Stock Options

How Do Stock Options Work?

Employee stock options give you the right (not requirement) to buy company stock (“exercise”) for a fixed price (“strike price”) for a fixed period of time (usually 10 years). Once you exercise options, you own company stock. 

To make money from stock options, whether Incentive Stock Options (ISOs) or Non-qualified Stock Options (NSOs), the hope is that the company’s stock price will be significantly higher than your strike price. 

Example: your strike price is $2, and you exercise stock options when the stock is worth $10. 

You’ve paid $2 for shares that are worth $10. This $8 spread is also known as the bargain element. The taxation of the bargain element differs for ISOs versus NSOs.

If you later sell the stocks for $20 per share, the $10 ($20 sale price minus $10 cost basis) is capital gain.

Refer to the “Taxation of Stock Options” section to learn more about how the bargain element and capital gain are taxed.

Why Are Stock Options Valuable?

Two Sources Of Stock Option Value

1. Intrinsic value (paper profit)
2. Time value (potential profit)

Intrinsic Value

Your paper profit is the current share price (“409A” for private companies) minus the strike price. 

Example: if Cloudflare’s stock price is $20/share, and your strike price is $2/share, the intrinsic value is $18. I often see prospective clients miscalculate their intrinsic value by forgetting to subtract the $2 strike price.

Time Value

Time value represents the future potential profit from waiting to exercise the option. 

If you’re only one week away from the stock option grant’s expiration, there’s little time value. It’s unlikely the stock price will jump significantly in value. Most of the option value is in the intrinsic value.

If you have 9 years until the option expires, however, there’s a much higher chance that the stock price will increase over time. You can wait it out and exercise the option when the price is right.

Software like StockOpter attempts to quantify the time value of employee stock options. If the intrinsic value comprises the bulk of the overall option value (Insight Ratio in StockOpter parlance), that’s a sign you should “cash in your chips” and exercise the option.

Refer to When To Exercise NSOs.

Leverage

“Leverage” is another term describing the future potential profit. Leverage typically refers to borrowing money to invest. It’s a risky move that can magnify gains if prices go up (and magnify losses if prices drop!). 

Employee stock options offer the potential for magnified gains with no risk of loss, however. There’s no risk of loss because if the company’s value drops below your $2 strike price (making it an “underwater” or “out-of-the-money” option), you can choose not to exercise.

The magnified gains are explained by your fixed strike price, and your ability to delay exercising the stock option.

Example: Buying Cloudflare (NET) Stock

Let’s compare me (a non-Cloudflare employee) buying a share of Cloudflare (NET) vs. a Cloudflare employee obtaining NET by exercising stock options:

• If I bought Cloudflare (NET) in February 2020 at $20 per share and sold for $40 per share on July 10, 2020, my return would’ve been 100% in only five months. 
• The Cloudflare employee benefits from the growth in the stock price from $20 to $40 even though they don’t yet own the stock. They can wait until July 10th to pay $2 for a stock that’s worth $40, leading to a 1,900% return.

Key Terms

Grant

You receive stock options when your employer grants a specific number of stock options subject to a vesting schedule.

Vest

The vesting schedule specifies the period of time you must wait before you’ve earned the right to exercise the options. A common vesting schedule is over four years: 25% vest after one year (“25% cliff”), and monthly thereafter.

Exercise

Buy company stock at the strike price specified in your stock options agreement.

Strike Price

The fixed price at which you’re buying company stock.

Example

You join an early-stage private company and you’re granted 240,000 options. If your options vest over four years with a one-year cliff, you earn the right to exercise 60,000 (25%) stock options after one year, and 5,000 options per month for the next 36 months.

Are Stock Options Better Than RSUs?

Stock options are better if you want to strike it rich, but they are high-risk, high-reward. RSUs are better if you want a sure thing.

Stock Options: High-Risk, High-Reward

If you join a startup, you likely sacrifice base salary in exchange for stock options, which represent a potential windfall if the company has an exit event. By paying lower salaries, startups free up cash to invest in the company’s growth.

It’s unlikely that a private company will have an exit event, however. In a 2021 Crunchbase study, only 7% of startups made exits during 2011-2018 (0.8% via a public offering). 

Cowboy Ventures’ 2013 study found that only 0.07% of private US-based software companies started since 2003 became “unicorns” valued at over $1 billion.

If you’re lucky enough to receive stock options at a company with an exit event, stock option “leverage” explains the financial windfall.

