Exercising Stock Options: A Step-by-Step Guide

Startups often use employee stock options as a powerful tool to attract and retain the most talented employees. While these options can be a valuable part of your compensation package, the process of exercising them can be confusing and daunting. Questions such as when to exercise your options and how to go about it are expected.

This blog explores the essential aspects of exercising stock options, including the meaning of exercise in this context, the cost implications, and the tax consequences. We will cover the scenarios where early exercise might be beneficial and explain the process of exercising employee stock options before expiration. Keep reading to learn more.

What are Employee Stock Options (ESOs)?

Employee Stock Options (ESOs)are a type of equity award that companies include in their employees' compensation packages. They grant individuals the right, but not the obligation, to buy a particular number of shares of company stock at a specified price, known as the exercise price.

The process begins with the grant of different types of stock options, which establishes the terms of the option, including the grant price, number of shares of stock, the exercise price, and the expiration date. Following the grant, there is typically a vesting period, during which individual employees become eligible to exercise their options. The length and terms of the vesting period can vary, but the common purpose is to incentivize employee retention and performance.

Once the options are vested, employees can choose to exercise their options, meaning they can purchase the shares at the predetermined discounted price. This decision involves multiple factors, such as the current market price of the shares, potential tax implications, and personal financial circumstances

Vesting and Stock Options

Vesting refers to the period during which your employees become eligible to exercise their options. The vesting schedule, which outlines the timeline and conditions for vesting, is typically defined at the time of the option grant.

Vesting schedules can take various forms, including cliff vesting and graded vesting.

• Cliff Vesting: In this scenario, your employees become eligible to exercise all their options after a specific period, usually one to four years. This means if an employee leaves before this period, they forfeit all their options. 
• Graded Vesting: With graded vesting, your employees gradually gain the right to exercise a portion of their options over a particular amount of time. This could be monthly, quarterly, or annually over several years. 

Vesting schedules serve several vital purposes for startups:

• Rewarding Long-Term Commitment: They encourage your employees to stay with you for a significant period, ensuring that they contribute to the company's growth and success.
• Aligning Interests: Vesting aligns the interests of your employees with the company's shareholders. As your company grows and the stock value increases, the value of stock options also grows.
• Protecting the Company: Vesting helps protect your company by preventing employees from leaving immediately after receiving the options and selling them for a quick profit.

Do Stock Options Expire?

Unlike some financial instruments, stock options don't last forever. They have a specific expiration date, after which they become worthless and can no longer be exercised. Typically, the expiration period for stock options is 10 years from the grant date. However, the exact timeline can vary based on the terms set by your company.

As a founder, it is crucial to communicate this timeline to your employees. Being aware of the expiration date is essential for employees as it influences their decision on when to exercise their options. If the employees do not exercise the options before the expiration date, they become worthless, regardless of the stock's market price.

Now, what happens if an employee leaves your company before their options are fully vested? Generally, unvested options are forfeited upon departure. However, vested options can often be exercised within a limited period, known as the post-termination exercise period. The specifics can vary, so it's essential to clearly outline these details in the stock option agreement.

What is the Meaning of Exercising Stock Options?

Exercising stock options refers to the process by which an employee purchases shares of the company's stock at the strike price. This price is typically set at the time the options are granted and is often less than the existing market price of the stock, allowing employees to potentially benefit from the difference. This can be a strategic financial decision, notably if the stock price has risen since the options were granted.

Employees might choose to exercise their options for several reasons:

• Financial Gain: If the market price of the stock is higher than the exercise price, exercising the options can result in a profit.
• Ownership: Exercising options allows employees to become shareholders, which offers them a stake in the company's success.
• Tax Considerations: The timing of exercising stock options can have significant tax implications. Understanding the impact of exercising stock options and taxes is crucial for making informed decisions.

