Maximizing The Return On Your Incentive Stock Options (ISOs) By Using Their Underlying Leverage

“Formula for success: rise early, work hard, strike oil.”

–J. Paul Getty

Planning your incentive stock option exercise strategy is both an art and a science. As a financial advisor who thinks about timing stock option exercises regularly, I’d like to share with you how the concept of leverage aids the “science” aspect of your decision. The “art” has more to do with the stage of your career or your start-up’s growth, which is another conversation altogether.

The lever is a nifty invention. If you, like me, spent any time on a playground with friends and siblings as a child you may have experimented with sitting at various points on the seesaw. The further you sat from the center fulcrum, the greater the effect of your weight on the opposite side of the seesaw. One skinny kid sitting at the very edge of one side of the seesaw could lift off the ground two bigger kids sitting up close to the center. Given an especially long seesaw, the skinny kid might even be able to pick up three of their larger peers.

Your ISO Savings Leverage

It turns out Incentive Stock Options are not unlike this playground seesaw. By taking advantage of the characteristics of your options, you can both leverage funds you have earmarked for option exercise to increase income while also protecting yourself from the underlying company stock’s potential downside. Let’s explore.

Owning company-granted incentive stock options costs you nothing. Once fully vested, you have the right either to purchase the underlying shares or hold onto the options without exercise. It’s often considered best practice to exercise your options one or two years before your company goes public, or before you leave the company. Under the right circumstances, this will allow you to take advantage of long-term capital gains rates on the growth of your stock as your company ends its post-IPO lockup period.

And this is where the leverage comes in. Say you’re six years away from an IPO. You have 2,000 shares that will cost you $5/each to exercise. By purchasing the stock you’ll be out $10,000. The hope is that your stock value will continue to grow, and the gains will be assessed at the long-term capital gains rates when you ultimately sell your shares.

But wait. If you don’t exercise the options their underlying value will continue to grow at the very same rate while you also have the $10,000 remaining in your bank account. Now if the $10,000 sits in your checking account earning no interest you’ll be no better off. BUT, if you invest the $10,000, or at a minimum place the funds in a high-yield CD earning 2% annually, your money effectively becomes the skinny kid sitting at the end of the seesaw. Effectively, it gets to flex its money-making power twice. Ignoring for a moment your individual tax situation, $10,000 at just 2% interest over the course of 5 years will have grown to $11,040.81. That’s 9% more money.

At that point you could exercise your options for the same $10,000 and pocket the additional cash. You capture the upside of the stock’s growth while simultaneously making money on your funds.

Risk Exposure

The second aspect of this leverage is the risk exposure of your $10,000 - the risk inherent in owning start-up stock. By exercising your 2,000 shares today your $10,000 would be tied to the company and could be lost if it fails. But by waiting to exercise you can both maintain liquidity and earn interest. Again, you effectively become the skinny kid at the end of the seesaw.

This deferment in exercising options allows you to protect yourself from the downside while using the funds compounding growth potential for an additional upside. Double win. Would you like to hear more about how to build a strategy around your own situation or talk to a financial advisor about your specific opportunities? Reach out and we’ll be happy to walk through the financial planning strategies with you.

What about the alternative minimum tax (AMT) you say? I recommend you start with my little guide on cracking the AMT right here.