It may be safe, but it isn't free. As with most other things, you pay a risk premium -- in this case, in the form of failure to qualify for capital gains tax treatment on the resulting gain, because you didn't exercise in time to hold the underlying stock for more than one year. Depending on the amount, this difference can be quite significant.
You do your own taxes so probably know all this already, but here's a simple example[1] anyway. Let's say you "risklessly" exercise options with a strike price of 100 and a FMV (tax-lawyer speak for fair market value) of 1000. You have immediate gain of 900 -- and because you didn't hold the shares for >1 year, all 900 is Ordinary Income, generally taxed at higher rates than capital gains. (Top federal OI rate is something like 39% last time I checked vs something like 17% for cap gains.) Assuming the OI rate is 39% and the CG rate is 17%, you pay tax of .39 * 900 = 351, for total post-tax cash of 900 - 351 = 549.
What if, instead, you had exercised speculatively, more than 1 year prior? You'd still have taxable gain on 900, but because you'd have held the stock for more than one year (and met some other qualifying factors I won't bother explaining here), your tax bill would be 17% -- meaning that you'd pay .17 * 900 = 153 in taxes, and keep cash of 900-153 = 847.
Not a huge difference when we're talking about gain in the hundreds, but adds up quickly if you're in line for tens or hundreds of thousands or more.
It's really just a question of how you evaluate different kinds of risks, and what you want to pay to hedge them. If you want to balance your tax bite against the risk that your company goes under or otherwise fails to deliver, you may still want to exercise early, but only partially.
[1] I'm eliding a few things and making some assumptions. Not legal advice, talk to a real tax attorney before making decisions, etc.
For you example, say I exercise my option to by 1 at strike price of $100 in 2015. I hold on to it and sell it in 2017 for the FMV of $1000. Do you only pay the capital gains tax of the $900 gain?
Ignore state rules, just at the fed.
However, AMT(alternative minimum tax) doesnt recognize ISO. So in 2015, you have to calculate AMT, which $400 counts towards. This is basically a no-deduction(except a high standard deduction) flat tax, you potentially owe 26-35% on that 400. Even though you didnt sell anything - this is where people get screwed.
So lets say you paid $100 in AMT. In 2017, you still owe capital gains tax on the whole $900, but you calculate AMT and claim the difference, up to $100, as a credit - the difference should be >100. You can actually claim this credit every year until previously paid AMT runs out, but most likely the difference wont be sizable enough until you sell.
Not a tax pro; this is not tax advice; yada yada.
Thanks for responding folks.
You can make ISOs be treated approximately as NQSOs, but otherwise, you're generally getting from an established program and within a company, you don't have to be prepped to negotiate one type vs the other. Over time, the company will no longer be able to issue ISOs and may implement other programs, but they will tend to be "one type fits all" in general.
They do fun things like giving you a loan with the options as a collateral. You would then default on the loan at the point of IPO.
So theoretically you don't sell them anything.
- $110k + 5k options, with 5M shares outstanding, at a strike price of $1 / share.
- $100k + 3k options, with 1M shares outstanding, at a strike price of $0.01 / share
Both are realistic scenarios for an early-stage startup. The 3k options in the second deal are worth much more than the 5k options in the first deal, on paper. (This is without even brining in valuation in question.)
A call option on a share of Google with a strike price of $50 is worth a heck of a lot more than a call option on "name any startup" with a strike price of a tenth of a penny.
There are, naturally, cash flow implications to this.
As an employee, you just don't know. So value them at zero. Or, if you want to be fancy, epsilon. And take the cash.
The only book I've read on stock options is _Consider Your Options_ by Kaye Thomas, which I thought was good. I do my own taxes, and there was enough detail in that book to let me figure out the tax implications of my options. (Including AMT the one time I had to pay it.)
The actual mechanics when you already have options are straightforward. You either exercise speculatively (pay real cash to turn options into shares, then hold the shares), or exercise risklessly (pay cash to turn options into shares which you sell immediately for more cash than it cost to exercise). Exercising speculatively has risks -- you pay real money for shares that then go down in value, possibly to less than the strike price, possibly leaving you with a tax bill even though you made a loss. Exercising risklessly is safe.
I don't like to speculate with meaningful amounts of money. If in doubt, sell the stock and diversify. Think of the worst case (the company crashes and you lose both your job and the value you thought the stock had). Better to not have all your eggs in one basket and sleep well. I suspect this is not a popular sentiment there, though.
The real question with options is when you're considering multiple job offers. Company A offers $100k and 3000 options. Company B offers $110k and 5000 options. How do you value the options? For a startup, the usual answer is that you can't, because there's no anti-dilution protection. If the founders want to hose you, they can hose you, by diluting your shares or by firing you right before a vesting date. So I value them at zero and take the job I like better, or the job that pays more actual cash.
(RSUs in a healthy public company are a bit different, since they have an actual immediate cash value. I value them at 75% of the current value of the stock. The 25% discount is because of vesting periods.)