Author Topic: Employee stock options (NSOs) at private company: exercise or let expire?  (Read 2765 times)

markus

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Hello Mustachians,

I currently have several packages of employee stock options with my private employer, all of which are non-qualified stock options (NSOs or NQSOs), and the first of which will reach its expiration date this year, just a few months from now. The options in this first package are fully vested at this point.

I've put off any decision about whether to exercise these options or not until now, and the more I read and understand about employee stock options, the less inclined I am to exercise, instead leaning toward simply letting the package expire. I wanted to list my quick pro/con list on this decision here in order to quickly plumb the depths of experience and perhaps expertise of this forum, so thank you all for any insights! I'll take it all as free advice and promise not to shake my fist at you later in life because of some big regret regarding this stuff. : )

Without getting into specific numbers, exercising these options would require an outlay of low six figures. I don't keep that kind of money liquid, and I'm not willing to touch any emergency fund's money to produce it, so this would require me selling off some stock in my taxable account. Bonus season is coming up and it's possible that such a bonus could provide a good chunk of the required money, but I've always preferred to instead sock away at least two-thirds of any windfall into my investments according to my AA, so I'd be reluctant to 'gamble' it like this.

Here's my quick pro/con list on whether or not to exercise my options:

PRO
- one day make a bunch of money very quickly (maybe)

CON
- opportunity cost ... low six figures worth of funds that I won't have invested at my usual AA, not producing dividends, etc.
- additional taxes ... the act of exercising the options is a taxable event, requiring tax payment on the value of the options at their strike price, so my cost to exercise already becomes significantly higher than just the value of the options, so opportunity cost above is even greater.
- my employer is private ... thus there is no secondary market to sell my options into. A purchase or IPO would have to take place, and that may never happen, leaving my stock effectively locked up. I still lose that tax money.
- or my employer eventually does sell or IPO ... but the stock price falls, leaving me either underwater and unwilling to sell, or even folding entirely and taking my stock with them. I lose the investment and the taxes I paid, too.
- more stock options could be issued in the meantime ... this further dilutes my shares, reducing their value.
- my employer is private ... valuing the company is complex and possibly unknowable for a layperson like myself
- IPO or purchase event would still entail a 'lock up' period ... so I couldn't immediately turn around and sell my shares, thus it becomes a gamble over time whether they're still in the money by the end of the lock up period.
- original shareholders and equity investors get paid first ... understandably, those who invested early are going to get paid back first, or even with a guarantee that they make their investment plus some additional amount. Any potential gain of my own would come second.
- taxes on any gains due at time of sale ... so I pay taxes first on the exercise, and later pay tax again on any gains. While there's still potentially a profit at the end of all that, that's an even bigger chunk taken out, so again I see it as opportunity cost. Oh, and long term capital gains paid on liquidating part of my taxable investments, too! Sheesh.
- owning stock in this one company would equate to a high single digit of my net worth, and this goes against my AA.

Obviously I'm a bit wary of exercising my options, maybe even pessimistic, as the rather CON-heavy list above illustrates. But I'm curious from you all whether there are other PROs that I'm not considering. What about my faith in my employer ... do I think they've got a bright future ahead, or do I believe in their ability to continue to produce and turn greater and greater profits? Actually yes, I think they're likely to continue to succeed in their business.

But is that enough that even if everything with these options goes according to plan, and their value doubles (and even that seems a bold assumption) or greater? Well, this is the key part I keep coming back to: If I just had left that money invested along with my normal AA, I'm probably going to make that same 'profit' over the course of a few years regardless, simply staying the course. That's where I really lean toward simply letting these options expire, not wanting to essentially take a piece of my 'stache and buy what seems to me is a lottery ticket but with slightly better odds.

I should also mention that I've still received bonuses on occasion over the years, and my compensation is good. I've worked very hard for this company for a long time now, and I still feel that this work has been recognized, so while I'm sure there's some amount of money that might have otherwise been offered in bonuses or compensation, these options don't necessarily feel like they're offered in lieu of more concrete rewards. This isn't a startup scenario where compensation is low but options are plentiful or something like that.

That's my situation. Thank you all for digging into this one and for any advice you take the time to share. I'll look forward to learning a few things.

