Stock options explained
As a startup employee, it can feel both exciting and overwhelming to earn stock options. You’re aware that startup stock options can represent a path to life-changing wealth for some people — but how do they work, how much do they cost, and what are their risks?
If you’re brand new to stock options and looking for a quick introduction to the topic, this starter guide is for you. It provides a high-level overview of key topics related to employee stock options, including how to exercise your options, and how to estimate your related tax liability.
In this guide, you’ll learn:
- How vesting works
- How and when to exercise your stock options
- How stock option taxes work
- Key terms that will help you better understand employee stock options
What are stock options?
Stock options give you the right — i.e. the “option” — to purchase shares in a company at a specific price, and within a certain time frame. If you decide to purchase the options, you’ll own a piece of the company. If everything goes well, the value of the shares will rise over time, and you’ll be able to sell your shares for more than you paid for them.
What is a stock option grant?
Companies that issue stock options to their employees detail everything you need to know about your stock options in what’s known as a stock option grant. Read through it carefully to understand what type of stock options you’re earning, your vesting schedule, strike price, and post-termination stock option exercise window.
What are the different types of stock options?
Check your stock option grant to understand which type of stock options you’re earning. There are three major types — incentive stock options (ISOs), non-qualified stock options (NSOs), and restricted stock units (RSUs).
The big difference between ISOs, NSOs and RSUs is that you have to purchase ISOs and NSOs, and you don’t have to pay for RSUs — you earn them on a regular basis, similar to a cash bonus.
In this guide, we’ll focus mainly on ISOs and NSOs, as those are more common at pre-IPO startups.
What is a vesting schedule?
“Vesting” is a financial term for when your options become available for you to exercise, or purchase. The most common vesting schedule is time-based, with many startup employees earning stock options under a 4-year vesting schedule with a 1-year cliff. Typically, you’ll vest 25 percent after one year, with the rest of it vesting on a monthly or quarterly basis for the following four years.
That means if you’re initially granted 10,000 stock options, you’ll be able to purchase 2,500 shares one year later — your “cliff.” Once you’ve done that, you’ll be able to purchase additional shares on either a monthly or quarterly schedule. After four years have passed, you’ll be able to purchase all 10,000 shares.
Note: You don’t need to exercise, or purchase, your stock options as they vest. Nor do you have to wait until they all vest before you can buy them.
Separately, some companies allow what’s known as “early exercise,” where employees can purchase shares that haven’t vested yet. The major benefit to early exercise is that it can potentially reduce your upfront tax liability.
Vesting schedules can also be performance-based, with some executives earning stock options after hitting specific sales targets, or completing specific corporate goals, such as taking the company public.
Check your stock option grant to understand your vesting schedule. In recent years, we’ve seen the rise of one-year stock option grants, and startups that have eliminated the one-year cliff, in an attempt to create more competitive compensation packages.
What is the strike price?
If you’re earning ISOs or NSOs, your strike price is how much it will cost to purchase, or exercise, a single share of your company’s stock. For example, if you’re earning 10,000 ISOs at a $1 strike price, it will cost you $10,000 (before taxes) to exercise all 10,000 shares.
Your strike price is set in stone on the day you’re issued a stock option grant, and doesn’t change over the course of that grant.
Note: If you earn additional stock grants (also known as “refreshers”) those additional grants will likely have a different strike price.
A company’s strike price is determined by the company’s current fair market value (also known as its 409A valuation). Pre-IPO startups that issue employee stock options are required to bring in a third-party valuation company every year to estimate how much the company’s shares are currently worth.
Legally, companies must issue new stock options at their current 409A valuation, or higher.
When do you exercise your stock options?
The most important choice you’ll make with stock options is deciding when to exercise them. Stock options are like any other investment, and carry the risk that you could ultimately lose money.
Let’s explore risk a bit further.
If you decide to exercise your stock options while the company is still private, you could face surprisingly high exercise costs. In 2021, the average Secfi customer required $543,000 to exercise their stock options, with roughly 73 percent of that amount going toward covering their tax bill.