Refer to Why Are Stock Options Valuable?

RSUs: A Sure Thing (But Lower Payout)

Restricted stock units will always have value (assuming your company is publicly-traded). This is true even if the stock price drops below the price on the RSU grant date. Let’s say you were granted 30,000 RSUs, and the stock price on the RSU grant date is $20 ($600,000 total grant value). If the stock price dropped to $15 upon the 25% cliff vest, the 7,500 RSUs are worth $112,500 (7,500*$15). Although it’s disappointing to experience a stock price drop, you’re still getting something. 

Because RSUs will always have value at public companies, the windfall from RSUs usually is much lower compared to stock options from a startup.

How Are Stock Options Priced?

Your strike price is determined by your company’s Fair Market Value (“FMV”) on your stock option grant date. For private companies, the FMV is also known as the 409A value. The most common method to determine the 409A is by obtaining an independent appraisal. 

Your CFO is responsible for updating the 409A value at least annually. If your company has a material event, which includes closing a new round of financing, the 409A must also be updated.

Can Stock Options Expire?

Stock options typically expire 10 years from the grant date, or 90 days after your termination date, whichever is earlier.

What Happens To My Stock Options If I Leave My Company?

If you leave your company before the stock option grant’s 10-year expiration date, you usually have 90 days to exercise your vested stock options before they expire. Check your stock option agreement for the “post-termination exercise period” or “PTEP.”

Incentive Stock Options must follow this 90-day rule because of IRS regulations, specifically Section 422(a). 

Non-qualified Stock Options don’t have to follow this 90-day rule. And in recent years, companies have offered longer PTEPs. Pinterest shifted to a seven-year period in 2015, for example.  

If your company allows you to exercise your ISOs after 90 days, the ISOs will convert to NSOs.

How To Pay Exercise Cost And Taxes

You need cash to: (1) exercise the options (pay the strike price), and (2) pay taxes. 

If you have 2,500 vested options at $2 strike price, you’ll need $5,000 cash to exercise the options. 

If you have 2,500 vested options at $20 strike price, then you’ll have to cough up $50,000, which is a significant amount of cash for most people. 

Exercising options is a taxable event. You’ll owe income taxes after exercising NSOs, and after  a disqualifying disposition of ISOs. You may owe AMT after exercising ISOs if you don’t sell the shares in the year of exercise. 

Consult a tax professional or financial planner with stock option expertise to run a tax projection before you exercise stock options.

Wait Until The IPO (Or Other Exit Event)

If you don’t have the cash to cover the exercise cost and required taxes, you can simply hold off on exercising options until your company’s exit event.

Financing Stock Option Exercises

It’s easier to exercise stock options in public companies because of the “cashless exercise” method that requires no cash outlay on your part. You can sell shares to pay for the exercise cost and required taxes. 

For a private company, however, you can’t sell shares since there isn’t a public market for the shares. If you need cash to cover the exercise cost and taxes, you could obtain financing. Companies like ESO Fund and SecFi offer nonrecourse loans for the exercise cost and required taxes. 

• If a company doesn’t have an exit event, the employee isn’t responsible for repaying the loan. 

If the company goes public, you must repay the loan and also a percentage of the stock’s upside. Learn more in this Forbes article.

After I Exercise Options, What Should I Do With The Stock?

Refer to When to Exercise NSOs and When to Exercise ISOs for more detail.

I also wrote an article discussing what you can do with stock if your company is publicly-traded.

How To Sell Private Company Stock Before An Exit Event

Find Out If You’re Allowed To Sell

Review your Stock Option Grant Agreement and the Plan Document to see if you’re allowed to sell shares. You may see a clause called the “Right of First Refusal” where your employer has first dibs on buying your shares. Usually companies give themselves 30 days to decide whether to buy an employee’s shares. 

Some companies require that you receive board approval, which is a bigger hurdle.

How To Sell Pre-IPO Stock

Companies like Forge Global and Equity Zen provide a “secondary market” that connects startup employees (who want to sell pre-IPO company stock) and potential buyers. Each marketplace will have different fees, minimum transaction sizes, and even different prices for the shares.

Be aware that these secondary market providers serve shareholders like yourself, AND investors who are hoping to buy pre-IPO stock. 

FYI, the “primary market” refers to companies selling new stocks and bonds to the public for the first time. An IPO is an example.

