What you need to know about your equity
As a startup employee, it can feel both exciting and overwhelming to have stock options or consider a job offer that includes options as part of the compensation package. Stock options can represent the possibility of life-changing wealth — but how do they work? If you’re brand new to stock options and trying to get your bearings, then this starter guide is for you. It provides a high-level overview of key topics, including what it means to exercise your options and how to estimate how much you may owe in taxes. In this guide, you’ll learn:
- 1How vesting and exercising stock options work
- 2The basics of how taxes work when exercising stock options
- 3Key terms that will help you become an equity expert
What are stock options?
Stock options give you the right — or option — to buy shares of a company at a certain price, within a certain time frame. If you choose to buy the shares, you’ll then own a piece of the company. If everything works out well, you can eventually sell the shares for more than you paid to buy them.
What is the grant and vesting process?
A company officially offers you options via a stock option or equity grant. This document spells out key details, such as the type and quantity of options, as well as the strike price, which is how much you’ll pay to purchase one share of the company.
The grant also specifies a vesting schedule. You’ll initially receive your options unvested — essentially, your company has granted you the option to eventually purchase shares, but only if you continue working there for a specific period of time. The vesting schedule determines the incremental rate at which you’ll be awarded options over the course of your employment. Once your options are vested, then you can choose to exercise them, i.e., buy the shares that are available to you.
Typically, you can exercise vested options whenever you want as long as you work at the company, and you don’t have to exercise them all at once. Meaning, you don’t have to wait for all of your options to vest before exercising them.
If you have vested options and leave your company, your ability to exercise the options will be determined by your company’s post-termination exercise period. Most companies allow you only 90 days to exercise vested incentive stock options (ISOs) or else you lose them. Some companies may offer longer exercise windows, but that can come with caveats, such as working there for a certain amount of time to qualify. Even if you work for an employer that offers a generous post-termination exercise window, ISOs convert to non-qualified stock options (NSOs) after 90 days. NSOs experience less-favorable tax treatment than ISOs.
Some companies also offer early exercising, which allows you to exercise your options before they vest.
What are the different types of stock options?
The two most common forms of stock options offered to pre-IPO startup employees are incentive stock options (ISOs) and non-qualified stock options (NSOs). Both give you the right to purchase shares at the strike price. ISOs and NSOs are differentiated by their tax treatment. In certain circumstances, the taxes to exercise ISOs are lower than on NSOs.
Instead of stock options that you have to buy, some companies offer restricted stock units (RSUs). An RSU is a share that will be delivered to you in the future, according to vesting and other conditions. You don’t get to choose when you receive the shares, you don’t have to pay upfront to receive RSUs, and companies who offer them typically reserve a portion of their value for tax purposes — similar to a cash bonus.
How are stock options exercised?
Once your options are vested, you can choose to exercise them, which means buying shares of the company at the strike price specified in your grant. Typically, you are able to exercise options as they vest — you don’t have to wait until all options in the grant are vested.
Generally, there are two ways to exercise stock options — pre-exit or post-exit.
The first is that you exercise your vested options whenever you want to, before an IPO or an exit. This has potential advantages, including lower upfront costs, and the possibility of lower, long-term capital gains taxes when it’s time to eventually sell.
Note: We dive more into these scenarios below.
Exercising early comes with more risk. If your company doesn’t IPO or exit, you’ll lose whatever you paid to exercise.
Another method is to complete a cashless exercise, by simultaneously exercising your options and selling your shares in a one-day transaction. The money you get from selling shares is used to cover the cost of exercising your options. This route is possible if your company’s shares are publicly traded — meaning it can be done after an IPO. It can also be done if you are participating in a tender offer, also known as a secondary offer. While a cashless exercise reduces your risk, it usually means you’ll be taxed at the highest possible rate, which can reduce your net gain.
How are options taxed at exercise?
The total cost to exercise your options has two components:
- The cost to buy shares (strike price x number of shares), and
- The associated taxes.
The tax costs are often what make options so expensive to exercise. In some cases, the tax liability is zero. But for the average late-stage unicorn employee, a significant portion of the cost to exercise is likely to be taxes. That’s because you’re taxed on the difference between your strike price and your company’s fair market value, a.k.a. 409A valuation — a spread which can be extreme for high-growth startups. As most employees are unaware of their tax liability at exercise, we call this “the surprise factor.”
To see what taxes you may owe, you can enter your details into our free Stock Option Tax Calculator.
What happens after options are exercised?
Once exercised, you own your options, which are converted to shares. As a shareholder, your hope is that the value of your equity goes up and you can sell your shares for more than you paid to buy them.
If your company is publicly traded, selling your shares is usually as simple as sending a sell order to your brokerage. If, however, your company just completed an IPO, there’s usually a lockup period when employees can’t sell their shares. There may be “early releases” from the lock-up, allowing you to sell a certain amount before the lockup expires. .
