How to exercise stock options in startups?
When an employee joins a startup they are walking into an uncertain employment opportunity. If the startup fails to live up to expectations, employees may have to start the job hunt all over again. The base pay isn’t always as lucrative as going to a bigger and more established corporation either. So it is natural for employees to lean on stock options as compensation for joining a startup to add to the upside potential.
Employee stock options are beneficial for the startup as well because they can use stock options as a way to make up for the lack of other incentives. Not to mention issuing stock options is cost-effective, making them the perfect form of compensation for startups to offer.
With that being said, a lot of employees who receive stock options aren’t sure how they can gain monetary benefits from them. Contrary to common belief, stock options don’t actually grant the employee a certain number of shares. Employees who have stock options have the choice to exercise their option to buy the stock once they have spent the required amount of time working for the startup.
When it comes to exercising the stock options, however, things can get tricky as employees who receive stock options for the first time aren’t sure how to exercise their options. If you are also wondering how stock options are exercised at startups then this article is for you and we suggest you keep reading.
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Here is the content that we will cover in this post. Let’s get started.
- 1. What Are Stock Options?
- 2. Terms:
- 3. How Can Employees Exercise Their Stock Options in Startups?
- 4. Holding onto your stock options
- 5. Exercise and hold stock options transaction
- 6. Use the exercise and sell to cover method
- 7. Exercise and sell method
- 8. When Is The Right Time To Exercise Stock Options?
- 9. Are you still employed by your employer?
- 10. What is the company’s performance?
- 11. Can you pay the taxes?
- 12. Conclusion
What Are Stock Options?
Stock options are a special form of compensation that fall under the umbrella of equity compensation. When an employee receives stock options, they get the right to purchase stock options at a special discounted price called the strike price. The strike price is agreed upon in the stock options agreement at the time of joining the startup.
The stock options agreement doesn’t force the employee to exercise their right of purchasing stock. It only gives them the opportunity to do so, and the employee can always choose to not exercise this right.
When an employee receives stock options, they receive an opportunity to make a decent profit by buying the stock at a discounted price and selling it at the market value. On the other hand, startups get the benefit of offering an incentive to employees that doesn’t incur any cost right away.
Employees who have stock options have a direct stake in the growth of their business. The higher the company’s stock price grows, the more profit the stock options holder can make when they choose to exercise their options. Here are some key terms associated with stock options that are worth knowing when you are exercising them. Keep them in mind when you’re trying to understand how to exercise stock options in startups.
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- Grant date: The grant date is the date when a startup formally issues stock options to the employee through a stock options agreement.
- Strike price: Strike price is set by the startup, and it refers to the discounted price at which an employee can buy the stock when they exercise their stock options.
- Vesting schedule: The vesting schedule is a time frame over which an employee gradually vests or earns the right to exercise their stock options. Not all startups give employees access to all the stock options at once to ensure employee retention. The vesting period may span over several years and the employee often vests a certain percentage of their stock options each year they work for the startup.
- Exercise window: Once stock options are vested completely to the employee they have a time period known as the exercise window during which they must exercise their stock options. This window is usually 10 years, granted that the employee keeps working for the startup. If the employee decides to leave the startup their exercise period gets reduced.
- Stock options expiry date: As the name suggests the stock options expiry date refers to the date at which your stock options expire. Once the expiry date has passed the employees can not exercise their stock options anymore.
Among the many startup hurdles every entrepreneur needs to overcome is recruiting and hiring great talent. If you would like a quick overview of the other potential snags you might face, you’ve come to the right place. Check out this video I have created.
How Can Employees Exercise Their Stock Options in Startups?
Exercising stock options is not a highly complex process. However, it does require some knowledge to get the most benefit when you exercise your stock options. Luckily there are different methods you can choose from when exercising your options. Here are those options and the benefits of each.
Holding onto your stock options
The very first choice you have when you exercise stock options is to hold your options until the company’s stock rises above the strike price. It wouldn’t make sense to exercise your options when the company is still in the early growth phases and the stock price of the company is lower than the strike price you have been promised.
Since the goal of stock options is to get the maximum benefit at the time of exercise the hold option works well to achieve this goal. You can treat your stock options as a long-term investment by holding onto them over the long run as your company’s stock value grows. However, as mentioned earlier there is an expiry date for every stock option and you have to make sure you exercise them before the expiry date arrives.
Some key benefits of holding your stock options over the long run include:
- Delayed tax liabilities as you only have to pay taxes on your stock options when you exercise them and get profits. So the more you hold onto the stock options, the longer you can delay your tax liabilities.
