Your startup equity could be worth a life-changing amount of money – but knowing when and how to exercise your stock options can have a huge impact on what you ultimately keep.
What are some reasons you may be interested in exercising options now?
- You may be leaving your job, and you’ve realised you have a limited time to exercise your stock options before losing them forever
- You may have heard your company is exiting soon, and you want to exercise your stock options to start the clock on long-term capital gains
- You may simply be interested to explore your pre-IPO liquidity options
No matter why you want to exercise your stock options, we’ve built this guide to help. We’ll cover:
- What to know before you exercise your options
- How to exercise your stock options: 5 steps
- How to estimate your tax liability when exercising
- Common risks around exercising your stock options
- How to pay for your stock options
- How Secfi helps startup employees and understand and exercise their stock options
- Why Victor chose Secfi to help him finance his options
- What happens after you’ve exercised your stock options?
Our goal is to help you make an informed decision about how, when, and if it makes sense to exercise your stock options. This guide is for informational purposes only and isn't a substitute for personalized tax or investment advice.
Do you want tailored information about your equity, your options, or the best way to maximize your wealth? Try our AI equity assistant Maeve for personalized equity and liquidity planning.
What to know before you exercise your options
When you started working at your startup, you were given a stock option grant — a core part of your equity compensation — that detailed the type of stock options you would earn, as well as your vesting schedule, your strike price, and your grant date.
It may have been a long time since you looked at this documentation in detail, particularly if you’ve been in the role for a long time. But if you’re looking to exercise your options – or you just want to get a clear idea of your financial situation – you’ll need to revisit these grants.
Typically, there are three details that you should be clear on before you exercise.
1. Check your type of stock option
One of the most important things you need to know is the type of stock option you have. This will impact how you’re taxed when you exercise (and if you later sell your options).
There are three major types of stock options:
- Incentive stock options (ISOs). ISOs give employees the right to exercise an option at a predetermined price (the strike price). One of the biggest advantages of ISOs is their favorable tax treatment – namely you won't pay income tax when you exercise them, and you may pay less capital gains tax if you sell them, but you may be subject to Alternative Minimum Tax (AMT).
- Non-qualified stock options (NSOs). NSOs don't qualify for the same tax benefits as ISOs. That means you'll typically have to pay ordinary income tax on these both when you exercise them and when you sell them. Importantly, NSOs are typically more common than ISOs.
- Restricted stock units (RSUs). An RSU is the promise of a gift of shares at a later date. Unlike ISOs and NSOs, you don’t need to buy or exercise them – they’re just awarded at no cost. Typically, you’ll need to work at a company for a given number of years to receive the shares, which you can then sell.
At some startups, it's common to earn multiple types of stock options at once, particularly if the startup expects to go public in the near future. Each type comes with different tax implications, so it's worth knowing exactly what you hold before you do anything else.
2. Understand your vesting schedule, strike price, and other conditions
Most options you receive will come with conditions that are outlined in your option grant. These will typically determine when and how you can exercise them, as well as how much it’ll cost you to do so.
It’s worth noting that you may have received refresher grants – i.e. additional options or RSUs – after your initial hiring package. These may differ from your original grant, so you’ll need to check both.
Some key information to look for include:
- Strike price. This is the set price – also called exercise price – that you can exercise your options for. This is usually the fair market value or FMV, (aka the 409A valuation) at the time when you were given your options. If the company’s value grows, you can still exercise at the strike price.
- Vesting schedule. Your vesting schedule determines when you can exercise your options. A common schedule is four years with a one-year cliff, meaning 25% of your options vest after your first year and the remaining 75% vest gradually over the following three years.
- Expiry. Most ISOs and NSOs expire after 10 years of working at a company. It means that, if you want to exercise your options, you’ll need to ensure you do so before that date. If you leave the company, you’ll also typically have 90 days to exercise from the date of departure.
Your grant documentation will again be your source of truth here. While most options conform to similar conditions, to know anything for sure you’ll need to check your original grant. If you’re using a platform such as Carta, Shareworks, or Pulley, you’ll likely find the details there too.
