Any advantage to exercising ISO's in company that is not yet public?

Question

I have ISO's in a private company and am trying to decide whether there is any advantage in exercising them. The price is low enough and my confidence in the company is high enough that I am comfortable taking a risk to exercise them.

I understand the tax implications with an exercise with respect to AMT with a public company as the market value is easy to determine.

I do not understand the same implications with respect to a privately held company that will one day be acquired.

Does anyone know reasons to start exercising now or reasons to hold off until an acquisition?

Answer 1

Exercising an option early if you can't sell the underlying stock being purchased is generally not advisable.

You're basically locking in the worst price you can possibly pay, plus you're losing the time value on your money (which is, admittedly fairly low right now, but still).

Let's say you have a strike price of $50. I get that you believe the stock to be worth more than $50. Let's assume that that's probably, but not certainly right.

Whether it's worth $51, $151, or $5,100 when your options are going to expire, you still get the profit of $1, $101, or $5,050 if you wait until expiration and exercise then. By exercising now, you're giving up two things:

• The interest on the money you pay to exercise from now until expiration.

• The guarantee that you can't lose anything.

If you buy it now, you get all the upside above your strike, but have all the downside below it. If you buy it later (at expiration), you still have all the upside above your strike, but no downside - in the (assumed to be unlikely) event that it's worth less than the strike you can simply do nothing, instead of having something you bought at the strike that's worth less now and taking that loss. By exercising early, you take on that loss risk, and give up the interest (or "carry" on the money you spend to exercise) for no additional updside.

It's possible that there are tax benefits, as other posters mention, but the odds that "starting the clock" for LTCG is worth as much as the "optionality", or loss protection, plus the "carry", or interest that you're giving up is fairly unlikely.

Answer 2

As I recall from the documentation presented to me, any gain over the strike price from an ISO stock option counts as a long term capital gain (for tax purposes) if it's held from 2 years from the date of grant and 1 year from the date of exercise.

If you're planning to take advantage of that tax treatment, exercising your options now will start that 1-year countdown clock now as well, and grant you a little more flexibility with regards to when you can sell in the future.

Of course, no one's renewed the "Bush tax cuts" yet, so the long-term capital gains rate is going up, and eventually it seems they'll want to charge you Medicare on those gains as well (because they can... ), soo, the benefit of this tax treatment is being reduced... lovely time to be investing, innnit?

Answer 3

As far as I know, the AMT implications are the same for a privately held company as for one that is publicly traded. When I was given my ISO package, it came with a big package of articles on AMT to encourage me to exercise as close to the strike price as possible. Remember that the further the actual price at the time of purchase is from the strike price, the more the likely liability for AMT. That is an argument for buying early. Your company should have a common metric for determining the price of the stock that is vetted by outside sources and stable from year to year that is used in a similar way to the publicly traded value when determining AMT liability.

During acquisitions stock options often, from what I know of my industry, at least, become options in the new company's stock. This won't always happen, but its possible that your options will simply translate. This can be valuable, because the price of stock during acquisition may triple or quadruple (unless the acquisition is helping out a very troubled company).

As long as you are confident that the company will one day be acquired rather than fold and you are able to hold the stock until that one day comes, or you'll be able to sell it back at a likely gain, other than tying up the money I don't see much of a downside to investing now.