Originally Posted by Saturdays
interesting didn't think about that. I know my father generally gets paid in a combination of stock and options - he exercises the options once in a while when he has a reason to.
It depends a lot on the strike price. Really early employees are likely to have options with really low strike prices ($0.10 - 0.50 a share), and for them, it often makes sense for them to exercise as they can afford to in order to hit the two year waiting period for LTCG tax treatment (so they can subsequently be ridiculed if they run for President...). For later employees, where the strike price is higher ($1+ per share), it gets more difficult to do this.
One of the first twenty employees is awarded 1 million options with a strike price of $0.10. You estimate that the shares are currently worth $2/share, but in the next two years, will easily be worth $10/share. If you exercise now, you're going to spend $100,000 of cash
(which most people, especially young employees who jumped into startups, don't have) and then you're going to get your ass kicked by the AMT to the tune of $500K come next April. So you really need to have $600,000 of cash lying around to exercise your options. BUT if you wait it out, it's a good deal, because in two years when the IPO happens, your gain of $9,400,000 is taxed at 15%, so you come out of it with ~$8M. If you hadn't spent the $600K two years earlier, an the IPO those shares would have been taxed as Ordinary Income and you would have netted out somewhere around $5.5 - $6M depending on what state you live in. So your $600K investment created savings of $2.0 - $2.5M, which is a pretty good deal.
Now, take a later employee, who also gets 1 million options, but his are at $1.50/share. At the same point in time, he could spend $1.5 million to exercise, plus an AMT hit of ~$150K for a total of $1.65M. After the IPO he would come out of it with an after tax payment of $7.1M. If he hadn't spent the $1.65M to qualify for LTCG, he'd come out with $5.1M at the IPO. So he spent $1.65M to save $2.0M, which is a 25% return (over two years) with quite a lot of risk.
The reality is that the strike price keeps people from exercising in most cases. Most startup employees don't have a couple million lying around to exercise their options. And it's one of the seedy underbellies of options - take employee #2 above, say he did a great job and took a low salary in exchange for options, but the company outgrew his skill set (this is a very common situation). Fire him. The newly jobless employee isn't going to spend $1.65M exercising the options that he earned
, and they're going to expire 90 days after he leaves the company. You got a great employee who did great things for your company, and you barely had to pay him....