Our financial system is built on loans. This money helps us pay for education, a car, a house, and other personal needs.
Now, we can add exercising stock options to the long list of things you can borrow money for.
This new facet of lending came about through the growth of private valuations and the longer amount of time companies take to go public. Private investors are eager to gain access to these highly-valued, private tech companies. One way they do this is by loaning money to employees and stock option holders, providing them with the capital to exercise their stock options and pay the taxes.
But How Does This Work?
Many companies offer their employees an array of stock options. For early employees, this package often comes with incentive stock options. An incentive stock option, or ISO, is a form of equity compensation given to an employee to provide a tax advantaged way to purchase company stock. An ISO comes with many tax benefits, such as the election for long-term capital gains tax, but there also can be upfront costs.
With many technology companies delaying their IPO or initial public offering, employees with stock options other than restricted stock units (RSU) aren’t left with robust opportunities. If these employees were to exercise their options prior to the company’s IPO, they would be faced with a huge alternative minimum tax (AMT) bill.
This can put you in a tough spot. On the one hand, your stock options might actually be worth something. Yay! On the other hand, you can’t leave the company to pursue other jobs because exercising will create a crazy tax bill and leaving without exercising will terminate the options. Yikes!
Private lenders have noticed this predicament and are offering a solution to those employees: a loan to exercise the options and pay the taxes.
We have written about tender offers before, and unlike the proposal to purchase a stock and a company allowing their employees to cash out their stock options, this strategy is about obtaining external financing. The options and the shares you receive remain yours. You don’t transfer ownership. You just borrow money now to exercise and then pay the money back later in an IPO.
The information that follows is based on a quick case study that is typical of what some loan offers our clients have received.
In this case, the client went through a three-step process:
- They filled out an online survey.
- Received a follow-up call to discuss their answers.
- After an in-depth discussion, the client received a customized written proposal.
Reviewing the Offer to Finance Stock Options
The first thing I wanted to do when approached to review my client’s financial offer was to print the offer.
Printing the document allowed me to take notes and follow the data flow of the document. This is important. You have to understand how the numbers are calculated.
Get an excel spreadsheet if you can. A spreadsheet is great because you can examine the inputs and calculations. If you are working from an original excel file, make a copy so that your notes and calculations won’t alter the data in the original offer.
What I Liked About the Offer
No two private lenders are built alike. They often have varying presentations, styles, and fees associated with their loan. There are a couple factors that stood out to me when evaluating my client’s offer.
The Lender Presented the Offer in an Excel Sheet
With the initial information in excel, I was able to evaluate all of the calculations with ease while also following the flow of the document.
Multiple Options and Scenarios Were Presented
The offer didn’t simply detail the best case outcome, rather it showed a representative spectrum of potential outcomes including one at a lower IPO price than the base projection.
The Highest Possible Capital Gains Rate was Assumed
One way to make an offer look really enticing is to display more favorable tax options. This often comes in the form of displaying the highest possible ordinary income rate and the lowest capital gains rate, which for most clients is 15%.
What I Did Not Like About the Offer
While there may have been some positive elements of the offer, there were many parts that I did not like.
Interest Charges
The interest cost at first glance appeared to be a fixed amount. But, it’s not.
Total interest cost will vary based on the time. This means that the longer you have the loan open the more expensive the interest becomes. It boils down to the time you exercise and when the IPO happens.
There were various scenarios around different IPO prices, but each scenario used the same assumption for time to IPO.
Highest Possible Ordinary Income Rate
I didn’t like that the illustration was based on the highest income tax rate. Very few clients end up in the 37% bracket just based on salary and bonus alone. There may be room to add income at lower brackets. It’s not as simple as assuming that if you don’t exercise and you sell in a disqualifying disposition that all of the income will be taxed at 37%.
The AMT Calculations were Incorrect
I noticed a discrepancy in the alternative minimum tax statement after I double checked the math. The number the lending company quoted my client was actually lower than the number I calculated. This can be dangerous because you could be under the assumption that you are covered then to be slammed with an unexpected bill come April.
Their AMT calculations weren’t clear and were untraceable. I was unable to determine how they landed on the particular figure.
The Offer Details
The offer stipulated that my client was to receive a $100,000 advance. The platform fee of 5.5% left them with a net balance of $94,500. $94,500 is the cash you get now; $100,000 is what you pay back after IPO.
The $94,500 will be used to exercise the stock options and pay the AMT.
The IPO triggers the repayment schedule. There is no payment required on the advance until the exit IPO.
Show Me the Money
After the company has their IPO, you will repay the advance. But there is much more than the initial amount to consider.
- Pay back $100,000 advance
- Pay deferred interest of 7.5% based on the total $100,000 advance
- Pay a participation rate of 14%
- The participation rate is the way that the lender partakes in your options. They take a percentage of the total number of shares you receive by exercising your stock options, when you sell after the IPO
This offer stipulates that the loan is a no recourse loan meaning that the lender does not get paid until you get paid.
Comparing Numbers
After evaluating the client’s numbers and the offer illustration, I found that both the client and the lender focused too much on taxes. Just because your shares will be taxed at a lower rate if uyou exercise now does not mean you should exercise no matter the costs.
I understand the focus on taxes after all the main purpose of taking the loan is to exercise now and pay the AMT so that your final sell is taxed at preferred rates. By taking the loan you would:
- Not risk your cash and still exercise your stock options
- Pay the AMT with borrowed money
- Start the clock on long-term capital gains tax
But taxes are only one consideration in your stock option plan. it is important to see beyond the taxes and look at what it actually costs you to borrow money to exercise your stock options.
Let’s consider two choices
- Exercise now and sell at long-term capital gains after the IPO
- Do nothing now and sell after the IPO at ordinary income rates
For the purposes of evaluating the offer to finance, we will ignore the alternative minimum tax.
The AMT is a problem in the short-term due to the amount of cash you need up front. But, AMT on incentive stock options is a deferral item. Meaning you would pay the tax later when you sell the shares, but instead you get to pay the AMT now. When you pay AMT on your incentive stock options, you will generate a minimum tax credit (MTC) which actually helps you down the line.
The two numbers that really count for this comparison are the percentages for the top ordinary tax bracket and the top long term capital gain bracket.
- Top Ordinary Tax: 37%
- Top Capital Gains: 23.8%
A 13.2% gap between the two will help determine how good of a deal this offer is. After we compared the difference between borrowing money to exercise ISO taxed at a capital gains rate and not borrowing, selling shares later and being taxed as ordinary income we found that borrowing money provided too little benefit at too high of a cost.
Between the interest, participation rate, and platform fee, the costs outweigh the benefits. This offer would have cost my client $8,000 more than simply waiting and doing a same-day sell.
The Bottom Line
Borrowing money in order to exercise your incentive stock options should be a last resort as opposed to a first choice. There are other ways to exercise your ISOs.
Remember, an ounce of prevention is worth a pound of cure. Keep these things in mind:
- Exercise your ISO early
- Use your AMT gap each year
- Understand the relationship between exercising your options and the subsequent AMT payments
- Evaluate other streams of cash
- Take out a personal loan for example. That way you will have a fixed interest rate and won’t be held liable to the additional lender fees.
- Work with your advisor to design the best option for you
Exercising your incentive stock options is a big decision and before you decide when and how to exercise make an appointment with your financial advisor. It is always good to have someone on your side, making sure you get the best advice possible.