Important Stock Option Exercising Terms

Understanding key terms related to exercising stock options is crucial for making informed decisions. Here are some essential terms you should know:

• Strike Price (or Exercise Price): This is the fixed value at which an individual can buy shares of the company's stock. The strike price is set at the time the options are granted and remains constant throughout the life of the option.
• Fair Market Value (FMV): This is the value that an asset would get in the open market under current conditions. It assumes that both the buyer and seller know all about the asset and are acting in their own best interests without any undue pressure.
• Vesting Period: The vesting period is the time an employee must work for the company before gaining the right to exercise their stock options. Vesting schedules can vary, but they typically are a combination of cliff vesting and graded vesting.
• Taxable Event: A taxable event is any action or transaction that results in taxes owed to the government. In the context of stock options, exercising the options and selling the shares are everyday taxable events.
• Alternative Minimum Tax (AMT): One of the purposes of the alternative minimum tax is to ensure that individuals with a higher income level pay a minimum amount of tax. When exercising stock options, especially Incentive Stock Options (ISOs), this alternate taxation system can come into play, potentially increasing the tax liability.

How to Exercise Stock Options?

Exercising stock options involves a series of steps that allow your employees to purchase company shares at the predetermined strike price. Here is a step-by-step guide on how this process typically unfolds:

1. Vesting: The employee must first fulfil the vesting requirements outlined in their stock option agreement. This usually involves a certain period of service with the company.
2. Decision to Exercise: Once the options are vested, the employee can decide whether to exercise them based on factors like the current market price of the stock and their financial situation.
3. Exercise Method: The employee chooses a method to exercise their options. This could be an 'exercise and hold' strategy, a 'cashless exercise', or a 'sell to cover' exercise, each with its implications.
4. Execution: The employee notifies your company of their decision to exercise the options, pays the exercise price, and receives the corresponding number of shares.

Exercising stock options can trigger a taxable event. In the US, the difference between the FMV of the shares at the time of exercise and the exercise price is often subject to income tax. Therefore, your employees need to consider the potential tax implications of exercising stock options.

Exercise and Hold

One standard method of exercising stock options is the 'exercise and hold' strategy. In this approach, your employees exercise their options and hold onto the shares, hoping for potential long-term gains.

Let's illustrate this with an example. Suppose an employee has the options to buy 1,000 shares with the exercise price of $10 per share. If the current market price is $20 per share, the employee can exercise their options, paying $10,000 to purchase the shares. They now own 1,000 shares of the company, which are worth $20,000 on the open market.

This strategy can be advantageous if the employee believes that your company's stock price will continue to rise. By holding onto the shares, they stand to gain from any future increase in the stock's value. However, this strategy also involves risks, including the potential for the stock price to fall and the upfront cost to exercise the options.

Exercise and Sell to Cover

The 'exercise and sell to cover' strategy involves your employees exercising stock options and selling just enough shares to cover the cost of exercising, including any taxes. This method allows them to acquire shares without needing to pay the total exercise price out of pocket.

Let's illustrate this with an example. Suppose an employee has the options to buy 1,000 shares at a strike price of $10 per share, whereas the existing market price is $20 per share. The total cost of exercising these options is $10,000. To cover this cost, your employee can sell 500 shares at the market price of $20 per share, generating $10,000. This amount covers the exercise cost, and the employee retains the remaining 500 shares.

This strategy is beneficial for employees with limited cash flow who want to acquire shares without upfront costs. By selling a portion of the shares immediately, employees can offset the exercise cost and manage potential tax implications. While this approach may reduce the number of shares owned, it still allows employees to retain a stake in the company and benefit from potential future gains.

Exercise and Sell

The 'exercise and sell' method involves exercising stock options and immediately selling all the shares. This approach provides immediate liquidity and can be a straightforward way to realize gains from stock options.

Let's consider an employee with options to purchase 1,000 shares at a strike price of $10 per share, with the current market price at $20 per share. The employee exercises the options, paying $10,000, and then sells all 1,000 shares at the market price, generating $20,000. The net gain is $10,000 minus any applicable taxes.

This strategy is particularly suitable for employees with immediate cash needs who want to quickly convert their stock options into liquid assets. By selling all shares immediately, employees can eliminate the risk of future stock price fluctuations. This approach can provide more predictable tax implications, as the entire gain or loss is realized in the year of sale.

When to Exercise Stock Options?

Exercising stock options is a crucial decision for startup founders and employees, impacting both financial outcomes and tax obligations. As a founder, understanding when to exercise stock options can help you optimize your financial strategy and help your employees make informed decisions about their options. Timing is critical, and your approach should be aligned with your company's growth trajectory, financial goals, and tax planning. 

