What Are Stock Options in a Private Company?

Stock options serve as a significant component of compensation packages, particularly within private companies. These options provide an individual with the opportunity to acquire company stock, linking their financial interests directly to the company’s success. Private companies frequently utilize stock options to attract and retain skilled professionals, especially when cash salaries might not be as competitive as those offered by larger, more established firms. This form of equity compensation allows employees to share in the potential growth and future value of the business.

Understanding Stock Options

A stock option grants the holder the right, but not the obligation, to purchase a specified number of company shares at a predetermined price. This fixed purchase price is known as the “strike price” or “grant price”. The “grant date” marks the day the company officially issues these options, and they come with an “expiration date” beyond which they can no longer be exercised. Private companies offer stock options as an incentive, fostering an ownership mindset among employees. This approach helps align employee interests with the company’s long-term objectives and growth, motivating the workforce to contribute to overall success, especially when cash resources are limited.

The Stock Option Lifecycle

The journey of a stock option begins with its granting to an employee, often detailed in an offer letter along with the strike price and vesting schedule. Options typically undergo a “vesting” process, which is the mechanism by which an employee earns the right to exercise their options over time. Vesting schedules encourage employee retention and commitment.

A common vesting structure is a four-year schedule with a one-year “cliff”. Under this arrangement, no options vest during the first year of employment. After completing one full year, 25% of the granted options typically vest all at once. The remaining options then vest incrementally, often monthly or quarterly, over the subsequent three years until they are fully vested. If an employee departs before the one-year cliff, they generally forfeit all unvested options.

Once options have vested, the holder gains the ability to “exercise” them, which means paying the strike price to convert the options into actual shares of company stock. There is an “exercise window,” a period during which the vested options can be purchased before they expire. This window typically extends up to 10 years from the grant date, but it often shortens significantly, sometimes to as little as 90 days, if an employee leaves the company.

Types of Stock Options

Stock options primarily come in two forms: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). These types differ mainly in their structural rules and who is eligible to receive them.

Incentive Stock Options (ISOs) are granted exclusively to common-law employees. They must meet specific Internal Revenue Service (IRS) requirements for their unique tax treatment. For instance, ISOs must be granted under a shareholder-approved plan, and the exercise price generally cannot be less than the stock’s fair market value on the grant date. There is also a limit on the value of ISOs that can become exercisable for an employee in any calendar year, typically $100,000; any excess is treated as an NSO.

Non-Qualified Stock Options (NSOs) offer greater flexibility than ISOs. NSOs can be granted to a broader group of individuals, including employees, independent contractors, advisors, and board members. Unlike ISOs, NSOs do not need to satisfy the same stringent IRS requirements for special tax benefits.

Tax Implications of Stock Options

The taxation of stock options is complex, with significant differences between NSOs and ISOs that impact when and how income is recognized. These tax events occur at various stages, from grant to exercise and ultimately to the sale of shares.

For Non-Qualified Stock Options (NSOs), there are generally no tax implications at the time of grant or vesting. The taxable event for NSOs typically arises upon exercise. At this point, the difference between the stock’s fair market value (FMV) on the exercise date and the strike price (the “spread” or “bargain element”) is taxed as ordinary income. When the shares acquired from exercising NSOs are later sold, any additional gain or loss is treated as a capital gain or loss. If held for more than one year after exercise, the gain qualifies for potentially lower long-term capital gains tax rates; otherwise, it is taxed at ordinary income rates as a short-term capital gain.

In contrast, Incentive Stock Options (ISOs) generally offer more favorable tax treatment. There are no regular income tax consequences at the time of grant or vesting for ISOs. When ISOs are exercised, there is typically no ordinary income tax due. However, the spread between the FMV at exercise and the strike price is considered income for Alternative Minimum Tax (AMT) purposes. This can lead to a significant tax liability, even if the shares are not immediately sold.

For the sale of shares obtained from ISOs to qualify for long-term capital gains treatment, specific holding periods must be met: the shares must be held for at least two years from the grant date and one year from the exercise date. If these conditions are satisfied, the entire gain upon sale is taxed at lower long-term capital gains rates. If the holding periods are not met, a portion of the gain may be taxed as ordinary income, with the remainder as a capital gain.

An 83(b) election allows individuals to pay taxes on the fair market value of unvested stock, or shares acquired from early exercised options, at the time of grant rather than when they vest. This election must be filed with the IRS within 30 days of the grant date. While it requires paying taxes upfront on potentially illiquid shares, it can be advantageous if the company’s value is expected to grow significantly, as future appreciation would be taxed only as capital gains upon sale. This strategy can help reduce the overall tax burden by locking in a lower taxable value early on.

Realizing Value from Stock Options

Realizing value from stock options in a private company differs substantially from that in a publicly traded company. The primary challenge is the lack of liquidity, as there is no readily available public market to sell shares immediately after exercising options.

Value from private company stock options is typically realized during specific “liquidity events”. One common event is an acquisition, where another company purchases the private company. In such cases, option holders or shareholders may receive cash, stock in the acquiring company, or a combination, in exchange for their options or shares. Another primary liquidity event is an Initial Public Offering (IPO), where the private company becomes publicly traded. An IPO creates a public market for the company’s shares, allowing employees to sell their stock, though often subject to “lock-up periods” that temporarily restrict sales, usually for 90 to 180 days.

Less common, but emerging, are opportunities to sell shares on private secondary markets. These platforms facilitate transactions between existing shareholders and interested buyers, offering limited liquidity before a major event like an IPO or acquisition. The value of private company stock, which directly impacts the potential gain from options, is determined through a 409A valuation. This independent appraisal assesses the fair market value of the company’s common stock, setting the strike price for new option grants and influencing the tax basis upon exercise. Companies typically obtain a 409A valuation annually to ensure compliance with IRS regulations and to avoid adverse tax consequences for option holders.