What Does It Mean to Exercise Stock Options?

Exercising stock options means using your right to purchase company shares at a set price, called the strike price. When you exercise, you convert your options from a contractual right into actual shares of stock that you own.

Until you exercise, you don't own anything. You have the right to buy shares, but that right expires, either at the end of your option term (typically 10 years) or, more urgently, within 90 days of leaving the company.

Exercising requires paying the strike price for each share you want to purchase, and it typically triggers tax obligations depending on whether you hold ISOs or NSOs. The rest of this guide covers both the mechanics and the tax implications in detail.

What Are Stock Options?

Stock options give employees the right to buy company shares at a set strike price. This can be a valuable benefit, allowing employees to potentially profit from the company's growth.

Types of Stock Options

• Incentive Stock Options (ISOs): Often granted to employees, ISOs have favorable tax treatment if certain holding periods are met.
• Non-Qualified Stock Options (NSOs): These are the other common type of stock options, taxed differently and available to both employees and non-employees (like contractors).
• Restricted Stock Units (RSUs): Though not technically options, RSUs are another form of equity compensation. RSUs are company shares granted outright, subject to vesting. Unlike options, RSUs don’t require exercise but do involve taxes upon vesting or sale.

See how the IRS explains stock options in Topic No. 427.

How to Exercise Your Stock Options

To exercise your options, follow these steps:

Step 1: Confirm your vesting status

‍Log into your equity portal (Carta, Shareworks, or similar) to confirm which options have vested and are eligible to exercise. Unvested options cannot be exercised.

Step 2: Check your expiration date

‍Verify when your options expire. If you've recently left the company, the clock is likely already running, most post-termination exercise windows are 90 days.

Step 3: Review your grant details

‍Note your strike price, the number of shares you want to exercise, and the current 409A fair market value. The spread between these two numbers determines your tax exposure.

Step 4: Choose your exercise method

• Cash exercise: Pay the full strike price out of pocket and hold your shares. If you have NSOs or live in Canada, you may owe tax withholding at the time of exercise.
• Cashless exercise: If your company is public or running a tender offer, you may be able to sell enough shares at exercise to cover the cost, no upfront cash required.
• Non-recourse funding: Providers like ESO Fund cover 100% of the exercise cost and taxes. If the company never exits, you owe nothing.

Step 5: Submit your exercise notice

‍Most companies handle this through their equity portal. If your company doesn't use one, you'll need to complete a Stock Option Exercise Notice and submit it to HR or your finance team along with payment.

Step 6: Arrange payment

‍Payment is typically made via wire transfer or through your equity portal. Confirm the accepted payment methods with your company before initiating.

Step 7: Receive your shares and track your tax basis

‍Once the transaction is complete, you'll receive confirmation of your share ownership. Record your exercise date, strike price, FMV at exercise, and number of shares, you'll need this for tax reporting. With ISOs, you will receive an IRS Form 3921 in the following January

When to Exercise

Choosing when to exercise stock options depends on factors like taxes, company outlook, and personal finances. For more insights, check out our guide on when to exercise stock options. Here are some scenarios:

• After Leaving the Company: Most options expire 90 days after leaving, making it important to exercise within this window if you want to retain them.
• Early Exercise: Typically you must vest your options before they can be exercised. Some companies offer the ability to Early Exercise your entire grant, before they are vested. This allows you to take advantage of low or zero taxes, but does involve some extra risk!
• Reducing Taxes: Exercising options along the way to start the Long Term Capital Gains clock or exercising ISOs without triggering AMT are just a couple ways to reduce stock option taxes.

Exercise Taxes

Exercising options can trigger different tax obligations based on option type. Taxes are owed on the difference between your strike price and the Fair Market Value at the time of your exercise. Taxes may include:

• Incentive Stock Options (ISOs): ISOs are subject to the Alternative Minimum Tax (AMT) upon exercise as outlined by IRS Topic 556. Long-term capital gains tax applies if you hold shares for at least one year post-exercise and two years post-grant.
• Non-Qualified Stock Options (NSOs): NSOs are taxed as ordinary income based on the spread between the strike price and the current fair market value at exercise. Additionally, long-term capital gains taxes apply on the sale of NSO shares held longer than a year.

For a full breakdown, explore our page on stock option taxes.

Covering exercise costs and taxes out of pocket isn't the only option. ESO Fund covers both, with no repayment required if the company doesn't exit. Schedule a call →

Stock Option Exercise Payout: What to Expect

Exercising your options doesn't automatically put money in your pocket, it gives you shares. The actual payout happens when those shares are sold, either at an IPO, acquisition, or through a secondary market transaction. This payout will be subject to capital gains tax, either long or short term, depending on how long your held the shares post exercise.

One practical note: for employees at private companies, there's often no way to sell immediately after exercising. Your payout timeline is tied to a liquidity event. That gap between exercise and exit is exactly why funding solutions exist, so you're not spending out of pocket years before you see a return.

IRS Rules on Stock Option Exercise (Topic 427)

The IRS covers the tax treatment of employee stock options in IRS Topic No. 427. It recognizes two categories:

Statutory stock options (ISOs) No tax is owed at exercise under the regular tax system, provided you meet the holding requirements: hold shares for at least two years from the grant date and at least one year from the exercise date. If you meet both thresholds, your gain is taxed at the long-term capital gains rate when you sell. If you don't meet them, you trigger a disqualifying disposition and the spread is taxed as ordinary income. Note that AMT may still apply at exercise regardless of holding period (see IRS Topic No. 556 for AMT specifics).

Nonstatutory stock options (NSOs) The spread between your strike price and the fair market value at exercise is taxed as ordinary income in the year you exercise, regardless of whether you sell the shares. Any subsequent appreciation is taxed as capital gains when you eventually sell.

The above is a general summary. Tax treatment varies based on individual circumstances. Consult a qualified tax professional before making exercise decisions.

Should I Exercise?

Deciding whether to exercise is a personal choice. Here are some considerations:

• Company Performance and Potential: How confident are you in the company's growth? If you are confident then go ahead and exercise, if not, there's probably a better place to invest your money.
• Cash Flow and Tax Implications: Exercising requires funds, and there may be a tax burden. Using tools like ESO Fund’s AMT Calculator can help determine potential AMT liabilities. While investing in private company stock can be exciting, it's important to approach it with caution. Be sure to invest only what you can comfortably afford to lose.
• Exit Strategy: Consider your timeline for holding the shares. Holding shares longer can mean lower taxes, but liquidity events like an IPO or acquisition may take time.

What’s Next After Exercising?

Once you’ve exercised, you’re officially a shareholder. Here’s what to expect:

• Share Ownership: You now own company shares, potentially benefitting from future company growth.
• Liquidity Events: If the company goes public or is acquired, you may be able to sell shares at a significant gain.
• Secondary Sales and Tender Offers: Pre-IPO companies may offer secondary sales or tender offers, allowing shareholders to sell some shares before an IPO.

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Written by Jordan Long, Marketing Lead at ESO Fund