Disclaimer: This article is for informational purposes only and does not constitute financial, legal, or tax advice. Consult a licensed professional for personalized guidance. The information provided is general and does not account for individual circumstances. FinFinancial LLC does not endorse specific financial strategies or outcomes.

A recent study found that executives who exercise their options early typically give up about 12% of their potential value, while non-executives leave even more money on the table, sacrificing up to 28% of their options' value.

But don't worry, this guide will walk you through everything about early exercise of stock options, from basic concepts to advanced strategies. Whether you're weighing an early exercise decision right now or just planning ahead, you'll find the answers you need.

What Is Early Exercise of Stock Options?

So what does early exercise of stock options mean? It's a way to buy your shares before they fully vest. Yet only 28% of non-early-exercisable options are exercised after someone leaves their company — so timing really matters.

How Early Exercise Works

When you exercise early, you're buying shares ahead of schedule. While in that case you'll own the shares, you might not be able to sell them right away until they vest. That's normal, and it's just part of the process.

American vs. European Options: What's the Difference?

European-style options have gotten more popular lately — they're up to 6% of total equity option volume in 2023 from just 1.1% in 2018. And they're a bit different from American options.

With American-style options, you can exercise whenever you want before they expire. With European options you've got to wait until they expire to exercise them, which means you might miss out on some good opportunities.

Employee Stock Options: The Basics

Companies love using stock options to reward their employees, and it's easy to see why. They usually come with a vesting schedule that tells you when you can exercise them. A few things affect how valuable they are:

• The strike price (what you'll pay for the shares)

• How well the company's stock is doing

• What you want to achieve financially

Benefits of Early Exercise

Let's talk about why you might want to exercise early.

Capital Gains and Taxes

If you exercise early and hold onto your shares for more than a year, you might pay a lower tax rate when you sell. That's because you'll qualify for long-term capital gains rates instead of the higher short-term ones.

Special Tax Benefits for ISOs

Incentive Stock Options (ISOs) might be a great deal tax-wise: if you exercise early and hold them long enough, you might end up paying capital gains rates instead of income tax rates on the profit.

Although, you should watch out for the Alternative Minimum Tax (AMT). The difference between what you pay for the shares and what they're worth might trigger AMT. You can handle this by:

• Exercising fewer shares at a time

• Getting professional advice about your specific situation

Being a Shareholder Has Its Perks

When you exercise your options, you become a real shareholder right away. That means:

• You get to vote on important company decisions

• If the company pays dividends, you'll get your share

These benefits show why early exercise is not only about the money, but also about having more control over your investment and your role in the company.

Risks and Disadvantages of Early Exercise

With all that being said, early exercise isn't always the right move, since there are some real risks you need to think about before making your decision.

Market Risk: What Could Go Wrong?

The stock market can be unpredictable, and that's something you'll want to keep in mind. Your company's stock price might go down after you exercise your options, and that can be tough to handle financially. You'll want to look at how the stock has been performing and what might affect its price in the future.

The Private Company Challenge

If you work at a private company, selling your shares can be tricky. Unlike public company stock that you can sell on the stock market, private shares are different — finding someone to buy them at a fair price isn't always easy. And if your company's planning any big moves like mergers or acquisitions, that could affect when and how you can sell your shares and at what price.

What Happens If You Leave?

If you leave the company before your shares fully vest, you might have to give some of them back. Every company handles this differently, so you'll want to read the fine print about vesting schedules and what happens to unvested shares if you decide to move on.

Tax Implications and Considerations

Taxes and stock options can get complicated pretty fast. When you get stock options as part of your pay, you might owe taxes at three different times: when you receive them, when you exercise them, and when you finally sell the shares.

Different Types of Options

There are two main types of stock options, and they're taxed differently:

1. Options from employee stock purchase plans or incentive stock option (ISO) plans

2. Nonstatutory stock options (everything else)

Publication 525, Taxable and Nontaxable Income goes into all the details about which type you have and how they're taxed. Speaking of taxes, you'll want to plan ahead for any tax bills that might come up when you exercise your options.

Statutory Stock Options: A Closer Look

When you're dealing with statutory stock options, the tax situation gets interesting. According to the IRS guidelines, you probably won't owe any taxes when you first get these options or when you exercise them — that's a nice break. But there's a catch: you might need to think about the alternative minimum tax in the year you exercise an ISO.

Understanding Your Tax Bill

The money side of early exercise can feel complicated, but it really comes down to two main things. First, there's the difference between what you pay for the shares and what they're worth when you exercise them — that's called ordinary compensation income. You'll pay regular income tax and payroll taxes on that amount.

The Long Game: Capital Gains

And then there's what happens after you exercise. Any extra money you make when you sell the shares could get taxed at capital gains rates. That's usually better than paying regular income tax rates, especially if you hold the shares for more than a year.

The 83(b) Election: A Smart Move?

Here's something that could potentially save you money: the 83(b) election. You've got 30 days after exercising to file it, and it lets you pay tax on the shares right away instead of waiting until later. That might sound strange, but if the shares aren't worth much when you exercise, you could end up paying less tax overall.

If you wait too long and miss that 30-day window, you might end up paying more in taxes than you needed to. The timing really matters here, especially since any future gains could be taxed at those lower capital gains rates if you plan things right.

By the way, when you finally sell the stock, that's when you'll have either a gain or a loss to report. If you didn't hold the shares long enough, though, you might have to count that money as regular income instead of a capital gain. Make sure to add any amounts that get treated as wages to your cost basis — that'll help figure out your real gain or loss when you sell.

Types of Stock Options Relevant to Early Exercise

When it comes to early exercise, you'll run into two main types of stock options. Let's break them down in a way that actually makes sense.

Non-Qualified Stock Options (NQSOs)

NQSOs are pretty straightforward when it comes to taxes. When you exercise them, you'll pay regular income tax on the difference between what you paid and what the shares are worth. Companies like these because they can give them to anyone — employees, consultants, board members, you name it.

If you're planning to exercise early, NQSOs might be your better bet. They don't come with some of the tricky holding requirements that other options have.

Incentive Stock Options (ISOs)

ISOs can give you some valuable tax breaks if you play your cards right. The gains might get taxed at those lower capital gains rates we talked about earlier. But there's a catch — only employees can get these, and they come with some extra rules about holding periods.

What Works Best and When?

NQSOs might work better if you're worried about the Alternative Minimum Tax (that can pop up with ISOs) or if you want to sell your shares sooner rather than later. ISOs could save you more on taxes in the long run, but you'll need to hold onto the shares for a while.

Here's a real-world example to show you how early exercise works: Say you get 48,000 options that vest over 4 years — that's 1,000 options each month. Maximizing your restricted stock units takes some planning. Without early exercise, you'd have to wait a year to exercise your first 12,000 options. But with early exercise rights, you could turn all 48,000 into stock right away. Just keep in mind those shares still follow the original vesting schedule.

And speaking of tax treatment, some tax preparers suggest going with NSOs for early exercise. It can get pretty complex, but at least you won't have to deal with that $100,000 ISO limitation (that's a whole new conversation to have with your tax advisor).

Making Your Early Exercise Decision

Stock options can be a great part of your compensation package, but as we've seen, the decisions around when and how to exercise them aren't always simple. There are lots of moving pieces to consider — from tax implications and vesting schedules to market conditions and your own financial goals.

The good news? You don't have to figure it all out by yourself. Financial advisors who work with equity compensation can help you think through your specific situation and create a strategy that makes sense for you. And with platforms like FINNY, connecting with an advisor who understands the ins and outs of stock options is easier than ever.

Get matched with a financial advisor.