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So You Think Your Options Are Worth Something…

You just got a job! They're going to pay you! Congrats!

Maybe as part of your offer they threw in a little something, some employee stock options, to sweeten the deal. "Well, I'll just ignore those for now, maybe they'll be worth something one day", you say to yourself.

This is for you. Yes, those options may indeed be worth something one day. Probably they won't. But even if they are, the road to the money is longer than it seems, and filled with speedbumps that you won't see coming. I'm writing this so you can navigate the road with as much foresight as possible, because from what I've seen these things aren't well documented.

If this document seems long and discouraging, that's because it is! When you're dealing with equity it's a player-vs-player world, and you have to be an active player. You can choose to see this as a fun challenge, or as an injustice, or as just being the rules of another game you have to play.

However you see the situation, you have to commit to playing if you want results.

A final note before starting: this is a living document. If any detail is wrong, missing, or incomplete, please let me know, and I'll keep it updated.

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What is a Stock Option

The first major speedbump on the road to payday is that you have to understand what a stock option is. I won't cover this too in-depth, as it's probably the only aspect of this process which _is_ well-documented elsewhere. In this, and all things finance, I highly recommend Investopedia as a starting point.

Investopedia - Employee Stock Options (ESOs): A Complete Guide

TLDR: An option is a contract giving you the ability to acquire a stock (share of the company) at a fixed price.

The fixed price is called the "strike price". You can "exercise" an option, paying the strike price and receiving the share in return. If the value of the share is higher than the strike price then that's a profit! So easy!

The Carrot

The reason companies like to give out options is because they provide both a carrot and a stick to keep you moving forward with the company.

The carrot is the vesting schedule. When you sign your employment contract the company may grant you N-thousand options, but you don't actually have them yet. In your contract it will be stipulated that the first chunk will "vest" - meaning become exercisable - after an initial long period of time, like a year. This is the "cliff".

After the cliff a small amount of options will vest every month, so that all are vested after some total number of years.

This means that, if you want your options to come to anything, regardless of how much you want to quit and open a bakery, you have to stick it out for at least a few years.

The Stick

The stick is more hidden, and takes the form of option expiry.

Even if your options are vested they aren't necessarily valid forever. Your employment agreement may stipulate that your options expire at a certain date, often a few years out from their full vesting. The contract may also state that the options will automatically expire within N days of you leaving the company.

Consequently, you need to make a decision to either exercise small amounts of your options over time, or have the cash on hand to exercise all of them if/when you leave the company.

Do you exercise little bits over time, potentially wasting money on a worthless stock? Or do you wait and risk potentially missing the boat because you couldn't drum up the cash before the expiry?

Or do you just walk away?

This is where stock options get stressful. You have to answer these questions based on the long-term health of the company you work for, with probably-imperfect information, and make an investment decision based on that. Even if you do have experience with this sort of thing, which you probably don't, this is not a simple task.

A Third Option

There is a third option which is easier in the short-term but more difficult in the long-term.

Instead of exercising options now, or keeping cash around to do so, you can hold out hope for a "cashless exercise". This is where you find a buyer who is willing to loan you the money to perform the exercise, and then you discount the final sale price by that loaned amount to pay it back immediately.

A cashless exercise is nice because you get to skip the uncertainty of exercising an option on a company with an unknown future, and you can pay off all your taxes in one shot using the cash you just made from the sale.

The downsides are that

Which you choose is completely up to you, your situation, and how you view risk. But no matter which choice you make, there's one thing you can't escape...

Taxes, Taxes, Taxes

The usual disclaimer: I'm not an accountant or lawyer or doctor or all that smart in general, so do your own research.

In many cases exercising an option is a "taxable event", which is a technical term for "you owe your government money".

A common attitude that governments take is that the difference between your strike price (what you just paid to exercise your option) and the current fair market value (FMV) of the share is considered a profit. Usually countries will consider it as income, but others as a capital gain, and you need to know which.

This means that not only do you need to have the cash on hand to perform the exercise, but _also_ the cash to pay the accompanying taxes. And if you're in a country which counts this as an income tax and has high income taxes, this could be a fairly non-trivial amount. It might be so non-trivial that exercising isn't even worthwhile.

The United States of Complicated Taxes

If you're not a US resident you can skip this section, but please do your own research to find out what insane tax rules your country of residence does have. It definitely has some!

If you're in the US, working for a US company, you may be offered ISOs. The "I" stands for "incentivized", with the incentive being that exercising them is not a taxable event (HUGE ASTERISK HERE, DON'T STOP READING.) Instead you get taxed when you sell the shares later on as a capital gain, with the strike price being your cost-basis.

Their corollary, NSOs (the "N" stands for "your company doesn't love you"), do count the gain between the FMV and strike price as income, and then when you sell the shares that FMV is your cost-basis for the capital gain.

So ISOs are obviously preferable, except for the GIANT ASTERISK that you might trigger the alternative minimum tax (AMT).

The AMT is a mysterious alternative tax system that you probably don't want to end up in. It gets triggered if, had you counted your ISO exercises towards your income as if they were NSOs, your new hypothetical income breaches some threshold compared to your actual income. At that point that hypothetical income _is_ your actual income, and you have to pay taxes as if you exercised NSOs.

Or something like that. There's a bunch of extra details about "disqualifying dispositions" and "minimum tax credits" to confuse things even more. In my opinion navigating the AMT requires an accountant. If you're one of those people who like spreadsheets and doing their own taxes and Don't Need No Accountant then I can only wish you luck.

