Exercising stock options refers to the process of using your stock options to buy shares of a company's stock at a predetermined price. When you exercise your stock options, put simply, you are converting them into actual shares of stock.
Receiving equity in the form of stock options is exciting! But knowing when and how to exercise your stock options can be overwhelming and even intimidating, especially for first time startup founders and equity holders.
In this guide we give you the nuts and bolts of exercising stock options and how to leverage the startup equity you were granted.
Exercising stock options, explained
What does it mean to exercise stock options
Exercising is good, in every sense of the word, but also in relation to stock options.
Stock options are a type of benefit given to startup employees which provide the right to purchase company shares at a predetermined price and is commonly referred to as an employee stock option plan.
Exercising stock options means you’re taking action to purchase shares of the company that has issued you equity, typically through a stock option grant.
When you exercise your stock options, you make a cash payment for the difference between the current share price and the pre-determined strike price. This action gives startup founders and employees ownership in their companies, which often leads to financial returns down the line.
Exercising stock options terminologies
To go deeper, you’ll need to become familiar with stock option terminology.
- Strike price. Price at which you have the right to purchase shares. This is usually equal to the fair market value (FMV) when your option was granted but could also be lower or higher depending on the terms of your grant agreement.
- Vesting schedule. A timeline determining when you may buy or sell certain shares as part of your employee equity plan. This often consists of several milestones based on years of service or other performance criteria.
- Expiration dates. Date your stock options will no longer be valid and can no longer be exercised. It’s essential to exercise any eligible options before this date, as they become worthless after that point in time.
- Exercise period. The terms of your option agreement typically determine the period during which you can exercise your stock options.
- Exercise price. The price at which you must purchase a share of stock when exercising an option; also known as the “strike” or “grant” price. This is usually the fair market value of a share on the date your option was granted to you.
- Incentive Stock Options (ISO). A type of employee stock option is given to startup employees as part of their equity compensation. It allows them to purchase company stock at a discounted price and provides tax benefits when the options are exercised.
- Non-qualified Stock Options (NSO). A non-qualified stock option is a type of stock option that does not qualify for special tax treatment under the Internal Revenue Code. It is subject to taxation of the difference between the exercise price and the market price at vesting. Unlike ISOs, NSOs can be granted to both employees and non-employees (advisors, contractors). Learn more about they key differences between ISO vs NSO.
With these basics under your belt, you’ll be able to make informed decisions about maximizing your equity grants and getting the most out of them.
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The hows and whens
When to exercise stock options
When it comes to exercising your stock options, timing is everything. After all, you don’t want to get stuck with worthless paper if the startup doesn't take off. On the other hand, it's important not to miss out on potential gains by waiting too long.
Understanding your company's vesting schedule is the most significant factor in deciding when to exercise your stock options. This will tell you how much equity you can access at any given time and give you an idea of when the right time may be for cashing out those shares.
This is especially important for startups on a series A funding round. Likely, the company won't reach a liquidity event until after series B funding, so exercising your stock options early can be risky.
If you decide to exercise them early, it’s best to do so in stages and spread out the risk of holding onto all of your equity at once. It's also important to keep an eye on market trends and consider any potential external factors that may affect the value of your shares.
For example, if there are rumours about another startup entering the same space as yours, you should think twice before committing too much of your equity. Let’s explore some specific examples.
Exercising options early
If you’re a startup founder or employee who has been granted equity, it may be tempting to consider exercising your stock options early. After all, why wait for the potential of future gains when you can cash in now?
While this certainly can be a viable option for some people, there are pros and cons to consider before taking action.
- You can get access to cash immediately, which can be beneficial in certain circumstances
- You can lock in gains and reduce your risk
- Taxes owed on the proceeds will be lower if you are exercising ISOs
- You may miss out on future gains if the stock appreciates over time
- There is a cost associated with exercising, which could potentially outweigh any benefit gained from accessing cash
- Tax planning becomes more complicated when exercising early as taxes are due in the year of exercise for NSOs (and possibly alternative minimum tax-AMT)
Ultimately, deciding whether or not to exercise stock options early depends on your situation.
Exercising stock options before IPO
What do you need to consider when exercising stock options in a private company? Here’s a quick overview of what to keep in mind:
- Timing. When and how many shares you should exercise is an important decision. You want to maximize your shares' value but also ensure you don’t miss out on potential future gains.
- Tax implications. Exercise your options when it makes the most tax-efficient sense, as this will help you maximize your return on investment.
- Cost of exercising shares. Depending on the company's vesting structure, fees may be associated with exercising stock options that need to be weighed against expected returns.
- Financing. You may need to secure funding to exercise your stock options before the IPO occurs, which could involve borrowing money or selling other assets.
Making sure you thoroughly understand the process and are aware of any associated costs will help ensure your return on investment is maximized.
Exercising stock options after leaving the company
It used to be that exercising your stock options was a pretty straightforward process. Companies typically had 90-day windows for employees to exercise their stock options after leaving the company.
