So, you’ve decided to exercise your stock options — you have a firm grasp on how much they’ll cost, and you’re comfortable with taking on the risks associated with exercising. There’s just one thing left to figure out: How will you pay for them?
In this article, we’ll explore the most common ways that people pay to exercise their stock options, and the risks associated with each.
Option #1: Cash
Exercising stock options with your own cash is simple and straightforward. You save up the money necessary to exercise, and follow the steps in your company’s stock option administration platform to purchase your shares.
Remember, you don’t have to buy all of your stock options at once — you can work with a financial advisor to build a plan where you exercise stock options in a tax-efficient way, such as staying under the AMT threshold.
The big benefit to paying in cash is that you own your shares outright. You don’t need to pay back a loan, or make interest payments while waiting for an exit.
The big risk is that your company fails or experiences a disappointing exit — in the case of failure, you’d likely lose your investment, and in the case of a disappointing exit, you could have earned better returns elsewhere.
There is a small silver lining to a company failing — if you end up losing money on your stock options, you may be able to report capital losses in your current (and future) tax years, to offset capital gains made elsewhere. If you paid AMT, you may also be able to get an AMT refund in future tax years.
Separately, depending on how much it costs to exercise your stock options, there’s an additional risk that you concentrate too much of your money in a single investment.
Option #2: Traditional loans
Many people take out traditional (recourse) loans to exercise their stock options, because they’re confident that their stock options will be worth something in the future, and feel comfortable paying a traditional interest rate to a lender in the interim.
The big benefit to using a traditional loan to exercise stock options is that you don’t have to tie up a large amount of money upfront to exercise your stock. If you already have that money on hand, you can invest it elsewhere — like a down payment on a house, or in the public markets.
The big risk is that the company fails, or experiences a disappointing exit. In that case, you’ll owe the lender the full amount of the loan, with interest.
Option #3: Secondary markets and tender offers
In select cases, there might be so much demand for your company’s equity that a secondary market emerges, and investors offer to purchase your privately held shares.
If you have shares in the company, you can choose to sell some or all of those shares, in return for cash today.
Note: Not all companies allow their shares to be traded on a secondary market, and those that do could impose limits on how many shares you can sell.
The big benefit to selling shares on a secondary market is that you’re guaranteeing a return on your stock options — after all, cash in hand today is more certain than the possibility of cash in the future.
The big risk is that the company successfully exits, and you fail to experience the upside from your shares.
Some people instead opt to sell a portion of their shares, and use the resulting proceeds to exercise their remaining stock options — allowing them to share in some of the upside if the company successfully exits.
Option #4: Non-recourse financing
Non-recourse financing is similar to a traditional loan, in that a lending company gives you the money you need to exercise a specific number of stock options. This financing option is non-recourse, which means the only collateral that the lending company can pursue is the value of the shares themselves, not your other assets, such as your savings, investment accounts or property.
The big benefit to non-recourse financing is that you don’t have to risk your own money when exercising your stock options. If the company fails, or experiences a disappointing exit, the lending company will attempt to recoup their money by selling some or all of your shares — none of your other assets are at risk.
The big risk is that you’ll lose some of the upside in your shares if the company experiences a successful exit.
What’s right for you?
So how do you plan to pay for your stock options? Unfortunately, these four major options aren’t available to everyone with stock options today.
You might be working at a company that’s so small that there isn’t enough demand for a secondary marketplace, or a company that’s so risky that a non-recourse lending company doesn’t feel comfortable taking on the risk. You might not have the collateral you need to take out a traditional loan at a competitive interest rate.
This challenge was summed up nicely by a recent computer science grad who joined a startup and learned it would cost $80,000 to exercise all of their stock options.
“I’d like to exercise now so I can minimize my AMT, but I have no idea how to come up with $80,000,” the employee wrote.
Unaffordability is one of the big reasons why an estimated $580 million worth of vested stock options expired in 2021, according to data from Carta.
If you’re building a plan to exercise your stock options, a financial advisor can help. Reach out to see if Secfi’s wealth management services are right for you.