Why and When to Exercise Your Options

Being granted employee stock options from a private company can feel like holding a golden ticket. It’s a chance to own a piece of a growing business that could one day be worth a substantial sum. But before you can think about realizing any gains from that startup equity, you need to “exercise” your stock options — which means using your right to buy the shares.

Remember: just because you’ve been given stock options, it doesn’t mean you have to use them. Before making that decision, it’s worth thinking through why you might exercise your options, and when might be the best time to do it.

Exercising Your Options

Stock options are agreements that give you the opportunity — though not the obligation — to buy a company’s shares at a certain price in the future. When you exercise, you are essentially converting your options (that right to buy) into actual ownership of shares.

Whether to Exercise

Before deciding to exercise your options, you’ll need to consider your company’s prospects. While it’s impossible to predict the future of the startup, you’ll need to consider how comfortable you are with investing in the business. You should approach the decision about whether to exercise and how much to invest based on your risk tolerance.

Before you exercise your options, ask yourself these five questions:

  • Do you have confidence in your company’s leadership team?
  • Is the company offering a uniquely valuable product or service with a large addressable market?
  • What is the company’s financial track record?
  • How competitive is the market?
  • Are there similar companies in the space that are public or have been previously acquired?

Why You Might Exercise Your Private Stock Options

Exercising your options means you are investing in a company. There are several reasons why this might be the right choice for you.

Capturing Potential Profits

If you work for a high-growth startup whose valuation has rocketed, a large amount of your potential wealth could be tied up in your stock options. If the fair market value for your shares is higher than your options’ “strike price” (the cost you pay to buy the shares), those options are currently valuable or “in the money.” By exercising, you’ll receive an on-paper gain of the difference between the fair market value and your strike price. Bear in mind that to realize that profit you’ll need to sell your shares on an investment platform like Mirai Capital, or wait for your company to exit (if it ever does so). You’ll also want to consider that you’ll probably need to pay tax when you exercise.

Gaining Ownership and Control

Exercising your options means you become a shareholder. You’ll have direct ownership of a portion of the company, which may come with voting rights, depending on the business’s stock option agreements and the type of options you hold. You’ll also be able to decide when and how to sell your shares, as long as you follow the company’s policies. This is especially useful if you’re planning to leave your company or have options that are about to expire.

Minimizing Capital Gains Tax

By exercising and holding your stock options for a specific period, you can qualify for long-term capital gains tax rates when you eventually sell your shares. Typically, you’ll trigger this favorable tax treatment if you hold your shares for one year from your exercise date. Long-term capital gains rates are generally much lower than ordinary income tax rates, and exercising your options allows you to start the holding period.

Minimizing Taxable Income

If there’s an indication that your company is nearing an IPO or an acquisition event, it’s worth strategizing about if and when to exercise your options. When you join your startup, your strike price will probably be close to that 409A amount. But as the company grows and becomes more successful, the 409A valuation will likely increase.

On one hand, that’s great news — your company is now more valuable. On the other hand, the more valuable your company gets, the bigger your tax bill becomes too. Assuming that the company’s valuation goes up after the IPO, you’ll pay less tax on the “income” generated on the spread between the strike and 409A price when you exercise before the business goes public. Make sure you consider any blackout or lockup periods, during which you might not be able to exercise or sell your shares directly.

Why You Might Not Exercise Your Private Stock Options

Cost

You’ll need to pay your company the exercise price for each share. For example, exercising 50,000 options at a $2 strike price costs $100,000. Beyond that, you’ll likely owe taxes on the “spread” — the difference between your strike price and the current fair market value — which can be substantial. A number of choices exist to help you pay to exercise your options, including a cashless exercise (where a portion of shares are sold immediately to cover costs and taxes), but these may not be suitable for your situation.

Locking Up Your Capital

If your company has no clear path to an IPO or acquisition, and there is no secondary market for your shares, it may be hard to sell your stock. Holding illiquid shares for an indefinite period of time carries significant risk.

When You Leave a Company or Are Dismissed

If you’re a current startup employee, your vested options usually have an expiration date that’s far in the future. A common expiration period is 10 years from the date your options were originally granted (not from when they vested). As a result, you generally have a long time to decide if and when you want to buy the shares.

If you leave the company, that timeframe changes significantly. If you resign or are terminated, there’s usually a much shorter window to exercise any options that vested before your last day. This is called the post-termination exercise period (PTEP), and it’s commonly 90 days from your termination date. If you don’t exercise your vested options within this window, they will typically expire, and you’ll lose the right to buy those shares.

Many employees in this position take part in a cashless exercise, where instead of using their own money to buy shares, a buyer helps them pay. In this process, you exercise and sell a portion of your shares, and the money from the sale is used to cover the cost of exercising the remainder of your options and any taxes and fees involved.

Remember: your options will only vest while you are working at the company. If you leave your job before they are fully vested, your vesting schedule will stop. Anything that’s vested is yours to keep, and you must exercise those options within your PTEP window. Anything that hasn’t vested will be returned to your company.

The Bottom Line

Stock options offer you a chance to own a piece of a growing private company, but exercising them requires careful consideration of factors beyond just potential profit. Deciding when to exercise involves weighing personal finances, the company’s growth trajectory, and your tax implications. Ultimately, it’s an important investment decision that can help fund major life milestones, but you need to make a plan about why and when you might choose to exercise your options.