First, the basics:
What are stock options?
Stock options give you the ability to purchase your company’s stock at a specific price, as long as you meet certain milestones — usually a specific length of employment, or by hitting predefined performance goals.
Stock options are designed to motivate employees to grow the company, and become invested in its success.
If you decide to purchase your stock options, you’ll become a shareholder and own a tiny piece of the company’s equity, which could gain in value as your company grows.
If your company goes public or gets acquired, your shares could be worth a lot more than what you paid for them. If your company fails, chances are, you’ll lose your investment.
There are two common types of stock options: Incentive stock options (ISOs) and non-qualified stock options (NSOs). Check your stock options administration platform, like Carta or Shareworks, to see which type of options you’re currently earning.
Note: Employees at later-stage startups and publicly traded companies often earn restricted stock units (RSUs), which are structured and taxed differently. In this guide, we’ll focus on ISOs and NSOs, which are more common at earlier-stage startups.
ISOs and NSOs are similar in that they both have a strike price (how much each share will cost you to buy), and a fair market value — for startups, contained in their 409A valuation, or for public companies, the stock’s current trading price on Wall Street.
In the U.S., every time you buy stock options, you’ll have to tell the IRS how much you paid for them, and how much they were worth at the time. You could owe taxes on the assumed gain, depending on the type of stock options you exercise, and your other income that year (more on that later).
How do you exercise your stock options?
Details about how to exercise your stock options will be contained in your stock option grant paperwork. There, you’ll see a vesting schedule, which describes what you need to do to unlock the ability to purchase your stock options.
Most employees are offered a time-based vesting schedule, where they’re granted a specific number of stock options when they join their company, and gradually unlock the ability to buy those shares over time.
In your paperwork, you’ll also see how many shares you’re vesting, and their strike price. For example, let’s say you’re vesting 10,000 ISOs over a 4-year period, at a strike price of $1 per share.
If you decide to exercise your shares halfway through your vesting period, that means you’ll be able to buy up to 5,000 shares for $1 per share. It’ll take another two years to fully unlock the remaining shares in that specific stock option grant.
Exercising your stock options is fairly straightforward — you’ll purchase the shares through your company’s stock options administration platform, and report the transaction to the IRS. Depending on the type of stock options you’re exercising, the value of the stock options exercised, and your other income, you might owe taxes on the transaction.
When should I exercise my employee stock options?
In general, if you plan to exercise your stock options, there can be significant tax benefits to exercising shares earlier, rather than waiting for an exit event, like an IPO or acquisition.
If you’re working at a very early-stage startup (typically defined as a company that has raised less than $50 million in venture capital), exercising stock options early could qualify you for the QSBS tax exemption.
The requirements to qualify for QSBS are narrow, but for those who do qualify, they could find they’re able to avoid paying hundreds of thousands of dollars (and in some cases, millions of dollars) in taxes when it’s eventually time to sell their shares.
Even if your stock options don’t qualify as QSBS shares, exercising early starts the clock on long-term capital gains, and can reduce your upfront tax bill (more on that later).
Note: If you decide to leave your job before the company goes public or gets acquired, you’ll have a limited amount of time to exercise your stock options or risk losing them forever.
The industry standard remains 90 days, although some companies have voluntarily opted to extend the stock options exercise window out to as much as 10 years.
How can you save money on taxes when exercising your stock options?
Calculating the total cost to exercise your stock options can be tricky on your own, which is why we’ve built the Stock Option Tax Calculator.
ISOs and NSOs are taxed slightly differently. ISOs enjoy more favorable tax treatment, because when you decide to buy them, they’re taxed under the alternative minimum tax system. NSOs have less-favorable tax treatment, because you’re taxed under the ordinary income tax system when you decide to exercise.
In either case, there can be significant tax savings by deciding to exercise your stock options early, when their strike price is still fairly close to the company’s 409A valuation.
Let’s consider two people who get hired on the same day, and earn the exact same number of stock options. One person decides to exercise their stock options early, while the other waits until the company goes public 10 years later.
