Is there a reason to exercise a stock option as soon as it vests?

Question

Background: I am currently employed by a start-up that, so far, is doing really well. As part of my contract, I have stock options that will come available on a typical vesting schedule. A quarter of my options are set to vest later this year. Also, the company is not public yet, and it may be several years before it is public / I could sell my shares of the company.

My question is, is there any reason I should exercise them as soon as they vest? As far as I know they don't expire as long as I work at my company (if I leave for any reason, then I only have 3 months to exercise).

I don't foresee leaving any-time soon, and if I did, I would have 3 months to make a final decision.

Is there any disadvantage to just letting the option stay an option for a while?

Answer 1

Advantages

• Long-term capital gains tax rates. If your company has a liquidity event, if it's been at least a year since you exercised your options, it will be considered a long-term capital gain and your tax rate will be lower. Note that it's entirely possible that you will have no choice but to receive cash for your shares, so it's not like you can just hold on to them longer for the preferential tax treatment.
• Equity. Once you exercise your options, you own the shares and thus part of the company, more or less irrevocably. If any issues are put to a shareholder vote, you will have a say (though founders will likely have majority control). While it's not common, unvested as well as vested but unexercised options could potentially be cancelled.

Disadvantages

• Up-front cost. Your options have a strike price or exercise price, which you'll have to pay to receive the shares.
• Loss of principal. The value of your shares could possibly (even likely, in the case of startups) fall to zero.
• Diversification risk. Depending on your situation, these shares could make up a significant portion of your net worth. And if the company does poorly, you could easily lose your job at the same time your shares lose value.
• Taxes. Exercising incentive stock options (ISOs) without selling them has no impact on the normal federal income tax system. However, the bargain element (difference between fair market value and strike price on the date of exercise) counts as income in the alternative minimum tax (AMT) system. It's difficult to predict how this could affect your taxes, it could be anywhere from no impact to thousands of dollars more in taxes. (This is moderated slightly by the fact that in future years when your normal tax is higher than AMT, the excess you paid will be credited back to you.) When exercising non-qualified stock options (NSOs), the bargain element is treated as regular income even in the normal federal income tax system.