NorCal

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You're right, this is a complex decision.  Questions:

Question #1: How senior are you, and are there a lot of people in a similar situation?  If so, it's fairly common for companies to come up with workarounds if management cares to deal with it.  I've known companies to either extend the exercise period, or arrange for share re-purchases (typically an existing investor will buy the shares from you).  This is all fairly common stuff, but it requires management to deal with the board, and it costs a little in corporate legal fees.  If you're senior enough, or there's a lot of people in your position, ask.

Question #2: Do you have a sense of what the stock is worth compared to your exercise price?  That will tell you a lot.  Ask to see the current 409a valuation.  If they won't share that, ask a new hire what their exercise price is.  If the current value is 2x or 10x your exercise price, exercising options is a lot safer than if your exercise price is close to the current value of the shares.

Question #3:  You seem to be thinking of this as an all-or-none exercise.  Is there any reason you wouldn't exercise a portion of the options that you're comfortable with?

If it were me, I would make a fairly big deal to management about this.  Try to make it their problem if you can get away with it.

If that doesn't work, I would base my decision on the difference between the exercise price and the current value.  If the exercise price is close to the current value, I wouldn't exercise.  If the current value is 100x the exercise price, you'd be stupid not to exercise.  If you're somewhere in the middle ground (which is most likely), I'd exercise a portion of shares based on my comfort on having money locked up.

My wife is a lawyer that deals with this stuff on a daily basis.  Feel free to send me a DM if you have specific questions.

seattlecyclone

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Good advice above. I wouldn't buy and hold more than I could afford to lose, but look into alternatives before deciding just to let the options expire.

Off the Wheel

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NorCal had excellent, practical advice. Here's my more emotional advice.

Employee options in underperforming companies with no exit strategy aren't worth much. I've passed on exercising those packages, because I knew we were hugely diluted with multiple rounds of big investments, that our business model wasn't sustainable (still not profitable 5 years in), and that we had no concrete exit strategy.

Employee options in highly performing companies with clear exit strategies can be worth a lot. I live in Vancouver, the land of lululemon and plenty of tech companies, and employee options led to a lot of un-intended FIRE for a lot of those first yogis and tech bros. I'm currently in a company where not only would I exercise my options, but I've also invested further into the company. The reasons I feel that way are:

  • I have full visibility into the business model and finances. We're profitable, we've got strong partners in the 'tricky' sides of the business, and we're growing quickly.
  • We have already started discussing the 3-5 year plan of acquisition or IPO, and there have been several examples in our industry recently of both.
  • I'm an early employee with a decent share, and we're focused on not diluting the base (have fewer than 10 outside investors with less than $2M raised)
  • The option price has already gone up from my package (I know this because of what the last investment round went at) - up 50% in a year, at a very conservative valuation, would already give me a $40K profit

However, perhaps most importantly, I see this money as a my 'fun' investment money, where i can try riskier things. The same way I would look at crypto. Great if it works out, no big loss if it doesn't. I don't keep track of this investment in my overall FIRE calculation.

If I were you, I would try to get as much information on the financials as possible, determine the exit strategy and viability of that strategy, and if those factors are still unknown, see if you can postpone the exercise date.

markus

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Question #2: Do you have a sense of what the stock is worth compared to your exercise price?  That will tell you a lot.  Ask to see the current 409a valuation.

Thank you, NorCal. I'm going to pursue the 409a, and thanks for suggesting it as I hadn't stumbled on that yet. I don't expect I'll be able to shake any info out of newer hires as we're a fairly large company at this point, so I'd have to guess which of the more senior people might have been presented stock options, and I'm pretty sure none of those people are going to be willing to discuss them. But I'll check out the 409a angle.

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However, perhaps most importantly, I see this money as a my 'fun' investment money, where i can try riskier things. The same way I would look at crypto. Great if it works out, no big loss if it doesn't. I don't keep track of this investment in my overall FIRE calculation.

