Early Exercise: What It Is and When It Makes Sense

by Knowledge Resources |

Early exercise refers to the practice of exercising stock options before they have fully vested. In other words, the option holder chooses to purchase the underlying stock before the option has reached its expiration date. While early exercise can be beneficial in some cases, it’s important to understand the risks and potential downsides before deciding whether to exercise early.

What is Early Exercise?

When a company grants an employee stock options, it typically sets a vesting schedule that determines when the options can be exercised. Vesting is the process by which the options become “earned” and can be exercised. For example, an option might vest over a period of four years, with 25% of the options vesting after the first year and the remaining 75% vesting evenly over the next three years.

Early exercise occurs when an option holder chooses to exercise some or all of their options before they have fully vested. This means that the option holder is purchasing the underlying stock before it has become fully “earned” and before the option has reached its expiration date.

When Does Early Exercise Make Sense?

Early exercise can be beneficial in some cases, particularly when the stock price is expected to rise significantly. Here are a few situations where early exercise might make sense:

  1. Tax benefits. When stock options are exercised, the difference between the exercise price and the fair market value of the stock is considered income and is subject to income tax. If the stock price is expected to rise significantly, early exercise can result in a lower tax bill because the difference between the exercise price and the fair market value is likely to be smaller.
  2. Risk management. Early exercise can help to manage risk by locking in the purchase price of the underlying stock. If the stock price is expected to rise significantly, exercising early can help to avoid the risk of the option expiring before the stock price has risen.
  3. Limited liquidity. In some cases, early exercise may be necessary due to limited liquidity. For example, if the company is privately held and there is no market for the underlying stock, early exercise may be the only way for the option holder to realize any value from the options.

What Are the Risks of Early Exercise?

While early exercise can be beneficial in some cases, it’s important to understand the risks and potential downsides before deciding whether to exercise early. Here are a few risks to consider:

  1. Opportunity cost. When stock options are exercised early, the option holder is giving up the potential for additional gains if the stock price continues to rise. If the stock price rises significantly after early exercise, the option holder may regret not waiting to exercise the options at a higher price.
  2. Lack of diversification. Exercising options early can result in a lack of diversification if a significant portion of an individual’s wealth is tied up in the stock of a single company. Diversification is important for managing risk and avoiding the potential for significant losses if the company experiences financial difficulties.
  3. Cash flow issues. Early exercise requires the option holder to purchase the underlying stock, which can be a significant cash outlay. If the option holder does not have the necessary cash on hand, early exercise may not be feasible.

Conclusion

Early exercise can be a useful tool for managing risk and realizing tax benefits, but it’s important to understand the risks and potential downsides before deciding whether to exercise early. When considering early exercise, it’s important to assess the potential for future stock price gains, the need for diversification, and any cash flow issues that may arise. With careful consideration, early exercise can be a valuable tool for managing stock options and achieving financial goals.

 

 

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