When Should You Exercise Stock Options in a Private Company?

Stock options offered by private companies are a significant component of employee compensation, particularly in startups and growth-stage environments. These options provide employees the opportunity to acquire ownership in the company they help build. Deciding when to exercise these options is a complex financial consideration, influenced by the company’s trajectory, personal financial circumstances, and tax implications. Understanding the mechanics of these options and the potential outcomes of exercising them helps employees maximize the value of their equity compensation. This article explores the fundamental aspects of private company stock options and the key considerations for their exercise.

Understanding Private Company Stock Options

A stock option grants an individual the right, but not the obligation, to purchase a company’s shares at a predetermined price. This fixed price is known as the “grant price,” “strike price,” or “exercise price,” and it is typically set at the fair market value (FMV) of the company’s stock on the date the options are granted. The potential profit from an option arises if the company’s share price increases above this strike price.

The ability to exercise options is earned over time through a process called “vesting.” Vesting schedules outline when an employee gains ownership rights to their options, often requiring them to remain with the company for a specified period or meet certain performance milestones. A common vesting schedule is a four-year plan with a one-year “cliff,” meaning no options vest until the employee completes one year of service, after which a portion vests, and the remainder vests gradually over the subsequent three years. If an employee leaves before their options are fully vested, any unvested options are generally forfeited and returned to the company.

For private companies, the FMV of their shares is not readily available as it is for public companies. Instead, it is determined through a “409A valuation,” which is an independent appraisal of the common stock’s value for tax purposes. Companies are typically required to obtain a new 409A valuation at least every 12 months, or sooner if a significant event, such as a new funding round, occurs. This valuation directly influences the strike price of newly issued options and the “spread,” or difference between the current FMV and the strike price, which is important for tax calculations.

Stock options also have an “expiration date,” which is the final date by which the options must be exercised. If options are not exercised by this deadline, they become worthless.

Two primary types of stock options are commonly offered to employees in the U.S.: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). ISOs are a type of equity compensation that can only be granted to employees and offer potential tax benefits if specific conditions are met. ISOs provide the right to purchase company stock at a predetermined price, which must be at or above the FMV on the grant date.

NSOs are more flexible and can be granted to employees, consultants, advisors, or board members. Unlike ISOs, NSOs do not have to meet specific IRS requirements for special tax treatment. The main distinction between ISOs and NSOs lies in their tax implications, which are triggered at different stages of the option lifecycle.

Tax Treatment of Stock Option Exercise

Exercising stock options involves distinct tax implications, both at the time of exercise and when the resulting shares are eventually sold. The specific tax treatment depends significantly on whether the options are NSOs or ISOs.

For NSOs, a taxable event occurs at exercise. The difference between the fair market value (FMV) of the shares on the exercise date and the strike price (also known as the “bargain element” or “spread”) is taxed as ordinary income. This income is subject to federal income tax, state income tax (if applicable), and payroll taxes, and it is reported on an employee’s Form W-2.

When the shares acquired through NSOs are later sold, any additional gain or loss beyond the FMV at exercise is treated as a capital gain or loss. If the shares are held for one year or less after exercise, the gain is considered short-term capital gain and taxed at ordinary income rates. If held for more than one year, the gain is long-term capital gain, generally subject to lower tax rates.

In contrast, ISOs typically do not incur regular income tax at the time of exercise. However, the “bargain element”—the difference between the FMV on the exercise date and the strike price—is considered income for the Alternative Minimum Tax (AMT) calculation. Exercising ISOs can trigger or increase AMT liability, especially if the bargain element is substantial. This AMT adjustment is reported on IRS Form 6251.

The preferential tax treatment for ISOs applies when the shares are sold in a “qualified disposition.” To achieve a qualified disposition, two holding period requirements must be met: the shares must be held for at least one year after the exercise date and at least two years from the grant date. If these conditions are satisfied, the entire gain from the sale (the difference between the sale price and the strike price) is taxed at the lower long-term capital gains rates.

If the holding period requirements for ISOs are not met, it results in a “disqualifying disposition.” In this scenario, a portion of the gain is reclassified and taxed as ordinary income, specifically the difference between the strike price and the FMV on the exercise date. Any additional gain beyond the FMV at exercise is treated as a capital gain, which can be short-term or long-term depending on the holding period after exercise. A disqualifying disposition can also eliminate or reduce the AMT previously incurred at exercise. Employees may receive tax forms like Form 3921 for ISO exercises and Form 3922 for NSO exercises from their companies.

Company Valuation and Liquidity Considerations

The financial health and future prospects of a private company significantly influence the decision to exercise stock options. The company’s current valuation, typically established through a 409A valuation, directly impacts the potential cost and tax implications of exercising options. A higher fair market value relative to the strike price means a larger “spread,” which can lead to a greater tax liability upon exercise, particularly for NSOs.

Considering the company’s future growth potential is important. Employees often exercise options with the expectation that the company’s value will increase, making their shares more valuable over time. However, private company shares are inherently illiquid, meaning they cannot be easily bought or sold on an open market. This lack of liquidity implies that even if options are exercised, the shares cannot be readily converted to cash until a “liquidity event” occurs.

Liquidity events, such as an Initial Public Offering (IPO) or an acquisition by another company, are important for realizing the value of private company stock options. An IPO creates a public market for the shares, allowing them to be traded and sold. In an acquisition, shares might be bought out for cash or converted into shares of the acquiring company. The anticipated timeline and likelihood of such an event play a substantial role in determining the optimal time to exercise.

Personal financial readiness is another consideration. Exercising options requires paying the strike price for the shares and often incurring immediate tax liabilities, especially with NSOs or ISOs subject to AMT. Given the illiquid nature of private company stock, employees must have sufficient personal funds available to cover these costs without relying on the immediate sale of the shares. This financial commitment carries risk, as the value of the private company shares could decline before a liquidity event materializes.

The Exercise Process

Once the decision to exercise stock options is made, the process typically involves several administrative steps. Employees usually initiate the exercise through their company’s human resources or finance department, or via a third-party equity management platform such as Carta or Shareworks. These platforms provide a structured interface for managing equity awards.

The exercise process requires specific information and forms. Employees generally need to specify the number of options they wish to exercise and their preferred payment method. The equity management platform or company typically provides the necessary documentation and guides the employee through the required fields.

Common payment methods for exercising options vary. A “cash exercise” involves paying the strike price and any associated taxes out-of-pocket using personal funds. Some companies may offer a “net exercise” or “cashless exercise,” where a portion of the vested options or the shares acquired upon exercise are withheld by the company to cover the exercise cost and the resulting tax obligations. Another method, “sell-to-cover,” involves immediately selling a portion of the newly acquired shares to cover the exercise price and taxes. However, sell-to-cover is less common in private companies due to the lack of a readily available market for the shares, unless it is facilitated as part of a larger liquidity event or secondary sale program.

After the exercise is completed and payment is processed, the company issues the shares to the employee. These shares are typically held either by a transfer agent or directly within the equity management platform. Following the exercise, employees receive documentation confirming the transaction and their ownership of the newly acquired shares. This documentation is essential for tax reporting and future tracking of the investment.