This is the aspect I perhaps hesitate on the most. My current portfolio has me well past 'FI' and now almost touching my own definition of being ready to 'RE', which in a nutshell is FI plus a number of safety margins. I have a rough plan to step away from my job in perhaps a couple of years depending on certain project dates, and if I leave things as they are then that plan is looking very good, granted the market could always tank between now and then. Hence my increased reluctance to potentially set those plans back another year or whatever the exercise money equates to. Knowing I'm in a position to walk away from my job has actually been a good strong wind in my mental sails when I'm feeling burnt out.

Nevertheless, I totally get your point, and as you and NorCal both suggested I could always exercise just a portion of this package and thus risk less. If I can get a sense of the company's value then that's probably the best 'middle of the road' course of action, plus it would sit better with my IPS. In the end if I decide to just let this package expire, I've still got another which is also fully vested and has another couple of years before its expiration, so there's another opportunity not far down the line that I could perhaps plan ahead for as far as having funds liquid and ready to commit.

---

Thank you all again for digging into this one and for your input. Best damn forum on the internet!

JohnGalt

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You've gotten great advice so far.

I noticed in your opening that you talked that you mentioned the risks that exist but didn't seem to put much of your own thoughts on the likelihoods.

How is the company doing?  Are they moving towards any sort of liquidity event? 

If the company is just floating along and you don't see them charting a course towards a liquidity event, I wouldn't put anymore than "fun" investment money into it unless management is willing to put something (ideally binding) together around repurchases or other alternative ways to cash out ownership.

As someone who's employer went through an IPO last year (so I may be biased) - there's a lot of upside.  At the same time, if you're basically at your number anyways, no need to take unnecessary risks.
 

NorCal

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Nevertheless, I totally get your point, and as you and NorCal both suggested I could always exercise just a portion of this package and thus risk less. If I can get a sense of the company's value then that's probably the best 'middle of the road' course of action, plus it would sit better with my IPS. In the end if I decide to just let this package expire, I've still got another which is also fully vested and has another couple of years before its expiration, so there's another opportunity not far down the line that I could perhaps plan ahead for as far as having funds liquid and ready to commit.

Be sure to check the exercise price on the old grant vs. the newer grant.  There could be dramatically different economics between them.  It's possible you could be underwater on one of the grants, but have major upside on the other one.

markus

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Update: Two years later, company is still private ...

I allowed the first package of options to expire. HR notified me that the options would expire in the next two weeks, and then I just let it happen and crossed them off of my spreadsheet.

A second package of options is now approaching expiration, but this time I have more choices available as to how I wish to handle them:
1) full cash exercise (strike price times the number of shares plus taxes due)
2) company lends me the money to cover the full cash exercise plus taxes due, I sign a promissory note to repay the loan in x time
3) authorize a "net settlement" (i.e. cashless exercise) through which the exercise price plus taxes due are deducted from my total number of shares. I retain the net number of shares in the company.
4) do noting / allow options to expire

I'm not doing #1. I'm sure as hell not doing #2.

#3 has piqued my interest and sounds like the way to go. I met with HR and asked how the taxes are calculated and paid. Statutory taxes are taken off the top, plus "incremental" taxes taking the withholding up to the highest marginal tax bracket (basically so they're sure enough was withheld), plus social security, medicare, state and local. I take the net remainder *in stock*. Again, the company is private and there is no other secondary market to sell to. Future is still completely murky as to whether this company goes public in the next year, five years, ten years or never, so I'm not counting on this.

FMV is now 2x my original strike price, so I would receive a substantial value (at least according to the most recent 409A valuation) in stock, even after turning over most of it to cover this cashless transaction.

What am I missing here? It seems to me that I might as well take this, and the worst case is that one day the company goes public, the stock tanks and I just never sell or sell enough to tax loss harvest. I asked HR why the company board might have made the decision to offer this net settlement option, and it sounds like other recipients weren't otherwise taking advantage of their options.

I'd love to hear your thoughts on anything else I should ask about or might be overlooking. It all feels like a weird way to try and reward someone but I guess this is how companies do it when you're already a high earner. If I could just take a hundred bucks cash and skip all the paperwork then I'd have done that.

Thanks all.

NorCal

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#3 is interesting.  Be careful of taxes.

