Ahh, the golden handcuffs.
Those lovely things that keep you chained to your current job until the IPO. They’re not so bad if your company is going to IPO in a year or two, but with more and more companies delaying their IPO, it puts startup and private company employees in a pickle.
Here’s why:
Stock options.
A lot of times, startup employees aged 40 or less have most of their net worth tied up in the stock options their company gave them in exchange for working there. And they only get to “cash out” on those stock options when an IPO happens, because exercising them before an IPO can get quite costly.
You may have an incredible job offer at another company on the table, but you also don’t want to give up the stock options you worked so hard to gain over the years. Exercising now may not be an option, because you can’t afford the hundreds of thousands of dollars you’d trigger in Alternative Minimum Tax (AMT) if you DID exercise them. And that probably isn’t going to change in the short 90-day window you have to exercise them after leaving your job.
So… what do you do?
Fortunately, more and more companies are giving employees a chance to do an ISO to NSO conversion with an extended post-employment exercise window or a new, lower exercise price. This really relieves the financial pressure of having to exercise within 90 days, lets you keep your net worth, and reduces some of the career risk of these golden handcuffs.
Note: Don’t quite understand the difference between ISO and NSO? Here’s the basics:
- ISO = Incentive Stock Options. The “incentive” is that the exercise of ISO is not taxable as ordinary income. However, the AMT may apply.
- NSO = Non-qualified Stock Options. The cost to exercise is the same as ISO, but NSO are taxed as ordinary income at the time of exercise.
Why Can’t I Just Keep My ISO?
Unfortunately, there are pretty strict tax rules around whether or not stock options can qualify as ISO. These rules don’t allow you to change the original terms of the stock option grant without disqualifying the option, effectively converting it to NSO. (Which is why it can be good to do an ISO to NSO conversion if you don’t want to stay in your current job.)
So… Should You Do an ISO to NSO Conversion?
Now-public companies like Uber and Pinterest have given employees the option of doing an ISO to NSO conversion, as well as many other late-stage startups that have yet to go public.
The (kind of) cool thing about this opportunity is that there aren’t strict nondiscrimination rules around stock options like there are with 401(k) plans. Qualified retirement plans, like a 401(k), require everyone to be treated equally, so there’s not much space for wiggle room on a person-by-person basis.
But with ISO conversions, your company is allowed to offer conversion individually, so even if it isn’t a company-wide policy, you may be able to get access to this opportunity anyway.
Let’s say you get a job for a company, and you’re granted ISO on January 1, 2021. With this ISO, you’re given an expiration window of December 31, 2030. (Basically meaning that you have until then to exercise this ISO before the opportunity expires.)
If the ISO remain ISO, you have to be an employee of the company to keep your stock options… or exercise all your ISO within 90 days after leaving the company.
However, if you stay at the company for three years and your company lets you convert your ISO to NSO on January 1, 2024, you then have the freedom to exercise these stock options until your original expiration date (December 31, 2029). But now that they’re NSO, you don’t have to be an employee of the company to exercise, and you’re not limited to a 90-day exercise window once you leave that job.
So… what are the three main reasons to do an ISO to NSO conversion with an extended post-employment exercise window?
- Eliminating career risk
- Keeping leverage
- Lowering your upfront investment cost
1. Eliminate Career Risk
When you get rid of career risk by converting ISO to NSO, you get rid of the golden handcuffs.
You can stay with your company if you’ve got a career trajectory there that excites you. But if you don’t, if you convert your ISO to NSO, you’re free to get a job elsewhere and still keep your net worth in your stock options.
This is incredibly important, especially since companies are going public (and letting their employees cash in on their stock options) later and later.
For example, Instacart went public in 2023… even though they were expected to go public around 2021. Putting your career development on hold for years is a lot to ask, especially when an IPO is not guaranteed… and when you consider the increase in salary you could be getting elsewhere.
2. Maintain Leverage
As long as you have options, you have leverage. Leverage is the positive difference between your exercise price and the fair market value. But the instant you turn your options into actual shares (read: exercise), you lose that leverage.
Leverage in stock options is a fixed exercise price with an unlimited upside.
For example, let’s say I don’t have any stock options in your company, but I want to invest. I buy a share for $50 and sell it a year later for $100. This is a 100% ROI, which is arguably pretty good.