- There is a high chance that your company’s stock price will appreciate over time, and you can get more gains when you exercise your stock options after holding onto them.
Understanding the benefits will give you a better handle on how to exercise stock options in startups.
Exercise and hold stock options transaction
Another commonly used method for exercising stock options is the exercise and hold stock options. This type of transaction involves exercising the stock options the employee holds to buy the common stock of the company. The employee can then hold the common stock of the company and benefit from its growth.
However, in order to exercise the stock options using this method the employee may need to use cash, or borrow using other securities the employee holds as collateral to cover the costs associated with this transaction.
Here are some benefits of exercising stock options using the exercise-and-hold stock options method:
- You get to own the common stock of your company and get added benefits such as dividends.
- You can benefit from the increase in the stock price of your company’s common stock similar to regular investors.
Use the exercise and sell to cover method
This method for how to exercise stock options in startups is similar to the previous method we have explained, with a slight difference. The exercise-and-sell-to-cover method means that the employee has to sell some shares at the time of exercising the options.
A portion of the shares is sold to cover the costs associated with exercising stock options such as brokerage fee and taxes. The remaining shares after all the costs of exercising stock options are covered are considered the proceeds from the transaction. This exercise method is ideal for employees who don’t want to use cash to cover the costs of stock options or borrow using their securities as collateral. Here are some benefits of the exercise and sell to cover method:
- You get to own the common stock of the company and can enjoy all the perks associated with it including dividends.
- Benefit from the appreciation in your company’s stock price as it grows.
- You can cover all the costs of exercising stock options using the stock options themselves. This method saves the employees from incurring additional costs before they can gain monetary benefits from their stock options.
Exercise and sell method
This method is very similar to the exercise and sell method to cover the cost of exercising stock options. However, when an employee chooses to use the exercise and sell method for exercising their options they exercise and sell the stock they receive at the same time.
The costs associated with exercising the options are also covered by selling the options so the employee doesn’t have to use any cash of their own during this transaction.
When an exercise and sell transaction is completed, the employee is left with proceeds with all the costs of the transaction already taken care of. If the employee is looking to make other investments rather than holding the stock of the company they work for, then exercise and sell is a great choice for them. By using the exercise and sell transaction they can get cash in hand that can be used to diversify the employee’s portfolio.
Here are some benefits offered by the exercise and sell method of exercising stock options:
- Employees get instant cash in hand after they exercise and sell their stock options at once.
- Employees can explore other investment opportunities rather than keeping all their eggs in one basket.
When Is The Right Time To Exercise Stock Options?
Now that you know how to exercise stock options in startups, you are probably wondering when you should exercise your options to get the most benefit. However, before you can go ahead and exercise your options you have to be sure that you are eligible to exercise them in the first place.
Refer to the vesting period we mentioned earlier in this article. Unless you have the stock options vested to your name by completing the vesting period you can not exercise your stock options. At the same time even if you have vested your options but your company isn’t public yet you will have to pay cash to exercise your options and there may not be any buyers for the shares.
Assuming your company has gone public and you have vested your stock options, you can now look for the right time to exercise the options. Ideally, you should exercise your stock options when the company’s stock price is higher than the strike price for your options.
For example, if your company stock is currently trading at $10 and your strike price is $20 then you will not benefit from exercising your options at that time. However, if your company’s stock is trading at $20 and your strike price has been set at $10 then you can exercise your option and get a nice profit thanks to the difference between the strike price and actual stock price.
Now of course this example was an overly simplified explanation of when and how to exercise stock options in startups. There are other questions you should ask to know whether it is the right time to exercise your options or not including:
Are you still employed by your employer?
As soon as you leave the startup that issued stock options to you, you have a short deadline during which the options must be exercised before they expire. So if you have left the company that issued options to you then you should exercise them before the specified deadline.
What is the company’s performance?
Another important question you should ask when you want to exercise your stock options is how well your company is performing. If your company’s key performance indicators appear low, then you can expect high proceeds when exercising your options. However, if your company is doing well it would be a good idea to exercise your options.
Can you pay the taxes?
When you exercise your stock options, you become liable to taxes. If you can’t afford to pay the taxes associated with exercising stock options you should wait until you can pay them to exercise your options.
Stock options are tricky, and there are some complexities involved with the exercise process. We hope that this article has helped explain what stock options are, how to exercise them, and when is the right time to exercise them, so you can make a better exercise decision.
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