The best time to exercise is probably today, and the clock is ticking
What we haven’t covered yet is when to exercise.
Barring a few exceptions: if you are optimistic about your company, the best time to exercise is now. ✱ (If you’re not optimistic, you shouldn’t be exercising.)
The reasoning is as follows. If you are considering exercising, it means you are optimistic about the growth of your company. If you are right about that, then unless you have a specific reason to assume the 409A valuation will go down (while holding this optimistic view about your company!), you should be expecting it to go up. And as soon as it goes up, costs of exercising increase.
You could argue that this buys you extra time to watch the future of your company unfold. But are those extra months worth the potentially doubling costs? Unless you foresee a critical ‘do or die’ moment for the company in the near future that you’d like to await before making the decision, we’d argue no: there will alway remain uncertainty in a startup.
If you agree with that logic, it means the theoretical optimal moment for you to exercise is right before the 409A valuation updates: you’ll then know more about the fate of the company while still exercising for the same cost. But unless you’re in the position to anticipate that moment with confidence, it’s a tricky optimization.
There’s one exception, which is when you’re reading this in November or December. That late in the calendar year, while you may not be able to anticipate the precise date the 409A valuation will be updated, you may be able to determine whether that’ll still be before January 1st. If you’re pretty sure that it won’t, you could exercise stock options in two batches: one batch this calendar year, and the other in the next, so as to avoid entering a higher tax bracket.
In other words, spending the same amount of money on your option exercise will get you a worse cash curve in the future than it would today.
So how much time do you still have to make your decision? When does that catalogue change happen?
This gets a bit technical, but it's when the 409A valuation updates.
Like all startups, your company is required to have a third party make a valuation of its shares for tax purposes. This so-called 409a valuation directly impacts your exercise costs: if it goes up, exercising becomes more expensive.
The 409A valuation goes up if the independent valuator believes the company is in a better shape than it was last time.
Re-valuations happen at least every year, but also whenever something big happens to the company. The typical example of ‘something big’ is raising a new investment round, but it could also be winning a substantial sales deal or entering a key partnership.
Note that the moment something big happens, your company is required to freeze option exercises and order a tax valuation update. You won’t be warned (your company is not supposed to, at least) – that’s the point.
If you want to anticipate this, discuss with your leadership when they expect the next re-valuation to happen. They won’t be able to say for sure however, because those ‘big events’ aren’t always planned. It's a good idea to be on the safe side and make up your mind well in advance.