3. Prepare for your tax bill
Stock options are taxed when you exercise them, and taxed again when you sell them.
As a general rule, if your startup is growing, your tax bill is growing, too. So, if you’re confident your startup will successfully exit, it’s typically more affordable to exercise your stock options now, rather than waiting.
But precisely how much you owe will depend on the type of options you have, how much your company is growing, and what state you live in. So, your tax bill is highly personal and can be quite complex to work out by yourself.
Rather than trying to work it out by yourself, it helps to have a tool walk you through it. Our secure AI equity assistant, Maeve, can give you the tailored information you need. Try it here.
How to exercise your stock options: 5 steps
Once you have all the necessary information at hand, here are the 5 key steps to exercise:
- Follow your company’s exercise process. Log into your company’s equity management platform – such as Carta or Shareworks – and select the stock option grant you want to exercise. The platform will guide you through the process and show how much it will cost. If your company doesn’t use an equity platform, contact your HR or finance team for instructions.
- Decide whether early exercising makes sense for you. Some startups allow employees to exercise stock options before they’ve vested. Early exercising can have tax advantages in some situations, but it also comes with risk – so consider whether it’s the right move for your financial situation. If you exercise early, you’ll typically need to file an 83(b) election with the IRS.
- Pay the exercise cost and any taxes owed. Your equity platform (if you’re using one) should estimate both the cost to exercise your options and any taxes due. Depending on your option type, income, and location, you may owe state and federal taxes when exercising. It’s ultimately you that’s responsible for paying the correct amount, so it’s worth double-checking the figures or speaking with a tax professional.
- Get company approval and receive your stock certificate. Once payment is complete, your company will review and approve the exercise request. After final signatures are submitted, the equity platform will issue a stock certificate confirming the number of shares you now own.
- Decide what to do next with your shares. After exercising, you officially own shares in the company. From there, you can decide whether to hold them or eventually sell them. But it’s worth noting that your company may restrict sales through secondary marketplace rules or trading lockup periods after an IPO.
It can be useful to talk to an equity advisor to help you make a decision about your options. Or you can use Secfi’s AI equity assistant, Maeve, to easily model different scenarios and related costs.
How to estimate your tax liability when exercising
There are three main types of stock options (ISOs, NSOs, and RSUs), and they’re taxed differently at exercise.
How RSUs are taxed
RSUs are the simplest, so let’s start there. RSUs are earned (rather than purchased), and are treated like a cash bonus with tax authorities.
For example, you might be granted 1,000 RSUs that vest over four years, with a one-year cliff. On your one-year work anniversary, 25% of the grant (250 RSUs) vests. The remaining RSUs then vest on a regular schedule, such as monthly or quarterly, over the next three years.
At many private companies, RSUs are subject to a double-trigger vesting structure. The first trigger is your time-based vesting schedule. The second trigger is a liquidity event, such as an IPO or acquisition. This means that even after your RSUs have vested, you may not actually receive the shares until the second trigger occurs.
Once both triggers have been satisfied, the vested RSUs are converted into company shares and delivered to you. At that point, the value of those shares will depend on the company's share price.
Tax authorities treat RSUs like a cash bonus because they assume the company’s shares have value on the day you get them. So, in this example, tax authorities would view the $25,000 of shares you receive in the same way as if your company had given you a $25,000 cash bonus.
Companies that issue RSUs typically calculate taxes on your behalf, and automatically withhold them from your paycheck, similar to a cash bonus. At publicly traded companies, the company typically sells a portion of your shares to cover your tax liability.
So, in the example above, your company might sell 100 shares to cover your tax liability, and give you the remaining 150 shares as common stock – the standard type of ownership share typically held by employees and founders.
Late-stage, pre-IPO startups occasionally issue RSUs, and will tell you how much you owe in taxes as they vest.
How ISOs and NSOs are taxed at exercise
ISOs and NSOs are similar, because you have to buy them before you own them. If you’re working at a high-growth startup, your cost to exercise ISOs and NSOs will likely rise every year, due to taxes.
