Should you get a loan to exercise your startup stock options?
8 min
Mike’s a CPF® at Secfi. He specializes in helping clients make the most of their stock options and integrate equity compensation into their broader financial plans.
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Mike’s a CPF® at Secfi. He specializes in helping clients make the most of their stock options and integrate equity compensation into their broader financial plans.
If you’re at a company whose valuation keeps going up, it’s likely that the cost of exercising your stock options is way more than you expected.
One question that often comes up in this situation is: Should you take out a loan to exercise stock options?
While loans are an option for getting the cash you need to exercise your stock options, they can carry a lot of personal risk and might not be enough to cover your entire exercise cost. Ultimately, it comes down to your personal financial situation and risk tolerance.
Rather than a loan, you can also consider non-recourse financing. It looks a lot like a loan, but with some key differences. With non-recourse financing, your personal assets are not on the line.
So, if available to you (which depends on the company you have stock options in), non-recourse financing can cover the costs of exercising (including taxes) without the risk of losing your personal money – or even other assets – should things go wrong.
Let’s get into the details.
A personal or consumer loan is any kind of loan that you can get straight from a bank or consumer-lending startup.
While you could potentially get some capital this way, consumer loans typically top out at $50,000. That won’t do you much good if you’ve got exercise costs of $200,000 or more.
And personal loans can come with very high interest rates, usually in the neighborhood of 20% or higher.
At that rate, you’d end up paying over $26,000 in interest for a $50,000 loan over a 5-year period.
You’ll also have monthly payments due immediately—even though you don’t know when you’ll be able to sell your shares.
And if the value of your shares tank or your company never exits, you still have to pay back the loan balance.
If you’re a homeowner, then home equity loans are another possibility.
Because your home is used as collateral, you can get better interest rates and larger borrowing amounts.
That’s great, but the major drawback is that your house is on the line.
If things go south for your company for any reason and your shares become worthless, you’ll still be responsible for making these payments until the loan is paid off.
A margin loan — also known as a portfolio line of credit — allows you to borrow against a portfolio of stocks you've been investing in.
Similar to a home equity loan, you can get more favorable interest rates when taking out a margin loan.
If the market is high, it’s a favorable time to take out one of these loans.
But if you take out a loan and then the value of your portfolio drops, your lender may ask you to put up more money or assets to collateralize the loan.
If the point of getting the loan in the first place is you don't have any cash available, then this will be an issue.
And since it’s a full-recourse loan, your personal assets are at stake if you can’t pay it back.
While it’s pretty uncommon, some startups will provide their employees with a company loan to exercise stock options.
For this to happen, employees sign a promissory note stating they will pay their company the required exercise amount in the future and then the employee uses that promissory note to pay for the exercise price of their options.
You only pay the loan back once you sell your shares. No monthly payments due.
It may seem like a great option if you can’t afford to exercise, but it comes with a catch: if for any reason your company fails, its creditors will effectively own all the company’s assets—including any outstanding debts (like your loan).
In that case, your shares would be worthless and you could have creditors wanting your loan repaid in full—regardless of what you’d have to sell to pay it.
By the way, be careful when taking a loan from your employer. If the terms are too preferential, the IRS could consider it disguised compensation, triggering taxable income.
If you don’t have enough money to self-fund the exercise of your stock options and loans are too risky, your next best option could be non-recourse financing.
Non-recourse financing is a cash advance that covers the cost of exercising plus any tax burden that exercising incurs.
It sounds like a loan, but it’s different. For starters, there are no monthly repayments. You only pay the amount back after there’s been a successful exit and you sell your shares.
But the most important difference: if in a bad scenario there’s no exit, you don’t have to pay it back the loan balance.
That’s why it’s called non-recourse: your shares act as collateral for the amount financed. Apart from the shares, none of your personal assets are on the line.
At Secfi, we offer non-recourse financing to startup employees. If your company goes downhill or never exits, we take the hit.
We often get the question how we can afford to take all the risk. It’s because:
We don't have any maximum or minimum requirements, so we’re able to cover the cost of exercising, whether you need $10,000 or $10 million.
One option that a lot of employees have taken is to simply wait until an IPO happens and then do what’s called a cashless exercise.
That’s basically where you exercise and sell your options on the same day to cover the costs. This way you avoid the upfront need for cash.
The drawback is you often end up paying way more in taxes. That’s because if you exercise your options at least a year before selling them, you get a tax discount. The gain can be up to 27%.
The more successful your company ends up becoming, the more this matters. We’ve seen cases of very successful IPOs where the average employee basically paid an extra million bucks in taxes (like DoorDash).
The other thing is at most startups you’ve got to still be at your company when the IPO happens.
You can’t leave and do anything else with your career if you’ve got a sizable amount of unexercised options and you’re waiting for a cashless exercise. Because if you do leave, you usually get just 90 days to exercise before your options expire. This is often referred to as golden handcuffs.
Having said that, some companies do offer extensions (although you lose out on the preferential tax treatment of your ISOs, because they convert to NSOs).
For some employees, selling stock options on a secondary market is also possible.
By selling some of your stock options, you can cover the costs of exercising the rest.
Not every company will allow you to do this. But if your company does, there are some downsides to consider. The biggest is that if you sell, and then later your company’s value continues to rise towards a successful exit, you lose out on these gains.
Another is that for the portion you sell, your proceeds get taxed at the highest possible tax rates.
Exercising your stock options is often too expensive to pay for by yourself – but taking out a loan can be risky (and may not cover your entire costs, especially if you factor in taxes).
Non-recourse financing can be a good alternative. It looks like a loan, but it’s specifically intended for the purpose of exercising startup stock options.
You’ll only pay the financing back after the startup has exited – and if for some reason that never happens, you won’t have to pay it back at all. Your personal savings are always left untouched.