Both employees are earning 100,000 ISOs at a strike price of 10 cents per share.
The first employee exercises their ISOs early, when the company’s 409A valuation is at 50 cents per share (Note: Private companies routinely perform 409A valuations, where an outside firm comes in to estimate how much the company’s shares are worth).
The employee pays $10,000 to buy the shares (100,000 shares x 10 cents per share), and reports to the IRS that on the day they exercised, the shares carried an assumed value of $50,000 (100,000 shares x 50 cents per share from the 409A valuation). The assumed gain of $40,000 is small enough that the transaction doesn’t trigger the employee’s alternative minimum tax that year, so they end up paying no upfront taxes upon exercise.
The second employee waits 10 years to exercise their stock options. The company has grown considerably larger, and now the company’s 409A valuation sits at $10 per share.
The second employee will pay $10,000 to buy the shares (100,000 shares x 10 cents per share), but will report to the IRS that on the day they exercised, the shares carried an assumed value of $1 million (100,000 x $10 per share according to the 409A valuation). The assumed gain of $990,000 is large enough that it will very likely trigger the alternative minimum tax.
The benefit of exercising stock options early is that you start the clock on long-term capital gains. That way, when it’s time to sell your shares, any profits will be taxed at the lowest rate possible.
The alternative to exercising early is a cashless exercise, performed during an exit event (either an IPO or an acquisition). Here, employees sell their shares and raise enough money to cover their exercise costs and related taxes, in what’s essentially treated as a same-day transaction by the IRS.
While a cashless exercise is the easiest way to exercise your stock options, any gains are taxed as ordinary income, which could bump you up new, higher tax brackets. The big drawback to a cashless exercise is that you’ll typically need to stay at the company until the exit event occurs — if you’re laid off before the exit, and can’t afford to exercise your shares, you could lose them forever.
What should you do if you can’t afford to exercise your stock options?
Exercising your stock options can be expensive. In 2020, the average Secfi customer required $505,923 to exercise their stock options — more than two times higher than their annual household income.
If you decide to exercise your stock options, there are five common ways to pay for them:
- Pay for stock options with cash
- Apply for a traditional loan
- Sell a portion of your shares on a secondary market
- Stay at your job until an exit event occurs, and perform a cashless exercise
- Apply for non-recourse financing through a company like Secfi
Paying for stock options with cash is easy and straightforward, if you have enough cash on hand, and feel comfortable investing it in a potentially risky investment. Even if you have enough cash on hand to cover the cost to exercise your stock options, you might not want to tie up so much money in a single investment, for what could be multiple years before an exit. If the company fails, you might lose your entire investment.
Applying for a traditional loan can be even riskier than cash — if the company fails to exit, you’ll still be on the hook to pay back the loan. In the meantime, you’ll likely have to pay interest on the loan.
Selling a portion of your shares on a secondary market, and using the proceeds to cover the cost to exercise your shares can be an expensive and time-intensive proposition. Your company might bar you from selling shares on a secondary market, and if they don’t, it can sometimes take months to work out a deal with a private investor. Investors on secondary markets minimize their risk by driving a hard bargain, in hopes of buying your shares at the lowest possible price.
Staying at your job until an exit event occurs is the easiest option, but carries the highest possible taxes when you decide to sell. It’ll also require you to stay at your company until an exit event — which could be years in the future. If you unexpectedly lose your job, and don’t have a plan to exercise your stock options during your post-termination exercise window, you could lose your stock options entirely.
With non-recourse financing, the financing company assumes the downside risk in the transaction. If your company fails, or experiences a disappointing exit, you won’t owe the financing company anything, because they assume the downside risk.
Non-recourse financing companies, like Secfi, reduce their risk by offering financing to employees who work at startups that have a better-than-average chance of experiencing a successful exit, so you may find your company is too early, or otherwise doesn’t qualify. The non-recourse financing company takes a percentage of your eventual upside in an exit.