If your company is still private, you might be able to sell shares in the secondary market or as part of a company-sponsored tender offer. Your company could also be acquired, i.e., bought by another company. This type of “exit” may allow you to cash out your shares and/or vested options, but it also depends on the specifics of the acquisition.
How are options taxed when you sell shares?
When you sell stock acquired by exercising options, your taxes depend on several things, including the type of options, when you exercised, and when you sold shares. There are a lot of factors to consider and tax codes you may encounter, so it’s always wise to consult with a tax expert and/or financial advisor.
You can learn more about how stock options are taxed in our comprehensive guide.
How do I value my stock options?
Until you actually sell your shares, you can’t be 100 percent sure how much money you’ll make from your options. So, how can you think about the value of your options? You can start by understanding the factors that can influence the value.
When your company exits, the total amount of money offered to shareholders is called the exit value. This is the proverbial golden pie. Your payout is your slice of the pie, and your net gain is the money you make after costs, like taxes.
Your payout is based on the percentage of the company you own (your stake). Your stake is the number of shares you own divided by the total number of existing company shares.
Here are two basic equations to keep in mind:
- Company exit value x Your stake at exit = Your payout
- Your payout – Your costs = Your net gain
We can see that a higher company exit value, lower costs, and bigger stake are all favorable when it comes to maximizing the value of your options.
Check out our Stock Option Exit Calculator to reveal your potential payout and net gain.
What if I can't afford to exercise my options?
Many employees find it simply unaffordable to exercise their options.
So, what can you do?
You could pay for your stock options using cash on hand, if you have enough money and feel comfortable tying it up in a single asset.
You could take out a personal, home equity, or margin to cover the cost of exercising your options. You could also turn to the secondary market to sell a portion to cover the cost of your remaining options. As we described earlier, another option is to wait for an exit and do a cashless exercise to avoid the upfront need for cash to exercise your options.
Each of these strategies comes with either high risk, high taxes, or lost upside. If you decide to pay for stock options using cash on hand or conventional loans, you take on the risk that the company might not exit.
If you sell a portion of your shares on a secondary market, you could experience lost upside. And if you perform a cashless exercise, you will likely pay the highest possible tax rate, eating into any gains.
Non-recourse financing is another way to get the cash to cover the full cost of exercising, including taxes. And it is a lower-risk option than traditional personal loans, because if your startup fails to exit, the non-recourse financing company assumes the downside risk.
Here’s how Secfi’s Excercise Financing works:
- We cover your exercise costs (including taxes)
- You pay us back after your company exits, and if your company never exits, you don’t pay us back
- Your stock options are the only asset at stake, meaning your personal assets are never at risk
- You remain the owner of your shares —you’re not selling them to us
Key terms and further reading
If you want to take a deeper dive into certain stock option scenarios or how options are taxed, you can read our other guides:
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Here are a few key terms you might come across as you get started with stock options. Secfi Learn also covers many of these topics in depth. .
- 409A valuation – An appraisal of the value of a company share for tax purposes. Also called fair market value, or simply the 409A.
- Acquisition – A type of exit where one company is bought by another.
- Alternative minimum tax (AMT) – A special tax you may owe when exercising incentive stock options (ISOs).
- Capital gains tax – When you sell a capital asset (like a stock) for more than you spent to buy it, you’ve created a capital gain. The federal government and many states have specific tax systems for the income generated by capital gains.
- Cashless exercise – Exercising options and immediately selling some or all of the resulting shares to cover the costs of exercising.
- Cliff – Vesting schedules typically include a “cliff” designating the length of time you must work for a company before your options start to vest.
- Dilution – When a company creates new shares to give to employees or investors, the total number of shares grows. Although you still own the same number of shares, your stake — the percentage of the company that you own — decreases. In other words, your stake has been diluted.
- Exercise – To buy the shares that are available to you.
- Exit – How shareholders monetize their investments in a company; common exit strategies include going public or by selling the company to a third party.
- Grant – An official document spelling out key details of your options package, such as the type and quantity of options, as well as the strike price.
- Incentive stock options (ISOs) – Give you the right to purchase shares at a specified price; could qualify for advantageous tax treatment.
- Initial public offering (IPO) – When a company sells shares in the public market for the first time.
- Non-qualified stock options (NSOs) – Give you the right to purchase shares at a specified price.
- Restricted stock units (RSUs) – A promise by your employer to give you company shares at a later time, as determined by the vesting schedule; you don’t have a choice of when you get the shares.
- Stake – The percentage of the company that you own; the number of shares you own divided by the total number of existing company shares.
- Strike price – The predetermined price at which you can buy stock from your company; also known as the exercise price. Typically determined using the fair market value of the stock at the time of grant.
- Tender offer – Gives private company employees a chance to sell a certain number of shares at a fixed price during a specific time frame.
- Vesting – The process of gaining full legal rights to your options. Once your options vest, you can choose to exercise them. The vesting schedule spells out how your options will be incrementally awarded during the course of your employment.