5 Strategies for Exercising Private Company Stock Options
Are you a startup employee or at a private company holding stock options? If you have stock options as part of your equity compensation, deciding when and how to exercise them can be complex. This guide breaks down five strategies to help you make an informed equity decision.
What Are Stock Options?
Stock options give employees the right to purchase shares of their company’s stock at a set price, known as the exercise price. The goal is to eventually sell those shares for a profit if the stock price increases. However, there are various strategies for when to exercise these options, each with its own benefits and drawbacks.
1. Exercise at Liquidity
One common strategy for startup employees is waiting until a liquidity event—such as an IPO or acquisition—before exercising their stock options. This strategy appeals to those who want to minimize risk or avoid upfront costs.
Benefits of Exercising at Liquidity:
Lower-risk: You avoid holding illiquid shares for an extended period.
No out-of-pocket costs: Often, you can exercise without paying upfront.
Time to assess the company’s future: You gain a longer window to evaluate the company’s performance.
Drawbacks:
Higher tax liability: Exercising and selling shares on the same day may result in ordinary income tax, even when holding Incentive Stock Options (ISOs).
Restricted career mobility: Post-termination exercise provisions can limit your ability to switch jobs without forfeiting your options. If you’re somebody who “enjoys the next adventure” and wants to move companies quickly, that can be an issue here.
2. Forfeiting Your Stock Options
Unfortunately, forfeiting stock options is more common than many employees realize. In my experience, this can happen due to a lack of education about equity compensation or simply missing key deadlines.
Reasons for Forfeiture:
Lack of understanding: Employees might not fully grasp the value or mechanics of their stock options.
Expired stock options: Stock options typically expire 10 years from the grant date(varies, so check your grant documents). If you fail to exercise within that window, they become worthless.
Post-termination exercise period (PTEP): After leaving a company, you generally have only 90 days to exercise your stock options, or they are forfeited.
Exercise costs: Many employees are unable or unwilling to cover the costs of exercising private company options. If the cost is to much for your liking, you may simply need to walk away. Or, if you’d like to buy your shares, you may need to look at financing or other loan options.
Tax costs: Depending on the type of options, you may face taxes such as ordinary income tax or the Alternative Minimum Tax (AMT). As with the exercise cost, if the tax is too high, you may need to seek outside monies to help.
Lack of confidence in the company: Some employees choose not to exercise their options if they don’t believe in the company’s upside potential. This one is tough as you’ve poured your blood, sweat, and tears into helping build the company.
3. Exercise at Expiration (Before a Liquidity Event)
What happens if you’ve held your stock options almost to expiration, and there’s still no liquidity event? You have two choices: exercise the options or let them expire.
Before making a decision, consider:
Company outlook: Do you still believe in the company’s long-term success?
Cash flow: Can you afford the cost of exercising without jeopardizing your financial stability?
Concentration risk: How does exercising affect the diversification of your investment portfolio?
Tax implications: What will be the tax impact in the current year?
Long-term goals: Does exercising align with your broader financial objectives?
Exit strategy: How and when will you sell your shares in the event the company does have a liquidity opportunity?
Take time to evaluate and answer these questions. Be honest with yourself and understand that your decision is right for you, and that's what matters most.
4. Early Exercise for Stock Options
If your stock option plan allows it, early exercise can be a savvy tax-planning strategy, particularly if you believe in the company's future success.
What is Early Exercise? Early exercise allows you to exercise unvested stock options and begin the holding period for long-term capital gains immediately. This can result in significant tax savings when you eventually sell your shares.
Key Steps:
Exercise your stock options while they are still unvested.
File an 83(b) election within 30 days to start your holding period for capital gains tax.
Pros:
Lower potential tax burden if the exercise price equals the fair market value (FMV) of the stock.
Start your capital gains holding period earlier, which can lead to lower tax rates when you sell.
Cons:
You risk holding illiquid stock that may not vest or could become worthless.
Early exercise isn’t available in every stock option plan, so you may need to negotiate for it.
5. Exercise Stock Options as They Vest
For many, exercising stock options as they vest can be the most effective way to manage taxes and maintain control over their equity compensation.
Why This Works:
By exercising options regularly, you can start the capital gains holding period earlier, similar to early exercise.
You avoid the higher tax costs associated with waiting too long to exercise, such as AMT or ordinary income tax on non-qualified stock options.
How to Maximize This Strategy:
Stay informed: Keep track of your company’s fair market value and any upcoming events that could affect the stock price.
Evaluate regularly: Assess the costs and tax implications of exercising as your options vest. It may take some financial planning, but the benefits often outweigh the work involved.
Final Thoughts: How to Choose the Best Strategy for Exercising Stock Options
Selecting the right stock option exercise strategy is crucial to maximizing the value of your equity compensation. Whether you’re waiting for a liquidity event, considering early exercise, or evaluating other options, the decision should be based on your financial situation, company outlook, and long-term goals.
Consulting with an expert in equity compensation—such as a Certified Financial Planner (CFP) who specializes in stock options—can provide you with tailored advice to make the best decision for your financial future.
By educating yourself on these strategies and making thoughtful decisions, you can unlock the full potential of your stock options and achieve greater financial peace of mind.
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