However, more and more companies are moving away from this traditional approach and offer longer exercise windows, sometimes up to 10 years or even indefinitely. These rules are set in the equity grant agreement, and usually this extended period is allowed when certain conditions are met. For example, 10-year exercise period after 2 year employment.
This means that employees have much more flexibility when it comes time to deciding when they want to cash in on their stock options.
Factors to consider when exercising stock options
When it comes to deciding when and how to exercise your stock options, here are some important things to keep in mind:
- Tax implications. Depending on the type of option you have been granted, exercising could trigger tax consequences such as capital gains taxes or alternative minimum taxes.
- Timing. You should also consider the current market conditions and your financial situation before deciding when to exercise.
- Liquidity. This refers to how easy it is for you to convert your stock options into cash. In some cases, exercising your options can be complicated if there are restrictions on selling or transferring them.
- Cost. Exercising your stock options can also be expensive. You’ll need to consider the cost of exercising, which includes any taxes and fees associated with it, as well as the broker’s commission.
These are just a few factors to keep in mind when deciding whether and how to exercise your employee stock options. Doing research ahead of time can help you make an informed decision that is right for you.
How to exercise stock options
Here are some of the most common ways to exercise employee stock options:
Exercise and hold. This strategy involves exercising your option to buy shares at a discounted price, then holding onto them until they increase in value or you decide to sell them. Doing this benefits you from any potential upside in the share price.
- Exercise and sell to cover. In this approach, you exercise your option but immediately sell enough shares for the proceeds to cover the cost of the option. This is a popular strategy if you believe the stock value will be flat or decrease in the near future and want to avoid any potential losses.
- Exercise and sell. The exercise and sell approach allows you to benefit from any gains since exercising your options by selling your shares at their current market value. You can use this strategy when you need cash now or simply don’t have faith in the company’s long-term prospects.
- Exercise and reinvest. Similar to exercise-and-sell, except that instead of taking the proceeds, you reinvest them in other stocks or assets.
- Spread out exercises. To minimize risk and maximize gains, you can spread your exercises over time so that if one option doesn't perform well, you have other options to balance it out.
- Don’t exercise. You don’t always need to exercise your stock options - sometimes, it can be better to wait until the market has stabilized or when more information is available about the company.
It's important to consider these strategies and ideally consult a financial advisor if you want to know which strategy is best, given the conditions set in your equity agreement.
Why does an employee have to pay to exercise their options
The need to pay an exercise price often confuses stock option holders. And rightly so, it’s a little complicated. Let us explain.
One of the advantages of an employee stock option plan can be the ability to use a valuation method that can drastically reduce the valuation (and your exercise price).
A company may be able to set the exercise price at $0.01 per option, even where the company is doing very well, if the relevant tax rules in your jurisdiction allow for it.
If an employee received $25k worth of options, it would not make sense for the employee to have to pay $25k cash to exercise those options. That’s why these valuation rules exist.
To resolve this problem, an employee stock option plan can be structured such that:
- the exercise price is calculated by an approved method, resulting in the exercise price being much lower than $25k ; or
- the employee can hold off on exercising the options until there is value in doing so (for e.g. an exit event where the price they will receive will be much greater than the Exercise Price)
Alternatively, if you leave the company your employer could buy your options back from you at the increased value. It’s usually at the company’s discretion as to whether they will buy the options back from you when you leave, so this is something to discuss with your employer.
Tax implications on exercising stock options
Exercising your stock options may be sweet, but make sure you’re not left with a sour tax bill afterward! It pays to understand the tax implications of exercising those employee stock options.
When you exercise your stock option, the difference between the market price and the strike price is added to your income subject to taxes that year.
This means if your employer grants you 1000 shares at $10 per share and your current market value is $20 per share when you exercise them, then it will get added to your taxable income for that year — effectively getting taxed as salary ($10 x 1000 = $10,000).
On the bright side, you also get to claim a capital gains tax benefit when you sell the shares. Any increase in value between exercising and selling will be taxed at a lower rate than your regular income.
Keep an eye on how long you’ve held these shares - if it is less than one year, they are considered short-term capital gains and will be taxed like regular income (which may be higher).
If it has been longer than 12 months since the exercise date, any profit made is subject to long-term capital gains tax rates, which tend to be lower. So make sure you know the rules of the game before exercising your stock options.
It’s a sweet deal, but you don’t want to get burned with a hefty tax bill!
FAQS on exercising stock options
What happens when you exercise a stock option?
When you exercise a stock option, you are buying the underlying shares of stock at a price set in your grant agreement.
What happens if I don’t exercise my options?
Your stock options will expire (after the agreed vesting period lapses) and will then go back to the option pool. Basically, you miss out on the chance to own a piece of the company!
Is it better to exercise an option or sell it?
That depends on your financial situation and goals. It is best to consult a financial advisor or tax professional for personalized advice.
Should I exercise my options before I quit, and how long do I have after I do?
It's ideal to exercise your options while you're still part of the company, but if you can't do that, the time frame varies based on the specific terms of your grant agreement. So make sure to check those details!
This article is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.