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The complete guide to exercising employee stock options

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Stock options explained

You’ve been working at a pre-IPO company for some time, and you’d like to exercise your employee stock options.

Why now?

You might have heard that your company is exiting soon, and you want to exercise your stock options to start the clock on long-term capital gains. Or you’ve been working at your company for awhile, and want to explore your pre-IPO liquidity options.

More likely, you’re leaving your job, and you have a limited amount of time to exercise your stock options before losing them forever.

No matter why you want to exercise your stock options, we’ve built this guide to help. In this guide, we’ll cover:

  • Information to gather about your stock options
  • How to exercise your stock options
  • How to estimate your tax liability
  • Common risks around exercising your stock options
  • How to pay for your stock options
  • What happens after you’ve exercised your stock options?

Our goal is to help you make an informed decision about how, when, and if it makes sense to exercise your stock options. Let’s dive in.

Information to gather about your stock options

When you started working at your startup, you were given a stock option grant that detailed the type of stock options you would earn, your vesting schedule, and strike price (if applicable).

If you’ve stayed at the company for some time, you may have also received refresher grants, which vest in tandem with your original stock grant. If the company’s grown over time, or received new rounds of funding since you’ve started, your refresher grants will likely have a higher strike price (if applicable) than your original stock option grant.

There are three major types of stock options — incentive stock options (ISOs), non-qualified stock options (NSOs) and restricted stock units (RSUs). All three types of stock options are taxed in different ways when they’re exercised, and again when they’re sold.

At some startups, it’s common to earn multiple types of stock options at once, particularly if the startup expects to go public in the near future.

If you’re getting ready to exercise your stock options, you’ll want to review your stock option grant (or grants), so you can build a plan for which options to exercise first, and how much it will cost to do so.

“Exercising” your ISOs or NSOs requires you to buy them from the company at your strike price, and pay for any associated taxes. It’s not enough to simply vest ISOs and NSOs, you’ll need to take the additional step of investing in the company by purchasing your shares.

RSUs are earned, rather than purchased. With RSUs, you get shares automatically as soon as they vest.

Note: ISOs and NSOs expire if they’re not exercised in time. If you’re nearing your 10-year work anniversary at your startup, and you haven’t exercised your stock options yet, you’ll want to look at your original grant to see if you’re nearing your expiration date.

A more common scenario that happens to numerous startup employees each year is that they leave their job and have 90 days to exercise their stock options, or they risk losing them forever.

Stock options are taxed when you exercise them, and taxed again when you sell them. If your startup is growing, your tax bill is growing, too. If you’re confident your startup will successfully exit, it’s typically more affordable to exercise your stock options now, rather than waiting.

How to exercise your stock options

Exercising ISOs and NSOs is relatively straightforward at most companies — simply log into your equity management platform, such as Carta or Shareworks, select which stock option grant you’d like to exercise, and follow the steps as instructed. At companies that aren’t using an equity management platform, reach out to your HR team or finance team for help.

Some startups allow employees to exercise their stock options before they’ve vested, in a process called early exercising. If you do exercise your stock options early, make sure to file an 83(b) form with the IRS to make it official.

If they’re using one, your company’s equity management platform will tell you how much it will cost to exercise your ISOs or NSOs, and handle payment. In most cases, you’ll also owe taxes at exercise to state and federal tax authorities — depending on what type of stock options you’re exercising, their assumed value at exercise, your tax jurisdiction, and your other income.

Your startup’s equity management platform will estimate your tax bill at exercise. Remember: It’s your responsibility to pay the correct amount of taxes, so double-check your math or consult a tax professional to make sure your tax bill is accurate.

Once you make payment, the equity management platform will notify your company that you’d like to exercise a specific number of stock options. Your company approves the request, and it gets sent back to you for final signature. Once complete, the equity management platform will issue you a stock certificate detailing the number of shares you now own.

You now own shares in the company, and can decide when and how to sell them — for the most part. Your company could potentially restrict your ability to sell your shares on a secondary marketplace, or subject you to a trading lockup period once the company goes public.

How to estimate your tax liability when exercising stock options

Two notes about taxes at the top: Stock option taxes are complicated, so we’ve built a free tool to help — the Stock Option Tax Calculator. We also generally encourage people to work with a CPA if they’re facing a complicated tax return. OK, let’s explore taxes.

