Exercising Stock Options: What It Means and When To Do It
What is true in general is also true of equity compensation: it’s nice to have options. We are referring, of course, to employee stock options, a popular form of employee equity compensation that allows (but doesn’t obligate) the employee to purchase a number of shares of company stock at a fixed exercise price.
Exercising stock options can be a confusing and complicated process. When should you exercise your options? How to even do it? These are valid questions even if you’ve been through this whole equity rodeo before.
We believe exercising stock options should be something to get excited about rather than dread, so we put this guide together to answer all the questions you may have about how the process works. Keep in mind that our focus will be on employee stock options and not exchange-traded options. So, if you’re an employee with an option grant in hand, you’ve come to the right place.
- What are employee stock options?
- What does vesting mean and how does it affect stock options?
- What is early exercise and should I exercise my options early?
- How exercising employee stock options works
- Do options have an expiration date?
- Final thoughts for founders and employees
What are employee stock options?
An employee stock option is a type of compensation that gives an employee the right to buy a number of shares of company stock at a specific price. This price is generally referred to as the “strike price,” though other names for it include “exercise price” and “grant price.”
Employee stock options are one of the most popular and prevalent forms of equity-based compensation around—and with good reason. As a key part of a startup’s compensation package, they can help employers attract talent to grow their business. And for employees, they provide an incentive to grow the value of the business and reap the rewards later down the line.
By “reap the rewards,” we mean exercising stock options—and more specifically, exercising them when they’re actually worth something. Remember: exercising means purchasing shares of company stock and thus owning a piece of the company itself. Assuming the value of those shares increases from the date of your options grant to the date you exercise your options, exercising stock options can mean buying common shares at a price well below the fair market value of the shares.
Buying company stock at a discounted price can be a solid way to grow your wealth. With that said, it pays to sit down and plot out a strategy for when, how, and even if you want to exercise your stock options. Exercising can have significant tax implications, and it may not make sense to exercise at all depending on the current market price or valuation of your company’s stock.
The first step in understanding these tax implications is understanding the different types of stock options. There are two major types of options in the U.S.—ISOs (a product of the U.S. tax code) and NSOs.
Incentive stock options (ISOs) vs. non-qualified stock options (NSOs)
Incentive stock options (ISOs) are a type of stock option that can only be granted to a company’s employees. If the ISOs meet a certain set of criteria, the recipient is only required to pay federal income taxes when they sell the stock.
Non-qualified stock options (NSOs) are another type of stock option you may come across. NSOs aren’t limited to company employees and can also be granted to contractors, consultants, advisors, and other qualifying service providers. NSOs are taxed at the ordinary federal income tax rate when they’re exercised—and the tax applies to the difference between the strike price and the fair market value (FMV) of the common shares on the date the options are exercised.
We have a whole guide that breaks down the differences between ISOs and NSOs, and whether you hold one or the other will have a major impact on the federal income taxes you’ll owe when you exercise your options.
We’ll get to all that tax stuff shortly, but first let’s focus on whether you even have the right to exercise in the first place. The process of earning that right is called vesting.
What does vesting mean and how does it affect stock options?
In most cases, you cannot exercise your stock options as soon as you’re granted them. Instead, you may have to earn the right to exercise your options by demonstrating a sustained commitment to the company. This is called vesting, and it’s common at companies that offer equity-based compensation.
When you sign your option grant agreement at one such company, you’ll likely see some language in there about a vesting schedule. This vesting schedule tells you what needs to occur before you earn the right to exercise your options, and it’s typically based on a specific period of time from the grant date. (Vesting may also account for non-time-based milestones as well, such as job performance or company performance, but this is a bit less common.)
Though vesting schedules vary between companies, a four-year, time-based vesting schedule is pretty standard. It may include a one-year “vesting cliff,” which means that your options start vesting only after you’ve stayed with the company for a full calendar year.
Once your vesting cliff passes, you’ll vest the full amount you would have vested over the pre-cliff time period. You may have to remain with the company in order to exercise those vested options, or exercise them within a window known as a post-termination exercise period.
Vesting is important to understand, but it’s not the only thing that determines when you can exercise your stock options. For example: in some cases, you may be able to exercise your options before they are fully vested. This is known as early exercise.
What is early exercise and should I exercise my options early?
Some equity plans allow the employee to “early exercise” their stock options before they vest. If your plan allows for this, it should be outlined in your option grant agreement.
Even if it is allowed, you’ll want to consider the pros and cons of early exercising before you pull the proverbial trigger. The pros of early exercise mostly have to do with the tax treatment of your options, while the risks relate to the ultimate value of your shares.
