Can You Get Stock Options in a Private Company?

Stock options are a form of equity compensation, granting individuals the right to purchase a company’s shares at a predetermined price. Private companies commonly use stock options to attract and retain talented employees. These options provide an incentive by aligning employee interests with the company’s long-term growth and success.

Understanding Stock Options in Private Companies

Stock options in private companies represent the right, but not the obligation, to buy a certain number of the company’s common stock shares at a set price. This set price is known as the “strike price” or “exercise price.” The strike price is established when the options are granted and usually reflects the fair market value (FMV) of the company’s stock at that time. Fair market value for private companies is determined through a valuation process, often a 409A valuation, which provides an independent appraisal of the share value for tax purposes.

The option holder’s potential profit depends on the difference between the company’s share price and the fixed strike price at the time of exercise. If the company’s value grows, shares can be purchased at a discount compared to their higher market value. Two primary types of stock options are commonly offered by private companies: Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). While both allow individuals to purchase company stock at a set price, their tax treatment differs significantly.

ISOs can qualify for favorable tax treatment under specific conditions and are generally reserved for employees. NSOs are more widely used and can be granted to employees, directors, or independent contractors. The fundamental distinction between ISOs and NSOs lies in when and how their gains are taxed.

Granting and Vesting Schedules

Private companies issue stock options through a formal process, typically documented in a stock option grant agreement. This agreement outlines key details, including the type of options (ISOs or NSOs), the number of shares an individual can purchase, the strike price, and the vesting schedule. The grant date is the specific date when the options are formally awarded to the recipient.

Vesting refers to the process by which stock options become exercisable over time, meaning the recipient gains the right to purchase the underlying shares. A common vesting schedule is a four-year period with a one-year “cliff.” Under this arrangement, no options vest during the first year of employment; however, after the first year (the cliff), a portion, typically 25%, vests immediately. The remaining options then vest incrementally, often monthly or quarterly, over the subsequent three years.

Vesting schedules serve to incentivize long-term commitment and align an employee’s tenure with their equity compensation. All stock options also have an expiration date, usually around ten years from the grant date, after which unexercised options become void.

Exercising and Tax Implications

Exercising stock options involves purchasing the underlying company shares at the predetermined strike price. This action converts the “option” into actual shares of company stock. The tax implications of exercising options vary significantly depending on whether they are Non-qualified Stock Options (NSOs) or Incentive Stock Options (ISOs).

For NSOs, the difference between the fair market value (FMV) of the shares on the exercise date and the strike price is generally taxed as ordinary income. This amount, often referred to as the “spread,” is subject to federal income tax, payroll taxes, and any applicable state income taxes. The company typically withholds these taxes at the time of exercise, and since cash is not directly involved in the transaction, the individual may need to pay the company to cover the withholding costs.

With ISOs, there is generally no regular income tax due at the time of exercise. However, the “spread” between the FMV at exercise and the strike price is considered income for Alternative Minimum Tax (AMT) purposes. The AMT is a separate tax calculation designed to ensure that individuals with certain tax preferences pay a minimum amount of tax.

An 83(b) election is a specific Internal Revenue Service (IRS) election that can be made for certain types of equity compensation, including stock options that allow for early exercise of unvested shares. By making an 83(b) election within 30 days of the grant date, an individual chooses to be taxed on the fair market value of the shares at the time of grant, even if they are unvested. If the company’s value is low at the grant date, this can potentially reduce the future tax burden, as any subsequent appreciation in value is taxed as capital gains when the shares are sold, rather than ordinary income. After exercising options and acquiring shares, the holding period of these shares becomes relevant for future capital gains tax treatment. To qualify for long-term capital gains rates, which are generally lower than ordinary income tax rates, shares must typically be held for more than one year from the exercise date.

Liquidity Strategies for Private Company Stock Options

Unlike public company shares, which are readily traded on exchanges, private company shares acquired through stock options are not immediately liquid. The ability to convert these shares into cash usually depends on specific “liquidity events.”

One significant liquidity event is an Initial Public Offering (IPO). When a private company goes public, its shares become tradable on a stock exchange. However, employees typically face a “lock-up period” after an IPO, often 90 to 180 days, during which they cannot sell their shares. After this period, they can sell their shares in the open market.

Another common liquidity event is an acquisition or merger of the private company. In such scenarios, the acquired company’s shares are often converted into cash or shares of the acquiring company. The terms of this conversion are determined during the acquisition process and can vary widely.

In some cases, private secondary markets exist where employees might be able to sell their shares before an IPO or acquisition. These platforms facilitate transactions between private company shareholders and interested buyers. However, these markets are not always available, can be less liquid than public markets, and may involve restrictions from the company. A private company may also conduct tender offers or share buybacks, offering to purchase shares directly from employees.