Early Exercise of Options

Early exercise involves exercising stock options before they are fully vested. This option allows your employees to notionally purchase shares and pay tax, earlier in the vesting schedule. This decision can offer several advantages:

• Lower Taxes: By exercising options early, your employees may be able to take advantage of lower tax rates. The variation between the exercise price and the FMV at the time of exercise is subject to income tax. If the stock's value increases significantly over time, exercising early can result in a lower taxable amount.
• Long-Term Gains: Early exercise can help employees start the holding period for potential long-term capital gains tax benefits sooner. This can result in lower tax rates on any future gains when they eventually sell the shares.

However, early exercise also comes with risks:

• Forfeiture Risk: If an employee leaves the company before their options are fully vested, they may forfeit the unvested shares, resulting in a financial loss.
• Upfront Costs: Exercising options early requires an upfront payment of the exercise price, which can be a significant financial commitment.

Exercise Before IPO

Exercising stock options before your company goes public can position you and your employees to maximize financial gains from an IPO. This strategy allows for purchasing shares at a lower strike price, anticipating an increase in value once the company becomes publicly traded. Here's why this strategy might be advantageous:

• Potential Gains: If your company goes public at a higher valuation, the shares acquired through exercising options can appreciate significantly in value.
• Tax Benefits: Exercising before the IPO can help manage the tax implications. By starting the holding period earlier, your employees can qualify for long-term capital gains tax treatment on any future gains.

However, this strategy also carries risks:

• IPO Uncertainty: If the IPO is not successful or the stock price declines after the IPO, your employees may face financial losses.
• Liquidity Issues: Before the IPO, the shares may be illiquid, meaning your employees cannot quickly sell them to realize gains.

Exercise After Leaving the Company

Exercising stock options after leaving a company involves several considerations. Typically, there's a 90-day window post-departure (mandatory for ISOs) during which vested options must be exercised, though some companies may offer longer periods. Here are some key points to consider:

• Time Frame: Be aware of the post-termination exercise period specified in the stock option agreement. Missing this deadline can result in forfeiture of the options.
• Financial Implications: Assess your financial situation to determine if you can afford the exercise cost and any associated taxes.
• Tax Considerations: Understand the tax implications of exercising options after leaving the company. The gap between the exercise price and the FMV is subject to income tax.

Making a timely decision is crucial to maximize the benefits of your stock options and avoid potential financial losses.

Factors to Consider When Exercising Stock Options

Your employees need to consider several vital factors before exercising their stock options. As a startup founder, understanding these factors can help you guide your team through the decision-making process.

• Cost: The financial outlay required to exercise stock options includes the strike price and any associated taxes. The strike price is the fixed value at which your employees can purchase the shares. For example, if an employee has options to buy 1,000 shares at a strike price of $10 per share, they will need $10,000 to exercise these options. 
• Liquidity: If the shares are not easily sellable, employees may face challenges in realizing their gains. This is particularly relevant for private companies where the shares may not be publicly traded. 
• Timing: The timing of exercising stock options can have significant implications. Employees should consider market conditions, such as the current stock price and potential future price movements. Personal financial goals and circumstances also play a crucial role. 
• Taxation: The tax implications can vary based on the type of stock options and the timing of the exercise. For example, exercising ISOs may trigger the  AMT, while Non-Qualified Stock Options (NSOs) are typically subject to ordinary income tax on the gap between the strike price and the FMV.

Conclusion

Understanding how and when to exercise stock options is crucial for maximizing their benefits. In this blog, we explored the key aspects of exercising stock options, including the meaning of exercising, the importance of vesting, the different methods of exercising, and the factors to consider when making this decision. 

At Qapita, we specialize in helping founders and employees manage their stock options and make informed decisions. Rated as #1 in the Equity Management software category by G2, our platform offers comprehensive solutions for equity management, including CapTables, ESOP programs, and liquidity options. We provide a one-stop solution for all equity matters, from inception to IPO, ensuring that your employees are well-informed and engaged.

If you need personalized advice or want to streamline the management of your equity compensation plans, we encourage you to consult with the experts at Qapita. Our team is here to support you every step of the way. Get in touch with us to learn more.