As established above, there are three types of stock options (ISOs, NSOs, and RSUs), and they’re taxed differently at exercise.

How RSUs are taxed at exercise

RSUs are the simplest, so let’s start there. RSUs are earned (rather than purchased), and are treated like a cash bonus with tax authorities.

For example, if you’re earning RSUs, you might be granted $100,000 worth of RSUs that vest over the course of four years, with a one-year cliff. On your one-year work anniversary, you’re given $25,000 worth of company stock, based on the company’s share value at the time.

If the company’s shares are valued at $100 each at the time, you’ll receive 250 shares. Then, on a regular basis going forward (either monthly or quarterly), you’ll continue to receive shares, based on the company’s current share value.

Tax authorities treat RSUs like a cash bonus because they assume the company’s shares have value on the day you get them. In the example above, tax authorities would view you getting $25,000 worth of shares on your one-year work anniversary like your company had given you a $25,000 cash bonus.

Companies that issue RSUs typically calculate taxes on your behalf, and automatically withhold them from your paycheck, similar to a cash bonus. At publicly traded companies, the company typically sells a portion of your shares to cover your tax liability.

So, in the example above, your company might sell 100 shares to cover your tax liability, and give you the remaining 150 shares as common stock.

Late-stage, pre-IPO startups occasionally issue RSUs, and will tell you how much you owe in taxes as they vest.

How ISOs and NSOs are taxed at exercise

ISOs and NSOs are similar, because you have to buy them before you own them. If you’re working at a high-growth startup, your cost to exercise ISOs and NSOs will likely rise every year, due to taxes.

For example, let’s say you’re issued a stock option grant for 100,000 shares of either ISOs or NSOs, at a strike price of $1 per share.

Four years later, you’ve completed a standard four-year vesting schedule, and you’re eligible to buy all 100,000 shares. At that point, the startup’s fair market value (also known as a 409A valuation) has gone up — from $1 per share when you started at the company, to $10 per share:

  • You’ll spend $100,000 to purchase 100,000 shares (100,000 shares x $1 per share strike price)
  • Your shares are worth (on paper), $1 million (100,000 shares x $10 per share valuation)
  • You’ll report to state and federal tax authorities an assumed gain of $900,000 ($1 million assumed value - $100,000 cost basis)

Here, ISOs and NSOs diverge — with ISOs, you may owe taxes under the alternative minimum tax (AMT) system. With NSOs, you’ll owe taxes under the income tax system. All things being equal, ISOs are typically preferable to NSOs, due to AMT treatment.

How much you’ll owe will depend on how many shares you exercise, where you live and any state taxes you might owe, and the assumed gain between how much you paid, and how much they’re worth — at least on paper.

Common risks around exercising your stock options

Like any investment, stock options carry risk — there’s risk in abandoning them, there’s risk in exercising them, there’s risk in selling them. As a startup employee, you’ll need to measure those risks, and decide whether you want to invest in your company.

Risk #1: Abandoning your stock options

Every year, startup employees abandon billions of dollars worth of vested employee stock options, by failing to exercise their options after leaving their jobs.

For example, consider Tesla. In 2008, less than 2 years before the company would go public, employees forfeited 2.8 million shares of company stock, which they could have exercised at an average price of 73 cents per share.

Today, those shares are worth an estimated $14 billion, following the company’s 5-1 stock split in 2020.

There are a number of reasons why employees abandon their stock options:

  • If your startup gives its employees “refresher” grants, you’ll always leave some unvested stock options on the table on your way out the door.
  • In some cases, employees make a conscious choice not to exercise their stock options, believing that the risk of company failure is too high.
  • In some cases, employees aren’t aware they have to buy their stock options and can’t afford to buy as many shares as they’d like.

The major risk to abandoning some or all of your stock options is that the company experiences a successful exit, and you lose out on the upside of your stock options.

Risk #2: Risk when exercising stock options

Every year, many startups fail. When a startup fails, founders typically liquidate the company’s assets, and use those assets to pay back company debt, and in some cases, pay back their investors.

For people who exercise stock options, the major risk is that the company they’ve bought shares into fails, and they lose their investment.

There’s also a related risk — that you exercise your stock options and incur a stock option-related tax bill that you can’t afford.

This happened during the dot-com bust to tech workers like Jeffrey Chou, a Cisco engineer who exercised his stock options, but saw the value of the company’s shares plummet on the public market shortly afterward. By the time tax season came around, he faced a $2.5 million tax bill, and no way to pay it.