However, let’s say you have NSO, and your strike price to exercise is $5.
You don’t have to spend any money when I buy my $50 share, but you still get to wait a year until the price goes up to $100 per share. You exercise your options and buy a share for $5, only to turn around and sell it for $100. That’s $95 made on a single share, and a 1,900% ROI.
Yes, this gets taxed as ordinary income instead of at the rate ISO is taxed, but if you’d been forced to exercise your ISO in the 90-day window after you left your job, you’d have missed out on this opportunity to not have to spend money upfront, but still rake in major profits.
When you’re able to keep your stock options as unexercised in the form of NSO, you don’t have to give up this leverage potential.
3. Lower your upfront investment cost
It costs you $0.00 to convert your ISO to NSO before you leave your company.
When you’ve got NSO, you can take a “wait and see” approach.
If the company does well and you can make a lot of money after the IPO with your unexercised stock options, that’s great! If not, it’s no big deal: you haven’t put your career on the line or risked your financial future by investing a lot of money in a risky company.
Normally, the “cost” to keep unexercised stock options is continued employment at a company, and therefore potentially the sacrifice of an increased salary elsewhere. With NSO, that “cost” is eliminated, and you’re not forced to spend a bunch of money to exercise your ISO in 90 days, potentially having to pay the AMT, on a company that may not be successful in the long run.
⚠️ Before You Do An ISO to NSO Conversion… ????
While converting your ISO to NSO can be a great financial move, it’s not an all-or-nothing deal. Usually, your company will let you exercise some ISO (so you can get the tax advantages ISO have over NSO), and convert the rest to NSO. This lets you exercise when you can afford to, rather than when you’re forced to by a 90-day exercise window.
If you’re about to convert your ISO to NSO, I’d consider exercising some of your ISO first, in one of three ways:
1) Exercise Up to Your AMT Threshold
Under the new AMT laws, most people have wiggle room where they can exercise some ISO without having to pay the AMT.
If you can do this, your only cost would be the cost of exercise, without paying additional fees for the AMT when your tax bill comes.
2) Exercise Up to Your Annual Minimum Tax Credit (MTC)
Paying the AMT on ISO will create a minimum tax credit (MTC) to use in future years to lower your taxes. This makes the additional tax cost of exercising ISO easier to bear because in year one, you’ll exercise and pay the AMT… but in year two (and possibly more years after that), you get all the AMT you paid back in the form of MTC.
Just be aware that AMT and MTC are incredibly complex and confusing to calculate. Don’t try to wing this math on your own. Hire a professional to help you figure it out.
3) Choose a Total Cost & Stick to It
Before you make any ISO investment moves, decide how much money you’d be willing to part with right now in order to invest in your company.
Then, calculate the number of ISO you could exercise before your reach that cost threshold, as well as any tax or AMT you’d have to pay so you don’t go over that amount.
And Always, Always, Always Read the Fine Print About Your ISO to NSO Conversion
Before you sign any paperwork or convert any of your option types, make sure you know what you’re agreeing to. ????
Sometimes, companies throw in additional clauses when employees convert their ISO to NSO that affect the expiration date of those options. For example, those options may now expire much earlier than the original expiration date when they were ISO. Or you could only have a small window exercise them (like six months) after the IPO happens before they expire.
If a clause like this does exist, it could really affect your decision-making, since it gives you fewer choices and kind of forces your hand as far as when you can exercise. This limits your leverage, and your ability to use tax as a source of return because you don’t have as much leeway as far as proactive income and tax planning.
Get a Solid Plan in Place On Converting and Exercising Your ISO & NSO
Converting ISO to NSO is one of the smartest things you can do, especially if you’re getting restless in your current job and want to seek career development elsewhere.
It does take some careful planning though, and knowing your way around stock options grant documents and financial planning to make sure you get the most out of any dollars you invest.
Our team of financial planners know these stock options and their different regulations and tax rules inside & out. We’ll help you come up with a plan that makes sense, that’ll work with the regulations in your stock option grant documents, and that will keep you free to grow your career when the opportunity presents itself, without giving up any of your potential wealth.
Book a call with us today to see what we can make happen.
