Exercising Stock Options

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.

How to Exercise Your Stock Options

To exercise your options, you’ll typically need to pay the strike price times the number of shares. If you have 1,000 options with a strike price of $1 per share it will cost you $1,000 to exercise them all.

• Equity Portal: Many companies have an equity portal where you can view your options, vesting schedule, and exercise details. Otherwise you may need to fill out a Stock Option Exercise Notice and send it in to the company along with your payment.
• Payment Options:
  • Cash Exercise: This is the standard method, where you pay cash to purchase the shares. Typically this is done via your equity portal or by wiring money to the company.
  • Cashless Exercise: In some cases, you may be able to exercise without upfront costs by selling a portion of shares at exercise. This approach requires no money spent initially but could mean selling at a low price, limiting potential gains.
  • 3rd Party Funding: Companies like ESO Fund offer risk-free stock option exercise funding in exchange for a portion of the shares. Fill out our form below to learn more!

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. 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.

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’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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