Toxic Stock Options

I got a strong feeling of deja vu when I read this article on the perils of carelessly exercising and holding stock options. While this is a topic that may seem a bit out of tune with the times, it is worth attention for all of us who work in the technology sector and hope to, eventually, do well with stock options in start-ups. I have seen others brought to the brink of financial ruin in the dot-com boom and bust because of this issue.

The article itself is pretty clear so I won't repeat what it has to say - go and read it if you have options in the company you work for and you are feeling optimistic about your prospects. That way when you do see your options in the money some time in the future, you will be prepared. Or consult a professional for advice before you exercise those options.

Those of us in this business tend to be an optimistic lot. When we accept options as compensation in a struggling start-up it is with the hope of future success. Sure there are no guarantees, but hope springs eternal. From time to time the unthinkable happens and the company flourishes and the market bounces. The company goes public and your low-priced options are suddenly well below market value.

Now let's say those options are set to expire as often occurs. Although this normally takes several years, it can be surprising just how fast the time can pass. You suddenly have a decision to make: exercise those options and hold them or sell them? A more common scenario is when you leave the company, whether voluntarily or not, and you are under the gun to choose.

If you exercise and sell, the tax treatment is straight-forward: take your profit and pay your taxes. If you decide to hold you have just incurred a taxable benefit. As the article points out, if the shares decline in value so that you later take a loss, the loss is magnified because of the different treatment of exercising versus capital losses. Even if the shares do not decline to this level, the taxes on the gain of exercising the options is due that same year - you will need to raise funds to pay the tax bill.

I've been in this situation only once in my career. I got good advice and I was aware of the mistakes others had made. I chose to sell the shares immediately upon exercising the options. I'm glad I did since only a short while later those shares were below the option price.

The lesson here is that optimism is fine, provided it does not blind you to the possibility of unpleasant outcomes. Protect yourself.