In Chou’s case, he would have likely experienced a better outcome by performing a cashless exercise, which is where you exercise your stock options and immediately sell some or all of them on the open market, in what’s effectively treated like a single transaction by tax authorities.

Note: Performing a cashless exercise also means you’ll pay the highest possible tax rate on the transaction.

The risk of finding yourself underwater on AMT taxes is particularly high if you’ve joined a later-stage company that’s preparing to exit, and your strike price is relatively high. AMT tax liability is calculated on the day that you exercise, which is a risk if the underlying value of the shares decline during the exit.

Note: Make sure you estimate your AMT liability before you exercise, and can afford your AMT bill. Occasionally, people exercise their stock options and hope that their shares will rise in value, so they can sell them later and cover their AMT. The major risk is that share value will instead fall, and you face an AMT bill you have no way of paying.

Risk #3: Risk when selling shares

Investors are familiar with the risk when selling shares — that the investment will continue to grow in value, and the investor will miss out on upside.

On a smaller scale, that’s true for startup employees holding pre-IPO stock options, and pre-IPO shares. Every year, startup employees sell billions of dollars worth of pre-IPO shares to accredited investors through company-organized tender offers and on secondary marketplaces.

Sometimes, employees turn to secondary markets and stock buybacks as a way to raise enough money to purchase the rest of their stock options. In doing so, they’re losing out on potential upside that they could experience during an eventual exit.

In a related vein, employees might also lose out on upside if they refuse to sell post-IPO. Work with a financial professional to build a plan for how and when you want to sell your equity.

How to pay for your stock options

By now, you should have a good idea of how to exercise your stock options, how to estimate your total cost to exercise, and how to weigh your own unique risks and potential rewards.

Finally: How do you pay for stock options?

Here are the four most common ways that people pay to exercise their stock options, with related risks:

Cash: The simplest way to exercise stock options is directly with cash. Risk: If the company fails, you could lose your entire investment. You risk tying up money in an illiquid investment, and losing out on potential upside from a more balanced portfolio of investments.

Traditional loans: With loans, you won’t have to risk your own money to exercise your stock options. Depending on who you loan money from, you may need to immediately begin paying interest on the loan. Risk: If the company fails, gets acquired at a deep discount, or experiences a disappointing IPO, you will still need to repay the loan — on top of the interest.

Secondary markets: Some people use secondary markets to sell a portion of their stock options, so they can raise enough money to exercise their remaining stock options and pay related taxes. Risk: It could take a long time to find a buyer on a secondary market, and buyers may drive a hard bargain. You may end up giving up more stock options than you’d like, sacrificing potential future upside.

Non-recourse financing: There are two major benefits to non-recourse financing — the financing company gives you the money necessary to exercise your stock options and pay your related taxes. However, the non-recourse financing company also assumes most of the downside risk in the transaction — if the startup fails and the startup’s stock options are deemed worthless, the employee doesn’t have to pay back the loan. Risk: You’ll pay fees to the non-recourse financing company, and will lose some of your potential upside upon exit.

Secfi offers non-recourse financing to employees at select startups. Sign up to learn more about your options and to request financing.

What happens after you’ve exercised your stock options?

Exercising stock options is very similar to purchasing shares in any other company — you now own stock in the startup, and get to decide when it’s time to sell the shares. Of course, you may need to wait until there’s a buyer for your shares — either in the form of a tender offer, stock buyback, a secondary marketplace, an acquisition, or when your startup goes public.

If you manage to hold onto your shares for at least 1 year after exercising them, you will qualify for the long-term capital gains tax rate when you eventually sell your shares.

Note: If you exercise ISOs, you’ll need to additionally hold onto your shares for at least 2 years after they were originally granted to qualify for long-term capital gains.

Once you’ve exercised your stock options, you can periodically check in your stock options benefits administration platform — like Carta or Shareworks — to see the company’s current fair market value (also known as a 409A valuation), which will ideally rise over time. For startups, the 409A valuation gives you a rough estimate of how much the startup’s shares are currently worth.

Deciding if and when to sell your shares is a highly personal decision. Consult with your CPA or licensed financial professional for personalized advice.

Additional resources
Stock Option Tax Calculator
Stock Option Exit Calculator
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