more enjoyable and more likely to be continued.”

But if you’re still at the point where exercise is hit or miss, scheduling it for the same time each day will help you make it a habit. Whether you choose morning, lunchtime, or after work to exercise, make it part of your routine.

“People who are just starting out and who exercise randomly are more likely to drop out,” White says.

She adds that starting out can be as simple as changing the route you come home from work so that you drive by a gym. “Get into the habit of going that way, and keep a bag of exercise gear in your car or at work,” she says.

Sources

SOURCES: WebMD Medical Reference provided in collaboration with Cleveland Clinic: “Sleep Disorders: Sleep 101.” Time-To-Run web site: “Timing Your Workout.” Steven Aldana, PhD, professor of lifestyle medicine, department of exercise sciences, Brigham Young University, Provo, Utah; author, The Stop & Go Fast Food Nutrition Guide. Cedric Bryant, PhD, chief science officer, American Council on Exercise, San Diego. Sally A. White, PhD, dean and professor, College of Education, Lehigh University, Bethlehem, Pa.

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