By Joe Ferreira and Sam Marshall, CPA
The general rule for exercising stock options is start with the options with the lowest strike price. There are two reasons for this:
- Options with the lowest strike price have the largest embedded gain. By exercising these options, the clock starts on the one-year holding period required to receive favorable long-term capital gains tax treatment.
i. Long-term capital gains rates are typically 9-13% lower than ordinary income rates, depending on your income level.
- Exercising the options with the lowest strike price allows you to exercise more options – even factoring in potential AMT.
However, sometimes circumstances upend the conventional wisdom. Even though exercising NQSOs is typically more expensive than exercising ISOs, both because of their relatively high strike price and because ordinary income tax would be owed immediately on exercise, it may be advantageous to start exercising your NQSOs.
So why might now be a good time to exercise NQSOs?
Exercising NQSOs generates ordinary income tax on the difference between the strike price and the current 409a valuation. Today’s 409a valuation of Procore stock is $40.17/share, but there has been a flurry of activity in the secondary markets and trades have gone as high as $70/share. The huge divergence between the current 409a valuation (what the IRS considers to be the value of the stock) and the current price in the secondary market (a better reflection of fair market value), creates an interesting tax planning opportunity.
At some point soon, perhaps even before the beginning of next year, the 409a valuation will converge with the FMV making those stock options a lot more expensive to exercise because of the increase in taxes you would owe. If you are able to exercise before the 409a adjusts, you essentially convert the difference between the current 409a and FMV (roughly $30 per share) from ordinary income to favorable long-term capital gains without having to worry about AMT, or paying long-term capital gains tax until you sell.
It’s worth noting that this strategy only makes sense for those who believe you will eventually be able to exercise all your ISOs with lower strike prices. If you don’t think you will be able to exercise all your ISOs, you should prioritize doing that as opposed to exercising your NQSOs. The huge gap between 409a and FMV also makes now a great opportunity to exercise ISOs (AMT bill would be much lower now than after the adjustment).
In a world where all financial resources are limited, maximizing your resources is critical. Paying less to exercise means having more funds available to exercise more options, diversify outside of Procore stock or to spend. These are all good things! Keep in mind that while this strategy should help save a considerable amount of tax down the road, it comes at the cost of increasing your taxes in the year of exercise.
There are lots of factors to consider when deciding to exercise or not. If you have questions, we’re happy to help.