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For my situation, is it better for me to exercise all my option shares whenever they vest (are exercisable), or is there any advantage to waiting?

What are the pros and cons?

What is the tax aspect, for United States & California?

MY SITUATION: I have about 5000 vested and exercisable option shares. I get some more options each month. My price per share is $2.50. The present share price is about $7.

WHAT IF'S: What if I got laid off? (low probability) What if the company, a very attractive startup, got purchased?

  • If you don't want huge risk and you're saying share price is $7, is it an option to exercise everything and sell some of the shares straight away? – SMeznaric Jan 23 '16 at 3:00
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The general rule with stock options is that it's best to wait until expiration to exercise them. The rationale depends on a few factors and there are exceptions.

Reasons to wait:

  • You defer taxes until you exercise and, in most cases, paying taxes is later is better (when you can do it legally and without penalty)
  • To exercise, you will need to provide cash to buy the shares. If you delay exercising the shares, you can use that cash for something else and also retain the value that underlies the options. (As noted in a comment by Pete Becker, you won't need cash if you plan to "flip" the shares immediately. See also points below about flipping and cashing out.)
  • If the options are marketable as securities themselves, the options probably have "time value" in addition to "intrinsic value," so you'd be better off selling the options than exercising them, BUT you seem to be in an employee plan so, in this case, it's likely that this last bullet does not apply to you. (Usually you cannot sell your options in this case.)

There would be cases to exercise early:

  • If you think the stock price is going to go down such that your options will be worthless at expiration, you might exercise early if you can "flip" the stock for a profit now.
  • If you think you will lose the options based on the terms of your employee plan due to events such as quitting or getting laid-off, you might exercise to avoid that loss. (You would need to understand the specific terms of your employer's plan to assess this option.)
  • If you think you may want or need to "cash out" the stock in "about" one year, then you might exercise early in order to set yourself up to sell the stock at a long-term capital gain rather than a short-term capital gain.
  • You think that your income is going to be much higher in future years, so you try to shift the tax on the options to an earlier year when you're in a lower tax bracket.

Tax implications should be checked with a professional advisor specific to your situation. In the employee stock option plans that I have personally seen, you get regular income tax assessed between exercise price and current price at the time you exercise. Your tax basis is then set to the current price. You also pay capital gains tax when you eventually sell, which will be long or short term based on the time that you held the stock. (The time that you held the options does not count.) I believe that other plans may be set up differently.

  • You don't always have to have cash to exercise options. One company I worked for had a "same day exercise and sale" arrangement with a brokerage. The brokerage would exercise the options for me and sell the stock. They'd pay the company for the options out of the proceeds and send me a check for the difference. – Pete Becker Jan 12 '16 at 15:31
  • @PeteBecker Agreed. I know of privately held companies that also provide for this. I tried to cover this in the points about "flipping" and "cashing out." I will update the answer to be more explicit though - You must have cash to exercise if you want to exercise and hold. – user32479 Jan 12 '16 at 15:35
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To me it depends on things like your net worth, debt, and how other assets are invested.

Currently you have 25K invested in the company you work for.

If you have 100K in student loans, are a renter, and 12K in your 401K, then I would recommend exercising almost all of your options. In that case you have a much to large part of your world wrapped up in your company.

If you have 250K in your 401K, own a home and have an emergency fund with no debt then you are fine with letting it ride. You can afford to absorb a loss of 25K without wrecking your net worth.

More than likely, you are somewhere in between (just statistics speaking there). So why not exercise some of them now with the purpose of improving your financial situation? Say do a 1/3 now and when they come available.

When 401ks were first invented people put almost all of their money in their company stock. They lost just about everything when the company went down in value and were often a victim of layoffs exasperating the issue. This is akin to the same situation. Most financial advisers recommend against putting any 401K money to company stock, or at least limiting the amount.

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