It models out your specific scenario and shows your benefit. This last step normally takes weeks, as our investment team does a risk assessment of the company. You'll automatically see whether your company is pre-approved when you sign up. If you're interested in exploring financing, you can sign up and request a proposal here.

Money you make with stock options is normally taxed as ordinary income. In other words, to unlock the tax savings, exercise 12 months prior to selling. This is the most advantageous scenario.

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But what if you not only exercise less than 12 months prior to selling, but never exercise at all? If you never actively decide to exercise, then when you sell your equity, what technically happens is you exercise your options at that moment. In other words, you buy and then sell the shares in an instant. Sign up for a Secfi account to use it for free. There will be several months from announcement to IPO. So depending on how far your employer currently is in the process just rumored to have plans, or IPO already formally announced your situations looks like this:.

You can wait some more weeks until long-term capital gains applies. If you wait, there is the possibility that the stock price falls in the meantime. Of course, it could also go up. But the stock price often takes a hit when the lock-up period ends, because many shareholders start selling that day. Note that the situation is different if your company gets acquired instead of going public. With ISOs, you may be able to recover some of it. Learn more about the AMT credit here.

With NSOs, you can take the loss as a 'capital loss' and reduce your capital gains tax in the future. If in that case the IPO disappoints or never comes , we take on the loss. The drawback of using Secfi financing to get long-term capital gains is that you share the upside with us. One alternative to taking exercise financing is selling pre-IPO shares to a third party.

This can either be as part of a company-organized tender, or by finding a buyer yourself. This is known as a secondary sale or as selling on secondary markets. It's called like that because no new company shares are created. The buyer gets second-hand shares. You can either sell just enough of your equity to cover your exercise costs, or sell all of it to take out cash prior to the IPO.

The downside is that by selling, you let go of your ticket to the IPO. You receive the dollar amount you sell for and that's it. With exercise financing your equity stays yours, so you can take out cash before the IPO and then make additional money after a succesful IPO. This time value decays at a rate known as theta, which is a square root function of time remaining. You believe in the long-term prospects of your company and plan to hold your ESOs until expiration. Even if you begin to gain intrinsic value as the price of the underlying stock rises, you will be shedding time value along the way although not proportionately.

The further out of the money that an option is, the less time value it has, because the odds of it becoming profitable are increasingly slim. As an option gets more in the money and acquires more intrinsic value, this forms a greater proportion of the total option value. In fact for a deeply in-the-money option, time value is an insignificant component of its value, compared with intrinsic value. When intrinsic value becomes value at risk, many option holders look to lock in all or part of this gain, but in doing so, they not only give up time value but also incur a hefty tax bill.

We cannot emphasize this point enough—the biggest downsides of premature exercise are the big tax event it induces, and the loss of time value. After you have acquired stock that presumably has appreciated in value, you are faced with the choice of liquidating the stock or holding it. If you sell immediately upon exercise, you have locked in your compensation "gains" the difference between the exercise price and stock market price.

But if you hold the stock, and then sell later on after it appreciates, you may have more taxes to pay. Remember that the stock price on the day you exercised your ESOs is now your "basis price. To get the lower, long-term capital gains rate, you would have to hold the shares for more than a year. You thus end up paying two taxes—compensation and capital gains. Many ESO holders may also find themselves in the unfortunate position of holding on to shares that reverse their initial gains after exercise, as the following example demonstrates.

You now decide to sell one-half your holdings of 1, shares and keep the other half for potential future gains. To summarize:. Note that this does not count the time value lost from early exercise, which could be quite significant with five years left for expiration. Having sold your holdings, you also no longer have the potential to gain from an upward move in the stock. That said, while it seldom makes sense to exercise listed options early, the non-tradable nature and other limitations of ESOs may make their early exercise necessary in the following situations:.

We discuss some basic ESO hedging techniques in this section, with the caveat that this is not intended to be specialized investment advice. We strongly recommend that you discuss any hedging strategies with your financial planner or wealth manager. We use options on Facebook FB to demonstrate hedging concepts. For reference, the Jan.

To keep things simple, we assume that you wish to hedge the potential share long position to just past three years i.

Of these strategies, writing calls is the only one where you can offset the erosion of time value in your ESOs by getting time decay working in your favor. Buying puts aggravates the issue of time decay but is a good strategy to hedge downside risk, while the costless collar has minimal cost but does not resolve the issue of ESO time decay. ESOs are a form of equity compensation granted by companies to their employees and executives. ESOs are not the only form of equity compensation, but they are among the most common. Stock options are of two main types. Incentive stock options, generally only offered to key employees and top management, receive preferential tax treatment in many cases, as the IRS treats gains on such options as long-term capital gains.

Non-qualified stock options NSOs can be granted to employees at all levels of a company, as well as to board members and consultants. Also known as non-statutory stock options, profits on these are considered as ordinary income and are taxed as such.

Equity Part 2: Stock option strike prices - Carta

While the option grant is not a taxable event, taxation begins at the time of exercise and the sale of acquired stock also triggers another taxable event. Tax payable at the time of exercise is a major deterrent against early exercise of ESOs. ESOs differ from exchange-traded or listed options in many ways—as they are not traded, their value is not easy to ascertain. Unlike listed options, ESOs do not have standardized specifications or automatic exercise.

Counterparty risk and concentration risk are two risks of which ESO holders should be cognizant.

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Despite the large tax liability and loss of time value incurred through early exercise, it may be justified in certain cases, such as when cashflow is needed, portfolio diversification is required, the stock or market outlook is deteriorating, or stock needs to be delivered for a hedging strategy using calls. Basic ESO hedging strategies include writing calls, buying puts, and constructing costless collars.

They should also consult their financial planner or wealth manager to gain the maximum benefit of this potentially lucrative component of compensation. Options Clearing Corporation. Stock Options. Your Privacy Rights.

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Table of Contents Expand. Understanding ESOs. Important Concepts. ESOs and Taxation. Intrinsic vs. Time Value for ESOs. Comparisons to Listed Options. Valuation and Pricing Issues. Risk and Reward. Early or Premature Exercise. Basic Hedging Strategies.

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The Bottom Line. ESOs can have vesting schedules which limits the ability to exercise. ESOs are taxed at exercise and stockholders will be taxed if they sell their shares in the open market. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.