For example, let’s say you’re issued a stock option grant for 100,000 shares of either ISOs or NSOs, at a strike price of $1 per share.
Four years later, you’ve completed a standard four-year vesting schedule, and you’re eligible to buy all 100,000 shares. At that point, the startup’s fair market value (also known as a 409A valuation) has gone up – from $1 per share when you started at the company, to $10 per share:
- You’ll spend $100,000 to purchase 100,000 shares (100,000 shares x $1 per share strike price)
- Your shares are on paper worth $1 million (100,000 shares x $10 per share valuation)
- You’ll report to state and federal tax authorities an assumed gain of $900,000 ($1 million assumed value - $100,000 cost basis)
Here, ISOs and NSOs start to work a little differently. With ISOs, you may owe taxes under the alternative minimum tax (AMT) system. With NSOs, you’ll owe taxes under the income tax system.
All things being equal, ISOs are typically preferable to NSOs, due to AMT treatment. This can allow employees to defer a portion of their tax liability and potentially benefit from lower long-term capital gains tax rates if the shares are held long enough.
How much you’ll owe will depend on how many shares you exercise, where you live and any state taxes you might owe, and the assumed gain between how much you paid, and how much they’re worth – at least on paper.
Common risks around exercising your stock options
Like any investment, stock options carry risk. There’s risk in abandoning them, there’s risk in exercising them, and there’s risk in selling them.
As a startup employee, you’ll need to assess those risks, and decide whether you want to invest in your company.
Risk #1: The company fails and you lose your investment (and can’t afford the tax bill)
On the other hand, many startups fail. When a startup fails, founders typically liquidate the company’s assets, and use those assets to pay back company debt, and in some cases, pay back their investors.
For people who exercise stock options, the major risk is that the company they’ve bought shares of fails, and they lose their investment.
There’s also a related risk: that you exercise your stock options and incur a stock option-related tax bill that you can’t afford.
This happened during the dot-com bust to tech workers like Jeffrey Chou. He was a Cisco engineer who exercised his stock options but saw the value of the company’s shares plummet on the public market shortly afterward. By the time tax season came around, he faced a $2.5 million tax bill, and no way to pay it.
In Chou’s case, he would have likely experienced a better outcome by performing a cashless exercise, which is where you exercise your stock options and immediately sell some or all of them on the open market, in what’s effectively treated like a single transaction by tax authorities. (Note: Performing a cashless exercise also means you’ll pay the highest possible tax rate on the transaction.)
The risk of finding yourself underwater on AMT taxes is particularly high if you’ve joined a later-stage company that’s preparing to exit, and your strike price is relatively high. AMT tax liability is calculated on the day that you exercise, which is a risk if the underlying value of the shares decline during the exit.
Note: Make sure you estimate your AMT liability before you exercise, and that you can afford your AMT bill. Occasionally, people exercise their stock options and hope that their shares will rise in value, so they can sell them later and cover their AMT. The major risk is that share value will instead fall, and you face an AMT bill you have no way of paying.
Risk #2: You abandon your stock options (and miss out on a big upside)
Every year, startup employees abandon billions of dollars worth of vested employee stock options, by failing to exercise their options after leaving their jobs.
For example, consider Tesla. In 2008, less than two years before the company would go public, employees forfeited 2.8 million shares of company stock, which they could have exercised at an average price of 73 cents per share.
Today, those shares are worth an estimated $14 billion, following the company’s 5-1 stock split in 2020.
There are a number of reasons why employees abandon their stock options:
- Employees aren’t aware they have to buy their stock options and can’t afford to buy as many shares as they’d like
- If your startup gives its employees “refresher” grants, you’ll always leave some unvested stock options on the table on your way out the door
- In some cases, employees make a conscious choice not to exercise their stock options, believing that the risk of company failure is too high
The major risk to abandoning some or all of your stock options is that the company experiences a successful exit, and you lose out on the upside of your stock options.
Risk #3: You sell your shares early (and miss out on a big upside)
Investors are familiar with the risk when selling shares – namely, that the investment will continue to grow in value, and the investor will miss out on upside.
