Employee Stock Options: Early Exercise and Vesting

Employee stock options have become a common form of compensation in the tech and startup industries, offering a way for employees to possibly benefit from the company's growth. However, when it comes to exercising these options before they are fully vested, the situation can be complex and depends on a range of factors.

Can You Exercise Unvested Options Early?

Employees might engage in something known as the “early exercise” of unvested options, which is the act of purchasing the company’s shares before the options have fully vested. This can be done either if the option grant agreement, including any relevant corporate documents, allows it, or if the company agrees to permit it, whether as a one-time waiver or as a corporate policy. This is particularly common in early-stage companies and can provide significant tax advantages.

When unvested options are exercised, they become unvested stock. This stock usually comes with all the rights of a shareholder, such as information rights, fiduciary obligations, and voting rights. However, unvested stock cannot be sold or used as collateral. In the event of the employee leaving the company, the company generally has the right but not the obligation to buy back any unvested stock.

Why Early Exercise Matters

Most employee stock options cannot be exercised before they are vested. The purpose of vesting is to ensure that employees earn the right to exercise the options based on their service to the company or the achievement of set performance goals. Some companies, however, allow employees, including newer hires or managers, to engage in an “early exercise.”

The main benefit of early exercise is that the employee can pay the exercise price and taxes in advance, potentially when the share price is lower than it will be upon vesting. However, the complexity lies in the fact that the shares remain subject to forfeiture if the employee does not meet the vesting requirement. In such cases, the company must repurchase the shares and cancel the award. Due to this, most companies do not allow early exercise across the board.

Partial Vesting and Early Exercise

For options that have multiple vesting tranches, such as those vesting 25% per year over a four-year period, employees can exercise the shares as they vest. For instance, 25 shares can be exercised after one year, 50 shares after two years, and so on. This allows employees to benefit from gains in the value of the stock as the options vest, but it requires careful consideration of the potential forfeiture risk.

Conclusion

Early exercise of unvested options is a nuanced and strategic decision that can offer significant benefits, particularly in terms of tax planning and early financial gains. However, it also requires a thorough understanding of the corporate policies and potential risks involved. Companies and employees should carefully consider the implications of early exercise, taking into account the specifics of the option agreement and the company’s policies.

Keywords: Employee stock options, early exercise, vesting