What Determines The Stock Price In The Secondary Market

Supply and demand:

• Palantir was private for 17 years and had a great deal of supply, which reduced the price of its stock. 
• If a prominent VC firm invests in the company, that tends to increase demand (and therefore the stock price).

Shop around at various private marketplaces for the best price.

How Are Stock Options Taxed Upon Exercise?

ISOs and NSOs are not subject to tax at grant or when they vest. 

However, taxes apply when you: 

1. Exercise stock options (answered below), and 
2. Sell the resulting stock (refer to How Are Stock Options Taxed Upon Sale?).

When you exercise stock options, the spread between: (a) the stock price on the exercise date, and (b) the strike price, is also known as the bargain element.

The bargain element ($8 in the illustration) is taxable, and the taxation of the $8 bargain element is different for NSOs and ISOs.

What Is AMT?

The Alternative Minimum Tax (AMT) was created to keep wealthy taxpayers from using deductions to avoid paying taxes. AMT ensures all taxpayers pay a minimum amount of tax. 

Every year, you must calculate your tax bill twice: under the regular rules, and under the AMT’s special rules. Each year, you must pay the higher of the two. If you DIY with TurboTax, the software is running both calculations.

Think of AMT as a pre-payment of regular tax. If you incur AMT, you may receive an AMT credit (“Minimum Tax Credit”) in subsequent years.

ISO exercises are a common trigger of AMT. If you hold the resulting shares past December 31st of the year of exercise, the bargain element will count as income for AMT purposes. If the AMT formula yields a higher tax than the regular formula, you will owe AMT.

If you sell the shares the same year you exercised the ISOs, AMT doesn’t apply. Instead, the profit is taxed as compensation income (i.e., regular income taxes apply).

How Are Stock Options Taxed Upon Sale?

The difference in the fair market value on: (a) the date of sale, and (b) the date of exercise is capital gain. Capital gains are either long-term or short-term. 

Long-term capital gains taxes (up to 23.8% as of 2021) are lower than short-term (up to 37% as of 2021).

California (and several other states) also taxes capital gains. California does not give you a tax break on long-term capital gains: you pay your standard income tax rate on all capital gains! California income tax rates are up to 13.3%.

Capital gains taxes vary for NSOs and ISOs.

NSO Capital Gains Tax

Building on the illustration above, you now own shares that are worth $20 per share. The new purchase price (“cost basis”) is $10: $2 strike price plus the $8 spread (“bargain element”) on which you were taxed at exercise. If you sell the shares, your capital gain is $10 per share ($20 current value – $10 cost basis):

How Are Stock Options Taxed If I Leave California?

Prove You’ve Established Residency In A Different State

Permanently leaving California isn’t straightforward. The California FTB is notoriously aggressive about auditing taxpayers who move to a no-tax state like Nevada or Texas. The FTB uses 29 factors to determine whether you’re still a resident under California law. 

Let’s assume you’ve established Nevada residency, for example. You *still* might owe California taxes on stock options that were awarded when you were living in the Bay Area.

Exercise Options Before Moving Out Of California

If you exercise NSOs and ISOs before you move:

• The entire bargain element (fair market value on the exercise date minus the strike price) is 100% “California source”. For NSOs (and ISOs if you sell the stock in the same year you exercise the ISO), the bargain element is compensation income. For ISOs where you don’t sell the stock in the year you exercised the ISO, your California tax return must make an AMT adjustment (with a potential AMT credit in the subsequent year).
• When you sell the resulting shares while living in Nevada, the capital gain is state tax-free since Nevada doesn’t have capital gains tax (0% California source since you’re a non-resident at sale).

Exercise NSOs After Moving Out Of California

The $8 bargain element will be partially taxed by California (refer to “How Are Stock Options Taxed Upon Sale”). According to Publication 1004, you must allocate a portion of the $8 per share bargain element to California based on the time worked in the state:

# of workdays in California between grant and move / # of total workdays between grant and exercise

Sudden Wealth

Transitions, even positive ones like a financial windfall from an exit event like an IPO, can be overwhelming. You may be uncertain about what to do with your upcoming windfall. And who will you turn to for sympathy? 

You could commiserate with coworkers, but money is such a personal topic. Or maybe you don’t want to run the risk of resentment if you have more options than your colleague (or if THEY have more than you!). 

Your friends and family probably won’t understand. Your new wealth may even impact your relationships. A financial windfall presents both blessings and burdens.

