Early exercise isn’t all it’s cracked up to be -- for employers or employees.

Stock options are a popular form of deferred compensation giving employees a sense of ownership in a company. Some firms allow for an early exercise of stock options. Before you allow such a policy, consider the implications carefully.

What Is Early Exercise of Stock Options?

Stock options usually work like so: Employees may buy a specified number of stocks over the course of a number of years at a certain percentage each year at a guaranteed price. For example, a company might allow an employee to buy 10,000 shares at $1 each, vesting 25 percent each year. This allows the employee to buy 2,500 stocks each year.

Early exercise allows the employee to buy all of the stocks at one time, while still keeping the restriction on how much is vested. Put specifically, our hypothetical employee can buy 10,000 shares of stock for $10,000 all at once. However, he only takes true ownership of 25 percent of the stock each year he works for your company. This prevents an employer from exercising the option to repurchase the stock, but does not allow the employee to leave his position and make off with $100,000 worth of stock at a price of $10,000.

Should You Allow Early Exercise?

Whether or not to allow early exercise of stock options is a controversial topic in contemporary business. Before allowing early exercise, consult with your legal department to determine the best option for your company and the firmest legal ground possible. Some things to consider before you move to an early exercise policy include:

  • The Rights of Stockholders: Optionees are not stockholders and do not have stockholder rights until they purchase their stocks. With early exercise, optionees gain stockholder rights even if they are not vested.
  • Administrative Burden: When there’s a noticeable increase in the number of stockholders at your company this can create an administrative burden for your company.
  • Securities Law: When your company has over 35 unaccredited stockholders, securities law can be far more complex if another company is looking to acquire yours. Further, when your company has more than 500 stockholders, you are required to register with the SEC as a publicly traded and reporting firm.
  • Employee Risk: It isn’t just companies taking on a risk with early exercise. Employees face potential risks as well. Obviously, the stock price might go down rather than up. Stocks purchased with promissory notes must have interest paid on them at market rates, a rate that can accrue quickly. For accounting, legal and tax purposes, all promissory notes must be full recourse. This can quickly eliminate any potential tax benefits for employees.

The Right Decision About Early Exercise

Your company should carefully examine early exercise before making a final decision. Then consider making early exercise an option you extend only to employees who request it. A legally and financially complicated area, many people find that an early exercise clause is far more trouble than it’s worth. Still others feel it sets their company apart in terms of potential compensation. Where you fall on that spectrum will depend on your company’s specific circumstances and consultation with your legal team.