Don't totally discount option #2.  I've seen a number of startups issue promissory notes for shares, and I've never once seen the company come after someone for repayment if the shares come out to be worth less than the exercise price.  I've seen a lot of companies just write off the promissory notes.  There could be some tax implications here, but in practice, the debt is really only due if the shares become worth something.

Of course, this is my anecdotal evidence, so I'm not saying this WILL happen to you.  I've just seen it happen enough to know that a write-off of this debt is not uncommon.

With the FMV being 2x your exercise price, I would lean towards exercising more.  Of course, this bit me personally.  I exercised shares in my last startup, which were valued about 50% above my strike price, but they tanked pre-ipo.  I expect to be about break-even on the shares when the lockup expires in a few months.

Also, ask (and push) to have the company allow you to sell your shares.  There are marketplaces for selling shares in private companies, however, the company (typically) has to consent to the sale.

RobertFromTX

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There's already been great advice given on this, but I'll just add a quick anecdote from my experience with private stock options.

I had options that represented about 0.1% ownership in a privately held commercial bank. I exercised them all and now FMV opinion of the stock is about 3x my strike price. And the annual dividend yield is currently 10% of what I paid for it which did not start until a year or so after I vested & exercised. I had colleagues that had to borrow money to exercise, but due to my MMM habits I did it all in cash. It basically sent me into warp speed toward FI.

RobertFromTX

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Re: Employee stock options (NSOs) at private company: exercise or let expire?
« Reply #10 on: January 21, 2020, 02:41:10 PM »
As @Off the Wheel mentioned above, it should be totally reasonable to request the last 2-3 years of audit reports with financial statements on the company. You're making a financial decision to become an owner and owners are entitled to those things.

markus

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Re: Employee stock options (NSOs) at private company: exercise or let expire?
« Reply #11 on: January 21, 2020, 07:16:00 PM »
NorCal:
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#3 is interesting.  Be careful of taxes.

Since part of this net settlement would include tax withholding, is there an additional tax angle I might be missing here? That in particular is what I'm curious to hear about from anyone who's had experience with this kind of cashless exercise. I totally get that I would owe ordinary income tax to the tune of the number of shares times their strike price value, but that's the part that the company would presumably be withholding in the form of shares of stock, leaving me with the net.

If I'm not missing any other details, it seems like I can end up with a handful of shares and with no outlay of cash required.

seattlecyclone

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Re: Employee stock options (NSOs) at private company: exercise or let expire?
« Reply #12 on: January 22, 2020, 01:18:00 AM »
NorCal:
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#3 is interesting.  Be careful of taxes.

Since part of this net settlement would include tax withholding, is there an additional tax angle I might be missing here? That in particular is what I'm curious to hear about from anyone who's had experience with this kind of cashless exercise. I totally get that I would owe ordinary income tax to the tune of the number of shares times their strike price value, but that's the part that the company would presumably be withholding in the form of shares of stock, leaving me with the net.

If I'm not missing any other details, it seems like I can end up with a handful of shares and with no outlay of cash required.

The company does not know the exact details of your tax situation. Will they be asking you for a percentage to withhold? The standard withholding tables they'll otherwise use as a part of this transaction may or may not match up with your actual marginal tax rate. If they withhold less than the exact amount you'll owe from this exercise, then you will need to put up some cash at tax time. Actually the ideal scenario for you might be an overwithholding, as this seems like the only way that you're able to convert some shares into cash value at this time.

markus

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Re: Employee stock options (NSOs) at private company: exercise or let expire?
« Reply #13 on: January 22, 2020, 06:04:22 PM »
RobertFromTX:
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As @Off the Wheel mentioned above, it should be totally reasonable to request the last 2-3 years of audit reports with financial statements on the company. You're making a financial decision to become an owner and owners are entitled to those things.

I did ask HR about what kinds of reports I could see, and the answer was that I can exercise these options or not. Well, they weren't that blunt, but they did say that the company is private and that's that, and so I have to come to my own conclusions. I have only their number from the most recent 409A to go on, thus my interest only being in the third option above of the net settlement.

