Exercising Underwater Stock Options - Possibly Justifiable or Always an Illogical Decision?

"Hey Stan, I have a question, would it ever make sense to purchase a set of shares where the exercise price is higher than the current FMV (i.e. my options are underwater)? Would there be a way to lower my AMT that way?" The client who recently asked me this had ISOs at a private company that recently experienced a downward 409a revaluation, which pushed the FMV below her exercise price. Many companies have experienced downward revisions to their 409a valuations over the last year-and-a-half due to the shakeups in the tech sector, so I'm hoping this will help other people who have underwater stock options and are wondering the same thing.

Can exercising underwater stock options make sense?

If there's any way for you to acquire shares at the current FMV or market price, exercising underwater options doesn't make sense because it would be more financially advantageous to buy them for the current price rather than your higher exercise price. For instance, exercising options in a publicly traded company with a strike price of $100 isn't prudent if the market price is $50 - if you want to own your company's stock, buy the shares on the stock market. Compared to buying shares at the current market price, exercising your options would either mean paying twice as much for the same number of shares or receiving half as many shares for the same cost.

This is true even if your options are about to expire. Yes, you'll lose your stock options forever, but they have no value anyway since you can still buy shares at a lower cost.

However, the above is only true if there are other ways for you to get the shares. Private company stock doesn't trade on the stock market, so exercising stock options is often the only way employees can get equity in their company. In this case, it might make sense to exercise even if your options are underwater. Here are a few situations where it might make sense:

Exercising your options is the only way to get equity in your company.
You feel like the depressed FMV is temporary and your company has strong future prospects. Even though you'd be "overpaying" by exercising today, your expectation is that your investment will ultimately pay off. On the other hand, if you have doubts that your company will be able to turn things around and increase the FMV enough for you to profit, it doesn't make sense to exercise your options. Even if you're eventually able to take a capital loss, the up-front cost of your options will outweigh any tax benefits you'd receive from taking capital losses in the future.
You don't want to wait for the FMV to go above your exercise price again because you want to avoid owing taxes on the exercise spread.
Your options are going to expire soon. You might be uncertain about your company's future, but if you don't exercise now, you'll lose those options and the potential upside. It's a tough decision to make, but like any other options-exercise decision, it's important to evaluate if making a bet on your company is worth the risk.

Exercising private company stock options is always risky, but exercising underwater options can be even riskier than "normal" for a few reasons. First, exercising underwater options means you immediately have an unrealized loss, and the stock has a longer way to go before it can become profitable for you. Second, an acquisition at depressed prices can be especially harmful to common shareholders (employees) because preferred shareholders (investors) often have clauses that allow them to recover their full investment before common shareholders get anything (liquidity preference or distribution waterfall). Third, a weak FMV can delay IPO plans, because current investors tend to prefer higher IPO valuations, and downward revaluations of private companies are often perceived negatively by potential investors.

Can exercising underwater options reduce taxes?

Unfortunately, there are no tax benefits to exercising underwater options. Big surprise, the IRS doesn't care if you "overpay" for your shares, they only care if you're able to get them at a discount. There's no recognizable "loss" that you can claim when you exercise underwater options.

The option spread or bargain element, which is the amount added to AMT income for ISOs or ordinary income for NSOs (normally the FMV at exercise less your exercise price), can't be negative and therefore doesn't subtract from your AMT income or ordinary income. As a result, you can't lower your AMT by exercising underwater ISOs, and you can't reduce your regular income tax by exercising underwater NSOs.

Since you can’t take a loss for exercising underwater options, from a tax perspective it doesn't matter if the FMV is $1 lower or $100 lower than your strike price. Your cost basis will be your exercise price for capital gains purposes and for AMT purposes. However, as mentioned earlier, the deeper underwater your options are, the more the price needs to recover before you can profit, and even if you're eventually able to take a capital loss, the up-front cost of your options will outweigh any tax benefits you'd receive from taking the loss.

Conclusion

If you're considering exercising your underwater stock options, first make sure that you can't buy the shares cheaper any other way. Next, think about how you feel about your company's future prospects. Then, evaluate whether you're comfortable taking the risk. Finally, consider whether now is the right time to exercise. Remember that there are no tax benefits for exercising underwater options, but taxes may come into your decision framework if you're concerned about owing taxes on a positive exercise spread if the FMV goes back up.

If you have any questions or would like to explore your situation in more detail, please don't hesitate to reach out or schedule a time to talk.