When you have unexercised Incentive Stock Options, leaving your current position creates an important inflection point. If you leave your company, you will have, at most, 90 days to exercise unexercised ISOs. The suggestion that you must either exercise your ISOs or let them expire is a false dichotomy. There is in fact a third approach.
It’s employee-friendly, and becoming increasingly the norm: conversion of ISOs to NSOs. Without this flexibility, leaving a position can create a liquidity crunch, given the need to purchase ISOs. Paying only the strike price at point of exercise can be manageable, but the tax side rears its head in April when the Alternative Minimum Tax is owed.
Whereas ISOs must be exercised within 90 days (and sometimes sooner), NSOs can be exercised a maximum of 10 years from their grant date.
The tax savings of ISOs relative to NSOs certainly exist. However, where a company permits ISOs to convert to NSOs, the suggestion that upon leaving your position you must do one of the following suddenly becomes an opportunity to evaluate the relative merits of that position, rather than falsely accept that you have only limited options:
- Sell a block of ISOs in a secondary transaction solely to cover the tax cost and exercise price on remaining blocks, at potentially a suboptimal price;
- Self-finance by dipping into your own capital reserves and savings, at potentially a high financial toll if an exit gets delayed or happens at a lower than expected valuation;
- Finance the exercise price and tax cost through an external capital provider, potentially trading future significant upside; OR
- Let the ISOs convert to NSOs, *doing nothing*, and waiting for an exit to simultaneously exercise and sell the NSOs for potentially a higher sale price at no financial risk to you in the interim
As tax advisors, we agree that ISOs are superior to NSOs except in very narrow cases. However, it’s important to acknowledge that this is true only from a tax vacuum. If, for example, you leave a company, retaining ISO status isn’t an end in itself, especially if under options (1) and (3) you sell other ISOs at too low a price, or trade away too much equity via financing.
Where your equity is expected to substantially appreciate, the better approach is often to keep more of your equity, accept potentially higher tax rates from same-day NSO sales, but know that you’re financially better off because you’ve retained enough additional equity to more than make up for the higher tax rates on what you have left.
In these situations, the tax analysis may illuminate that the preservation of ISO share status doesn’t come close to compensating for the loss of equity. The worst thing you can do with your options is to assume you have fewer options that you actually do. You must triangulate with third parties, and even when several options are available, objectively evaluate under which conditions each of these options produces the best financial result for you. The tax analysis is an important tool to make these situations less financially opaque, reveal hidden assumptions, and scrutinize inflection points.