SeattleCyclone:
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The company does not know the exact details of your tax situation. Will they be asking you for a percentage to withhold? The standard withholding tables they'll otherwise use as a part of this transaction may or may not match up with your actual marginal tax rate. If they withhold less than the exact amount you'll owe from this exercise, then you will need to put up some cash at tax time. Actually the ideal scenario for you might be an overwithholding, as this seems like the only way that you're able to convert some shares into cash value at this time.

Yes, good point and I did ask about this. The company will be withholding at the highest marginal rate exactly because of the reason you raised, and so this should cover my taxes due plus extra which would suit me fine. That being the case, it sounds like the net settlement is the way to go: I get some shares that are (at least currently) in the money, and I fork over zero of my own cash. Maybe one day the company goes public, and after some lockup period I can sell these shares and pick up a few bucks. Thankfully I'm comfortably financially independent and just plain don't need to take the risk of laying out a chunk of my own cash for a big 'maybe' in the indefinite future, so if there are no other surprises I should be wary of then this sounds like the way to go.

Thanks for everyone's input.

appleshampooid

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Re: Employee stock options (NSOs) at private company: exercise or let expire?
« Reply #14 on: January 23, 2020, 07:18:00 AM »
RobertFromTX:
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As @Off the Wheel mentioned above, it should be totally reasonable to request the last 2-3 years of audit reports with financial statements on the company. You're making a financial decision to become an owner and owners are entitled to those things.

I did ask HR about what kinds of reports I could see, and the answer was that I can exercise these options or not. Well, they weren't that blunt, but they did say that the company is private and that's that, and so I have to come to my own conclusions. I have only their number from the most recent 409A to go on, thus my interest only being in the third option above of the net settlement.

SeattleCyclone:
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The company does not know the exact details of your tax situation. Will they be asking you for a percentage to withhold? The standard withholding tables they'll otherwise use as a part of this transaction may or may not match up with your actual marginal tax rate. If they withhold less than the exact amount you'll owe from this exercise, then you will need to put up some cash at tax time. Actually the ideal scenario for you might be an overwithholding, as this seems like the only way that you're able to convert some shares into cash value at this time.

Yes, good point and I did ask about this. The company will be withholding at the highest marginal rate exactly because of the reason you raised, and so this should cover my taxes due plus extra which would suit me fine. That being the case, it sounds like the net settlement is the way to go: I get some shares that are (at least currently) in the money, and I fork over zero of my own cash. Maybe one day the company goes public, and after some lockup period I can sell these shares and pick up a few bucks. Thankfully I'm comfortably financially independent and just plain don't need to take the risk of laying out a chunk of my own cash for a big 'maybe' in the indefinite future, so if there are no other surprises I should be wary of then this sounds like the way to go.

Thanks for everyone's input.
They will probably be withholding at 22%, which is the supplemental withholding rate:
https://www.irs.gov/publications/p15#en_US_2020_publink1000202352

I recently learned about this, as my company RSUs (very different than NSOs, but they do get taxed at vest time) get taxed at 22%, and I have no option to change this, which is fracking annoying since my effective tax rate is closer to 5% these days (2 kids, non-working spouse, mortgage interest deduction, etc.).

Note if you read that IRS pub very closely, they aren't required to withhold 22% which is what my company equity person said. The IRS allows them the option to combine the supplemental wage income with your regular wage income from previous or next pay period and just use the standard withholding tables (which take your W-4 elections as input). This would be a much better situation for me, but alas. My company is not doing it. I can understand, as it's more work for them. So now I just have to continually tweak my W-4 throughout the year to avoid getting a huge refund. Because who wants to give the government an interest free loan for thousands of dollars? Not me.

Sorry for the rant. OP, I support your decision for option 3. Seems like a no-brainer. You're not putting anything on the table, and getting a lottery ticket. I have only worked at public companies, but if I had this option I would go for it.

markus

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Re: Employee stock options (NSOs) at private company: exercise or let expire?
« Reply #15 on: January 23, 2020, 06:00:30 PM »
appleshampooid:
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Sorry for the rant. OP, I support your decision for option 3. Seems like a no-brainer. You're not putting anything on the table, and getting a lottery ticket. I have only worked at public companies, but if I had this option I would go for it.