IPO Lockup: Prepare For An Emotional Rollercoaster

Once a company goes public via IPO, employees can’t sell their shares right away. This is because of the lockup period that blocks insiders (like employees) from selling shares. 

In a traditional IPO, the lockup period lasts six months. But companies are being creative: some traditional IPOs release the lockup period in only four months, or they open interim trading windows (“early release”) for employees to sell a small portion of shares before the lockup fully comes off. Snowflake offered an early release during which employees could sell 25% of vested options and shares in December 2020. Their lockup was fully released in March 2021.

Companies that go public via direct listing often allow employees to sell 100% of shares from day one. Some direct listings like Coinbase, however, allowed employees to sell 15% upfront, and then enforced a lockup period, which is typically associated with traditional IPOs. 

Learn about the three mental traps that may tempt you as you wait for your first opportunity to sell shares.

Going Public

Going public includes a traditional IPO, direct listing, or SPAC merger.

Merger/Acquisition

An acquisition can either be an all-cash (where all of your equity is cashed out immediately), all-stock (swapping your equity for the acquirer’s equity), or a mix of cash and stock. Acquisitions don’t follow a standard playbook.

Tender Offer

A tender offer is when investors like VC firms offer to buy shares from employees at a premium over the FMV (fair market value, or “409A valuation”). A tender offer would give you a company-endorsed opportunity to sell shares even though your company is private. 

You also can sell shares via secondary marketplaces like Forge Global, but you likely will need permission from your company. Refer to How to Sell Private Company Stock Before an Exit Event.

Can I Donate Stock Options To Charity?

You can’t donate stock options (whether vested or unvested). But once you exercise and own the company stocks outright, you can donate the shares. 

It’s best to donate stocks that are at a gain and are long-term holdings:

• Stocks from NSO exercise at least one year and one day ago
• Stocks from ISO exercise that meet the qualifying disposition rules (acquired at least two years from grant date, and at least one year from exercise date)

If you’re subject to blackout periods, ask your stock admin team if you’re allowed to donate company stock outside of a trading window.

Donating your company stock is a win-win: your favorite charitable organizations benefit, and you benefit financially as well:

1. Reduce your concentration risk. 
2. Reduce your taxes in two ways.

Can I Gift or Transfer Stock Options?

You can’t gift or transfer stock options (whether vested or unvested). But once you exercise and own the company stocks outright, you can gift or transfer the shares.

In terms of gifting shares:

• To a non-charity (family member, friend, etc): you likely will have to wait for an open trading window. Check your company’s Insider Trading Policy or ask your stock admin team to be sure. If you gift more than the annual exclusion limit to one person ($15,000 in 2021), you have to report the gift on your tax return. But you won’t have to pay gift taxes until you exceed the lifetime gift limit ($11.7M in 2021), which very few people will approach.
• To a qualified charity: refer to Can I Donate Stock Options to Charity?

If you’re thinking about transferring shares of your company stock to a different brokerage account, beware of violating your company’s blackout periods. It’s best to keep shares in the default equity account since your plan administrator (Schwab, Shareworks, etc) enforces blackout dates and trading windows. If you transfer your company stock to a different brokerage account, your plan administrator can’t prevent you from selling during a blackout period, which would violate your company’s insider trading policy.

Can I Gift Stock Options (And Get The Tax Writeoff)?

You can’t gift stock options, but you can gift the shares once you’ve exercised the option. 

Financial gifts are tax-deductible only if the recipient is a qualified charitable organization. Refer to Can I Donate Stock Options to Charity?

When you make financial gifts to an individual (non-charity), be aware of gift tax issues. You can gift up to an “annual exclusion” amount. If you have two siblings, you can give $16,000 of stock to each sibling in 2022 for a total of $32,000. You can gift more than the annual exclusion amount, but you’ll need to file to report the gifts on your tax return. You don’t have to pay gift taxes until you give away more than the lifetime gift limit ($12.06M in 2022).

What Happens To My Stock Options If I Divorce?

In a community property state like California, you’ll need to determine what portion of stock options granted during the marriage are community property vs. separate property. Determining community vs. separate depends on the stock options grant date and vesting schedule, your date of marriage, and the date of separation. 

• The portion that’s community property is owned 50/50 
• Separate property belongs 100% to the employee spouse

You and your spouse must fully disclose your finances to each other during the divorce process. This includes disclosing equity-based compensation like stock options.

If you have a prenuptial agreement, this will supersede default California law.