Let’s break it down:
Pros of early exercise
- If you have ISOs, early exercising your options may result in a more favorable tax treatment. We mentioned earlier that ISOs must meet a certain set of criteria to qualify for favorable tax treatment. One important requirement is that they must be held for more than two years from the time of grant, and for more than one year after exercise. Exercising your ISOs early allows you to start the post-exercise timer early. This is crucial, as selling ISOs before your holding period is up will cause you to lose the tax benefits of the ISOs. These benefits include not having to pay taxes upon exercise, and paying capital gains tax (rather than normal income tax) when you sell the shares.
- If you have NSOs, early exercising your options can help you qualify for long-term capital gains tax rates sooner. When you exercise NSOs, you must pay ordinary income taxes on any gains. These taxes apply to the difference between the strike price and the fair market value on the date you exercise. You must also pay capital gains tax rates on any gain from when you bought the stock to the price you sold it at. There are short-term capital gains tax rates (applicable if the holding period is less than one year) and long-term capital gains tax rates (applicable if the holding period is more than one year). The long-term capital gains rates are lower, and early exercising your options can allow you to start the holding period clock earlier.
- Early exercising at the time of your grant can help you avoid higher taxes later. If you can purchase your shares when your strike price is the same as the fair market value of the stock, you may be able to pay less in taxes. Paying ordinary income taxes on your shares now—before they grow in value—means that you’ll only have to pay capital gains taxes on your shares when you sell them (hopefully at a much higher price) later down the line. Note: You will need to file an 83(b) election within 30 days of exercising your options early if you want to take advantage of this option.
As you can see, the benefits of early exercise have a lot to do with taxes, and there can be some not-so-great consequences if you fail to make the appropriate elections. For this reason, we recommend consulting with a tax advisor before making any hasty decisions.
Cons of early exercise
- Your shares may never actually grow in value. The dream is that the value of your shares continues to climb and climb as your company grows and becomes more successful. But this dream doesn’t always pan out in reality—and it can be difficult to evaluate a company’s prospects before you’ve worked there for a significant period of time. Waiting longer can give you a longer track record to look at, in terms of how much the fair market value of your company’s shares has grown in value. If you exercise early, you risk paying more for the shares now than they may ever be worth.
- Your company may be able to buy your unvested shares back if you’re terminated or leave. If you early-exercise and decide to leave your company before your options vest, you should be aware of what will happen to your exercised options. In a typical case, the company may repurchase any stock you own that hasn’t yet vested.
It’s also worth noting what happens to your vesting schedule if you exercise early. Typically, your vesting schedule for your options is simply transferred to the shares you receive from exercising.
How exercising employee stock options works
Exercising stock options can come with a lot of…options. Once your options are fully vested, you may have a number of choices about what, exactly, to do with them.
Here are some common choices that you and your tax advisor may want to consider. Note that any choice that involves selling your shares requires there to be a buyer for those shares, which isn’t always the case with private companies.
Cash payment and hold
You can pay cash out-of-pocket to exercise your options and then immediately sell them for a profit. Your brokerage will generally allow you to use your own cash to cover all the taxes and brokerage fees involved in the transaction.
If you don’t want to pay any cash out-of-pocket to exercise your options, you may not have to. Many brokerages allow you to pay for the taxes and brokerage fees in a “cashless” way, which means that you can sell off a portion of your shares—including the shares you receive from the exercise of the options—to cover the transaction costs. You can then receive the remaining shares of common stock in your account and hold onto them.
A cashless exercise works similarly to a cashless hold. The only real difference is that you would not hold the remaining shares of common stock in your account. Instead, you would sell them at the current market price and take the proceeds to use or invest elsewhere.
Sit on your vested options—but not forever
You don’t need to exercise your options as soon as they vest. There are some legitimate reasons for waiting a bit longer to exercise. For example, you may have a ton of faith that the market price of the company stock will continue to increase over time. If that’s the case, you may well want to hold onto your options for a while longer. The downside to this, of course, is that it’s no certainty that the stock’s price will continue to go up. Another downside is that, if your options pass their expiration date, they will expire with no value.
Do options have an expiration date?
Unfortunately, yes—stock options have an expiration date. This date should be spelled out in your option grant agreement, and it’s a date you should keep very close to your heart.
Why? Because if you don’t exercise your options before the expiration date, they will be worth absolutely nothing. Nada. Zip. Options are very much a use-it-or-lose-it proposition, and it could be very painful to “lose it” if your strike price is below the current fair market value of the common stock.
Final thoughts for founders and employees
Figuring out when and how to exercise employee stock options can be tough. But it can also be, well, kind of fun. After all, you’ve worked hard to earn your vested stock options, and the prospect of exercising those options and increasing your wealth should be an exciting one.
If you want to learn more about options and other types of startup equity, check out Pulley’s tactical guides. We have a comprehensive library of content that walks through everything related to cap table and equity management—from stock options and RSUs to 409a valuations and dilution modeling. We’re also here for you if you want to chat. Schedule a call today and see how we can help.