Startup companies rely heavily on stock options to recruit, motivate, and retain the best employees and executives. The stock acquired can become very valuable if the company goes public or is acquired. However, options in private companies are tricky, given the lack of liquidity to trade the stock and the other risks. Some of the most frequent questions I get as the editor-in-chief of myStockOptions.com are whether and when to exercise private company stock options.
Options in a private company, as with public companies, can be either nonqualified stock options (NQSOs) or incentive stock options (ISOs), though ISOs are more common for startups. In a potential twist, with private company options the terms of your grant may allow you to exercise them before they vest, including immediately at grant (sometimes referred to as early-exercise options). If you do this, you get restricted stock that has a vesting schedule identical to the options, and you make a Section 83(b) election with the IRS within 30 days of your exercise.
I recently moderated a webinar on stock option exercise strategies that featured three leading advisors. Webinar panelist Megan Gorman, the founder of Chequers Financial Management in San Francisco (and also a Forbes.com senior contributor), discussed rules of thumb to go by when you have stock options in a private company.
1. Don’t Risk Money You Can’t Afford To Lose
“Can you afford to lose the money?” is the first question Megan asks her clients with stock options in private companies. The planning complication here revolves around the illiquidity of private company stock, which is neither registered with the Securities and Exchange Commission (SEC) nor listed on any trading market.
When you exercise stock options in a public company, you can typically sell shares at the time of exercise to pay the exercise cost and any taxes. You can’t do that in a private company. “When you exercise stock options in a private company, you will have to put out money to buy the shares,” Megan explains.
Moreover, as the stock acquired cannot easily be sold, you risk tying up that money in illiquid stock if the company does not go public or gets acquired—or losing it if the company fails. “For some people that risk may work, and for some people it may not,” cautions Megan.
Alert: If you are exercising your options while losing your job or moving on to another company, make sure you know your company’s rules on post-termination exercises. Vesting is likely to stop, and to avoid forfeiting the options you will probably need to exercise them either immediately or within a specified number of days after your termination date.
2. Remember You May Owe Taxes
You may be surprised to learn that income recognition and taxation at the time of an option exercise are not delayed by the lack of liquidity in private company stock. This is also true for the lockup period of the stock after an initial public offering (IPO). Therefore, Megan asserts, you must think ahead about paying the taxes you will owe after you exercise stock options in a private company.
Whether you have NQSOs or ISOs, any spread between the exercise price and the fair market value of the stock will require you to think about taxes. As with the exercise cost, you cannot sell any shares at exercise to pay taxes, as you can do with stock options in a public company. With NQSOs, for the required tax withholding your company may hold back shares, take the money from your salary, or make you pay it separately.
“Run some tax planning to understand what is going to happen here if you exercise,” Megan recommends. With ISOs in particular, she advises, be sure you know whether any spread at option exercise will trigger the alternative minimum tax (AMT).
3. Methods To Help You Avoid A Liquidity Crunch
Once you’ve exercised your stock options and acquired the shares, the money you paid is stuck in private company stock that cannot easily be sold. As private companies are now taking longer to go public or get acquired, they are increasingly sponsoring share liquidity programs, notes Megan.
“Your company may have an ongoing liquidity-type program, such as the one at SpaceX,” she says, adding that often these companies organize their liquidity programs through tender offers. (SpaceX regularly conducts secondary offerings and tender offers as a way for employees to sell equity.)
Megan also points out that resale markets have developed for employees with illiquid stock in private companies, including firms that can lend against private stock.
“The startup equity market has evolved,” she observes. “There is a segment of the startup market where you can get financing on your equity to help you with liquidity. There are providers out there that will work with you. But move slowly. Truly understand what you’re getting into.”
For more on this topic, see another of my articles at Forbes.com: Financing Stock Option Exercises In Private Companies: Insights From A Top Financial Advisor.
4. Consider Exercising Right Before The Company’s IPO
Of course, the ideal liquidity event for private company stock is either an IPO, in which the company becomes a publicly traded issuer listed on the NYSE or Nasdaq, or an acquisition by another company for a purchase price at a substantial premium.
If the company is preparing for an IPO, timing your option exercise just before the IPO could make a lot of sense, explains Megan. “Sometimes it’s really great to exercise private company stock options right as the IPO is happening, because you know the stock is going to go public. It’s a sure thing.” You can get yourself ready for it, she adds, and exercise at a time that may minimize risk.
“But know when the IPO lockup period ends,” Megan warns. After the IPO you will be unable to sell shares for a specified period, often up to six months. During that time the stock price could fall, raising another risk.
5. Planning Depends On Your Own Personal Circumstances
Remember that financial planning for stock options in a private company is complex. It must ultimately be built around your own personal circumstances, which may be very different than those of your colleagues. Consider the guidance of an advisor with experience in this niche.
“I can’t emphasize enough that this planning is very subjective,” Megan cautions. “It depends on the person, their risk tolerance, their finances, and their goals. Always move slower rather than faster with this planning.”
She urges clients to have a stock-selling strategy that plans for where the proceeds will go, and also reminds them to not let the “tax tail wag the financial planning dog” (i.e. don’t let taxes be the primary driver of your planning).
The webinar in which Megan and other top financial and tax experts spoke is available on demand on the myStockOptions Webinar Channel: Stock Option Exercise Strategies: Managing Risk & Building Wealth, also featuring Bill Dillhoefer (President and CEO, Net Worth Strategies) and David Marsh (Financial Planning Case Manager, Ameriprise Financial
). The website myStockOptions.com also has an extensive section with resources on the special tax and financial planning issues for stock options in private companies.