Your exercise costs could be higher or lower, depending on your specific numbers. If you’d like to estimate how much it would cost you to exercise your stock options, we’ve built the free Stock Option Tax Calculator to help.
Exercising your stock options pre-exit typically carries higher financial risk, as well as higher potential financial rewards. The financial risk is that the startup could experience a disappointing exit, or fail entirely. If that happens, you’ll likely lose your investment in your stock options. Another risk to consider is that your money could be tied up in a single asset for years, when it could potentially be growing if invested in a different asset. The prevailing trend line is toward private companies staying private for longer periods of time.
There are a couple major benefits to exercising stock options pre-exit: Doing so could reduce your upfront tax liability, and start the clock on long-term capital gains. You’ll also own your shares, which means you don’t have to remain employed at the company until the exit, breaking what’s colloquially known as your “golden handcuffs.”
If you decide to exercise your stock options after an exit event — either an IPO or an acquisition by another company — your risk plummets, because you can see exactly how much it will cost to exercise your stock options, how much you’ll owe in taxes, and how much the shares are ultimately worth.
That said, the major risk to exercising your stock options after an exit is that you’ll pay the highest possible tax rate, reducing your potential gains, and you’ll likely need to remain employed at the company until the exit.
How are stock options taxed at exercise?
If you decide to purchase (i.e. exercise) your ISOs or NSOs, you’ll very likely owe taxes on that transaction.
With both types of stock options, you’ll take your strike price, compare that to the company’s most recent 409A valuation, and pay taxes on the difference between the two numbers. Tax authorities view this difference as an assumed gain.
- You exercise 10,000 shares of stock options at a strike price of $1 per share, and a 409A valuation of $5 per share
- You’ll pay your company $10,000 to purchase (i.e. exercise) your shares (10,000 shares x $1/share strike price)
- The shares have an assumed value of $50,000 (10,000 shares x $5/share 409A valuation)
- You’ll report to state and federal tax authorities an assumed gain of $40,000, an amount that you could potentially owe taxes on ($50,000 assumed value - $10,000 cost basis)
ISOs are taxed under the alternative minimum tax system (AMT), while NSOs are taxed under the income tax system. Secfi’s Stock Option Tax Calculator can help you estimate how much you’ll owe in taxes before you exercise. We always recommend working with a tax professional.
How are shares taxed when they’re sold?
Once you exercise your stock options, you own shares in the company and can decide when you want to sell them.
While the company is still private, your ability to sell your shares is largely limited to secondary marketplaces and company-led tender offers. In both cases, you can sell your shares to investors interested in buying private stock in the company.
Additionally, companies like Secfi offer liquidity financing, where you can borrow money based on the value of your stock options.
Once your company experiences an exit event, your shares will have a much wider marketplace of buyers — either on the open market in the case of an IPO or SPAC, or by the acquiring company in the case of an acquisition.
When it comes time to sell your shares, you’ll owe taxes based on how long you held onto your shares and whether you’re making money on the transaction.
If you manage to hold onto your ISOs for at least one year after exercising them (and two years after they were initially granted), you’ll qualify for the long-term capital gains tax rate, which is lower than most startup employees’ income tax rate.
It’s the same story with NSOs — you’ll need to hold onto them for at least a year to qualify for long-term capital gains.
If you sell your shares at a loss, you’ll report a capital loss, which you can use to offset income taxes, or gains from other investments.
How do you exercise your stock options?
Once you decide how much it will cost to exercise your stock options, and when you’d like to do it, the act of exercising your stock options is fairly straightforward. Simply log into your company’s stock option benefits administrator, such as Carta or Shareworks, and follow the steps to exercise your stock options.
Depending on whether you’re exercising ISOs or NSOs, you’ll see different options for how to pay associated taxes.
