Early Exercisable Stock Options: What You Need to Know

What is an early exercisable stock option?

An “early exercisable” stock option is like any other stock option awarded to an employee, consultant, director or other advisor, except that the holder may exercise the option before it has vested. For example, a stock option may vest over a four year period, provided that the optionholder remains continuously employed or in service on each vesting date. Despite this vesting requirement, an early exercisable stock option would allow the optionholder to exercise all or a portion of the option immediately, even as to the unvested piece of the award.

The company’s board of directors needs to approve an “early exercise.” Often this is done at the time it approves the stock option grant (and this should be reflected in the option paperwork; for example, Cooley’s standard form of grant notice has a check-the-box election for early exercise). Alternatively, the board of directors might approve an amendment to an already existing option to allow for early exercise.

What happens when an early exercise occurs?

Upon early exercise, the optionholder receives common stock that is subject to the same vesting schedule that applied to the stock option. If the optionholder subsequently leaves the company before that stock vests in full, then the company will generally have the right to repurchase the unvested stock (see below for a description of the company’s repurchase rights).

Why would the optionholder want to early exercise a stock option?

Early exercise has a number of potential advantages to the optionholder, including:

• the capital gains holding period would start upon exercise;
• if the optionholder early exercises the stock option immediately or soon after the grant date, then the optionholder should owe little or no taxes upon exercise (assuming the fair market value of the company’s common stock has not changed or has only increased slightly), and can avoid any taxes upon vesting by filing an 83(b) election; and
• the optionholder becomes a stockholder.

Why would the optionholder not want to early exercise a stock option?

Stock options allow optionholders to lock in an exercise price and wait-and-see if the company’s common stock increases in value before being required to pay the exercise price and become a stockholder. Early exercise means investing in the Company earlier, on the expectation that the value of the stock will increase in the future.  The optionholder risks losing all or part of the investment if the value of the company’s common stock decreases. As the aggregate cost to exercise the options increases relative to the optionholder’s financial means, the decision to early exercise the options is likely to become more difficult for the optionholder.

Can a company grant an early exercisable stock option as an incentive stock option (ISO) or nonqualified stock option (NSO)?

Assuming the company is a corporation, both incentive stock options (ISOs) and nonqualified stock options (NSOs) can include an early exercise feature. If the company knows that an employee will immediately early exercise her options, it makes more sense to grant the employee her option as an NSO so as to avoid a special two-year ISO holding period requirement. It is worth noting, too, that an early exercise feature impacts one technical rule that applies to ISOs. Specifically, a stock option may qualify as an ISO only as to $100,000 of share value (the number of shares subject to the option multiplied by the fair market value of the common stock on the grant date) that is first exercisable in any calendar year.  This “ISO $100,000 limitation” applies cumulatively to all ISOs granted to an employee.

By way of a simple example, assume that Employee A receives an ISO (which is the only ISO held by Employee A) this year that covers 10,000 shares of common stock, and the stock’s fair market value on the date of grant is $15 per share.  Assume that the ISO is vested and exercisable as to 50% of the shares immediately on day 1, and is scheduled to vest and become exercisable as to the remaining 50% of the shares one year later.  In this example, the $100,000 test (as applied on the date of grant) is satisfied because the “value” of the option that is first exercisable in each of this year and next is less than $100,000 (5,000 x $15 = $75,000).

However, if an ISO allows early exercise, the entire “value” of the stock option is taken into account in the calendar year in which the option becomes early exercisable in determining the $100,000 maximum that applies to ISOs.  In our example above, if the stock option could be exercised in full this year (whether or not it is actually exercised), only a portion of the option would qualify an ISO (a portion of the option would fit within the $100,000 limit (6,666 shares) and a portion would be treated as an NSO (3,334 shares)).

There may be significant tax differences between early exercising an ISO versus an NSO.  Optionholders should consult their personal tax advisors to learn more.

What stockholder rights does the optionholder have if the optionholder early exercises a stock option?

The optionholder is treated like any other holder of the Company’s common stock.  The optionholder is eligible to vote (even as to unvested shares) to the extent the shares are voting shares, may receive dividends, and can request company financial information.

Must the optionholder file a Section 83(b) election if the optionholder early exercises?

Not necessarily, but many of the tax advantages of early exercise depend on the filing of a Section 83(b) election. By filing a Section 83(b) election, the optionholder agrees to immediately include in gross income any “spread” associated with the exercise of the option, based on the stock’s fair market value on the exercise date, rather than later as the stock vests (which is when the income would otherwise be recognized). Section 83(b) elections, to be effective, must be filed within thirty (30) days following the date of exercise. One meaningful downside to the company of allowing optionholders to early exercise is that the company can face disputes with optionholders who neglect to make this filing. Such optionholders might fault the company for not giving adequate notice of the deadline, or of the consequences of failing to file, or might even expect the company to handle the filing for them. The time and cost of educating optionholders about the 83(b) election, coupled with the potential for disputes with people who might not complete their filing in time is enough for many companies to steer away from allowing early exercise.

Can the Company repurchase stock obtained by early exercising a stock option?

Yes.  If the optionholder early exercises, the company will retain the right to repurchase the stock that is unvested when the optionholder terminates service.  The repurchase price is generally the lower of the exercise price or the then-current fair market value of the stock. This repurchase right will lapse as the stock vests. Companies generally would not have the right to repurchase any of the vested stock.

How does the company complete the repurchase of unvested stock when the employee leaves?

The company generally holds the unvested stock in escrow to facilitate the repurchase in the event the person leaves the company, and also collects from the optionholder at the time of exercise all of the signed documents that would be required to re-sell the unvested shares back to the company. The company only uses those documents if and when the person leaves the company while holding unvested shares.