Good points, and thanks for your input as well. In my case the company will be withholding that statutory 22% and then an additional amount on top of that to take the withholding up to the top marginal bracket. That will also be too much withholding, so I'll likely need to adjust throughout the year as you did. Interestingly, that seems like it will allow me to actually capture some of that liquid value since the rest will be in the form of stock. As you put it, it's essentially a free lottery ticket that would otherwise be pretty expensive.

Grafter

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Re: Employee stock options (NSOs) at private company: exercise or let expire?
« Reply #16 on: January 26, 2020, 03:29:12 PM »
@markus, I'm a bit late to the thread, but I do have some thoughts, in no particular order:

-  "my employer is private" - Have you asked if there are any buy-sell restrictions?  As if not, it very well would be possible to resell these shares once you have exercised the options.  In addition, do they have any repurchase agreements or an internal shareholder bulletin board?  Or if it is one of the tech companies, there may be a secondary market, ala equity zen or the like.
-  What industry is the company in?  Have you tried googling them to see if there is any financial info (or press releases out there)?
-  Where are they in their live cycle?  Basically, are they not profitable and/or reinvesting every dollar in growth?  Or are they at/or could be at the point where they start paying a dividend in the near future? 
-  Have you fully read the share purchase agreement, and understand what the rights of your shares are?  As in most all companies that I'm aware of, minority holders do have some rights, including the right to see books and records (i.e., financial statements).


Though, if they are going to withhold at the max federal and state tax rates and do a cashless exercise (option #3), I'm not really seeing a down side, as you will end up some equity with no cash out of pocket.  Other than potentially hitting some income tax cliffs/phase outs, but if you are at the max tax rate, you have hit most of them, and potentially increasing the amount to meet the safe harbor for estimated tax payments for the following year.  But then, I also would want them to be crystal clear (and potentially provide an ahead of time detail of how the transaction would work and amounts) as to that they are withholding the correct taxes.

markus

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Re: Employee stock options (NSOs) at private company: exercise or let expire?
« Reply #17 on: January 27, 2020, 05:04:16 PM »
@markus, I'm a bit late to the thread, but I do have some thoughts, in no particular order:

-  "my employer is private" - Have you asked if there are any buy-sell restrictions?  As if not, it very well would be possible to resell these shares once you have exercised the options.  In addition, do they have any repurchase agreements or an internal shareholder bulletin board?  Or if it is one of the tech companies, there may be a secondary market, ala equity zen or the like.
-  What industry is the company in?  Have you tried googling them to see if there is any financial info (or press releases out there)?
-  Where are they in their live cycle?  Basically, are they not profitable and/or reinvesting every dollar in growth?  Or are they at/or could be at the point where they start paying a dividend in the near future? 
-  Have you fully read the share purchase agreement, and understand what the rights of your shares are?  As in most all companies that I'm aware of, minority holders do have some rights, including the right to see books and records (i.e., financial statements).


Though, if they are going to withhold at the max federal and state tax rates and do a cashless exercise (option #3), I'm not really seeing a down side, as you will end up some equity with no cash out of pocket.  Other than potentially hitting some income tax cliffs/phase outs, but if you are at the max tax rate, you have hit most of them, and potentially increasing the amount to meet the safe harbor for estimated tax payments for the following year.  But then, I also would want them to be crystal clear (and potentially provide an ahead of time detail of how the transaction would work and amounts) as to that they are withholding the correct taxes.

Thanks, Grafter. Restrictions on selling are laid out in all the legalese that accompanies my option paperwork, and it's buttoned up tight: I can't sell jack squat until the company registers as a public entity. I have googled about over the years for finer financial details, but they seem to keep their cards very close to the vest. I can find a few profit estimates at different "pay us to see all of the hidden info" kinds of sites, and their numbers vary wildly. Yeah, we've been profitable at the time I've been there, but my industry is fickle and it can all turn on a dime. I know because my previous company was in great shape, and within a few years we were all laid off and the doors were closed. It's part of the reason I don't feel the need to fork over anything in order to make a larger bet with these options. I've worked really hard and saved aggressively while at this company, and so I simply do not need to take the risk. But I digress ...

Regarding shareholder rights, I specifically asked HR about this and was told that I would receive certificates for the shares and that is it. No reports, no dividends. It's very "take it or leave it".