With ISOs, you’re responsible for calculating your tax liability and paying those taxes on your own. With NSOs, your employer calculates the minimum amount of tax that you’ll owe, collects that from you, and sends it to tax authorities on your behalf.
Note: If you exercise NSOs, you’ll want to double-check your employer’s math, to make sure they sent the correct amount of taxes on your behalf — if they didn’t, you’ll owe additional taxes when it’s time to file.
Alternatively, if you decide to exercise your stock options after an exit event — i.e. your company goes public or gets acquired — your employer will give you information about how to exercise your stock options.
Companies that go public typically impose a lock-up period, where employees aren’t allowed to immediately sell their shares. Companies that get acquired typically handle the process of turning vested stock options into cash, stock in the acquiring company, or a mix of both.
What is a post-termination stock option exercise window?
Once you decide to leave your job, you stop vesting any unexercised stock options and have a limited amount of time to purchase (i.e. exercise) those vested, unexercised stock options, or allow them to expire.
Today, the industry standard is a 90-day post-termination stock option exercise window. If you fail to exercise your stock options within that 90-day window, you’ll very likely lose them forever.
Some companies have voluntarily extended their post-termination stock option exercise window out to as much as 10 years.
Note: If you’re earning ISOs at a company that has a longer-than-90-day window, they’ll automatically turn into NSOs after 90 days. NSOs have less generous tax benefits than ISOs.
How do people afford to exercise their stock options?
Depending on your specific situation, you could be facing significant stock option exercise costs. Even if you have the money to pay for your stock options, you might not feel comfortable tying up so much cash in an illiquid asset.
People typically pay for their stock options using cash savings, a financing solution, taking out a loan, selling a portion of their stock options on a secondary marketplace, or waiting until an exit event to perform a cashless exercise.
Glossary of common terms
- 409A valuation – An appraisal of the value of a company share for tax purposes. Also called fair market value, or simply the 409A.
- Acquisition – A type of exit where one company is bought by another.
Alternative minimum tax (AMT) – A special tax you may owe when exercising incentive stock options (ISOs).
- Capital gains tax – When you sell a capital asset (like a stock) for more than you spent to buy it, you’ve created a capital gain. The federal government and many states have specific tax systems for the income generated by capital gains.
- Cashless exercise – Exercising options and immediately selling some or all of the resulting shares to cover the costs of exercising.
- Cliff – Vesting schedules typically include a “cliff” designating the length of time you must work for a company before your options start to vest.
- Dilution – When a company creates new shares to give to employees or investors, the total number of shares grows. Although you still own the same number of shares, your stake — the percentage of the company that you own — decreases. In other words, your stake has been diluted.
- Exercise – To buy the shares that are available to you.
- Exit – How shareholders monetize their investments in a company; common exit strategies include going public or by selling the company to a third party.
- Grant – An official document spelling out key details of your options package, such as the type and quantity of options, as well as the strike price.
- Incentive stock options (ISOs) – Give you the right to purchase shares at a specified price; could qualify for advantageous tax treatment.
- Initial public offering (IPO) – When a company sells shares in the public market for the first time. Popular alternatives include a direct listing, where companies sell shares directly to the public, or a SPAC, where a company goes public by being acquired by a publicly-traded acquisition company.
- Non-qualified stock options (NSOs) – Give you the right to purchase shares at a specified price.
- Restricted stock units (RSUs) – A promise by your employer to give you company shares at a later time, as determined by the vesting schedule; you don’t have a choice of when you get the shares.
- Stake – The percentage of the company that you own; the number of shares you own divided by the total number of existing company shares.
- Strike price – The predetermined price at which you can buy stock from your company; also known as the exercise price. Typically determined using the fair market value of the stock at the time of grant.
- Tender offer – Gives private company employees a chance to sell a certain number of shares at a fixed price during a specific time frame.
- Vesting – The process of gaining full legal rights to your options. Once your options vest, you can choose to exercise them. The vesting schedule spells out how your options will be incrementally awarded during the course of your employment.