On a smaller scale, that’s true for startup employees holding pre-IPO stock options, and pre-IPO shares. Every year, startup employees sell billions of dollars worth of pre-IPO shares to accredited investors through company-organized tender offers and on secondary marketplaces.
Sometimes, employees turn to secondary markets and stock buybacks as a way to raise enough money to purchase the rest of their stock options. In doing so, they’re losing out on potential upside that they could experience during an eventual exit.
Similarly, employees might also lose out on upside if they refuse to sell post-IPO. That’s why it makes sense to work with a financial professional to build a plan for how and when you want to sell your equity.
How to pay for your stock options
By now, you’ll have a good idea of how to exercise your stock options, how to estimate your total cost to exercise, and how to weigh your own unique risks and potential rewards.
So, finally, how do you pay for stock options?
Here are the four most common ways that people pay to exercise their stock options, with related risks:
1. Cash. The simplest way to exercise stock options is with cash out of pocket. If you can afford it, it can make sense.
Risk: If the company fails, you could lose your entire investment. You risk tying up money in an illiquid investment, and losing out on potential upside from a more balanced portfolio of investments.
2. Traditional loans. With a loan, you won’t have to risk your own money to exercise your stock options. Depending on who you loan money from, you may need to immediately begin paying interest on the loan.
Risk: If the company fails, gets acquired at a deep discount, or experiences a disappointing IPO, you will still need to repay the loan – with the interest on top.
3. Secondary markets. Some people use secondary markets to sell a portion of their stock options, so they can raise enough money to exercise their remaining stock options and pay related taxes.
Risk: It could take a long time to find a buyer on a secondary market, and buyers may drive a hard bargain. You may end up giving up more stock options than you’d like, sacrificing potential future upside.
4. Non-recourse financing. There are two major benefits to using non-recourse financing in a way that Secfi offers. Firstly, the company gives you the money necessary to exercise your options and to pay any related taxes. Secondly, the company also assumes most of the downside risk in the transaction, so if the startup fails and the startup’s stock options are deemed worthless, you don’t have to pay back the loan.
Risk: You’ll pay fees to the non-recourse financing company, meaning you’ll lose some of your potential upside upon exit. There may be some additional tax consequences depending on your tax situation.
There’s no right answer when it comes to paying for your options. Each choice comes with its advantages and risks.
That’s why it’s useful to discuss your situation with a specialist equity advisor who can help you make the right decision for you.
How Secfi helps startup employees understand and exercise their stock options
As you’ve seen, exercising your stock options is not a straightforward decision. It typically requires a lot of cash up front – and you’ll likely have a large tax bill to pay too.
Exercising comes with significant costs, often to the tune of tens of thousands of dollars. As such, it’s not a question of cost alone, but of risk too. There’s no guarantee that the startup will exit. And if you’re paying out of pocket to exercise, you may not get that money back.
At Secfi, our founders experienced the challenges of exercising first-hand. They were working in a startup, but they didn’t have the cash they needed to exercise. That’s why they started Secfi, to help other people in similar situations.
Now, we help startup employees and executives navigate the complexity of their stock options, thanks to our combination of planning tools and expert guidance.
We also provide financing solutions to support you to exercise your options without a significant financial burden up front.
Here’s how we can help:
Get the clarity you need to make confident decisions about how to exercise your options
Most people only start thinking about their stock options when there's a deadline looming, for example, after leaving a company and discovering they have just 90 days to exercise.
The challenge is that generic online advice can't tell you what exercising will actually cost. Your tax bill depends on factors such as your option type, income, state of residence, and company valuation.
If you need personalized guidance, Secfi's equity strategists can help you evaluate the costs, tax implications, and risks of exercising, and whether it makes sense in the first place.
Or, if you'd like to explore different scenarios yourself, try Maeve, our AI equity assistant. Maeve uses your actual equity data and live market signals to provide personalized tax estimates and model potential outcomes.
Try Maeve now and instantly get the details you need to act on your options with confidence.