Fair Market Value, sans-Market

Moving on from US-specific tax nonsense, what even is this FMV anyway?

If the company is publicly traded then the FMV is simply the market price of its shares. But, if the company is not publicly traded, how can its privately traded shares have a market price? The answer is that the company is supposed to periodically hire an outside firm to do a business analysis and determine the FMV.

The frequency and timing that your company updates their FMV affects how much taxes you pay on option exercises.

So you need to keep an eye on it. If the FMV is trending upwards you want infrequent updates (less FMV/strike price difference, less taxes), if it's trending downwards you want more frequent updates (same reason).

Or maybe you want more frequent updates even if it's trending upward, because that might push prices on the private markets up. Or maybe you want less frequent updates if it's trending downwards because you're trying to sell on the private market and a new FMV would depress the price.

Whatever your goals are, the FMV will become an important number in your life if you have any interest in selling this paper. Which brings up a good question...

Can I Sell This Paper Yet?

Ok, let's pretend that you have some kind of strategy for intelligently exercising your options based on your specific situation in life. You've researched this strategy heavily, with consultation from your accountant, financial advisor, therapist, priest, and downstairs neighbor.

Let's say also that you've actually exercised enough options, and the FMV is high enough, that you feel it would be worthwhile to sell some shares, even with the taxes. You might then reasonably ask: can I sell this paper?

If your company is publicly traded then the answer is... yes! Go for it (taking into account that obviously selling shares is a taxable event). The rest of this document probably doesn't apply to you.

If you're like most people, and not working for a publicly traded company, then the answer is complicated.

There do exist marketplaces for private shares; I won't name any here but you can search for them. It's easy enough to create an account, list how many shares you have and your target price, and wait and see what happens. It is very akin to fishing.

Depending on how much hype there is around your company you may find action at your price, you may not. Furthermore, the marketplace will take a cut of any sale, so that's another thing to price in.

Liquidity Events

Apart from marketplaces, there can be specific "liquidity events" which occur in a company's lifetime.

These most commonly will be big milestones, like fundraising rounds or buyouts, where outside investors will come in to dump a bunch of money on the company in exchange for shares. Sometimes these rounds will involve investors buying existing shares, sometimes they'll involve the company diluting the existing pool of shares, sometimes both. Sometimes the company may just buy back some of its own shares!

If you catch wind of a fundraising round or buyback coming up then that might be an offramp from this highway to hell.

Alternatively, the smell of a fundraising round in the air might just breathe some life into the private share marketplaces, and you can find an exit there. Just be careful about making direct contact with someone about buying your shares outside of a marketplace listing; there's rules about advertising the sale of securities (a category which includes stocks), with the gist being "don't".

Corporations Have Rights, Too

When selling on the private market there's an interesting wrinkle to be aware of, even if there's essentially nothing you can do about it.

If you read the terms attached to your shares you may find a clause called the Right of First Refusal (ROFR). This clause gives the company who issued the options/shares the right to intercept any sales, acquiring the shares from the seller at the same price in place of the original buyer.

From the seller's point of view, aka you, it doesn't seem to make much difference; the sale price remains the same, just the buyer changes.

Where ROFR does affect you is that, when companies exercise their ROFR, it tends to discourage buyers.

Why go through all the hassle of finding a seller, setting up all the documentation, working with the broker, etc... if the issuing company is just going to swoop in and steal your sale and you get nothing? Buyers may decide it's worth the risk if there's lots of hype, but during a quiet period ROFRs can really suck the air out of the room.

Initial Public (Not You) Offering

In the weeks, months, possibly years leading up to the company's initial public offering (IPO) it will probably be a popular subject at the office. All those options that no one had given any thought to will now have real liquidity and finally be worth something! No more fishing in the private marketplaces or waiting hopefully for Big Boy Bezos to buy your company!

There's just one problem, and it's called the lockout.

The company may include in its IPO filing with the SEC a lockout period which prevents you or anyone else who is already holding shares from selling them.

The lockout is disclosed at that moment of filing, usually starts at IPO pricing, and lasts until a fixed number of months AFTER the IPO has been completed. In addition, the company is able to enact freezes on option exercises and private market sales in the leadup to filing.

In effect, by the time you officially find out there will be a lockout period, you may already be in it.

This means that everytime you see a company's shares go absolutely crazy on IPO day, when there's euphoria in the market and you feel huge FOMO for having missed it, many employees of that same company are feeling it 10x more. By the time they are allowed to sell their shares the euphoria will be gone and the company's share price will have leveled out.

So, you're left with a choice. Given rumors of an upcoming IPO of your own company, do you try to find a buyer before filing to get a hopefully-good price now? Or do you wait and see if there will be a lockout, and if so hope that the actual market price beats the current price on the private market?

And remember that the IPO filing will be a surprise (officially, at least), so this whole decision is purely vibes-based. And also remember that leading up to IPO your company may freeze option exercises and private market sales (yes, they can do that!), leaving you stuck even before the big surprise.

Was It Worth It?

Let's say you got this far with options or stocks still in-hand, and after all these years (and it will be years), you are able to finally, definitely, without a doubt, find out what these options are really worth. You will finally find out if it was worth it to play this stupid game. I hope it was!

Look, I'm not here to tell you not to bother with options, to reject them if they're offered, or that they're a scam.

They're only kind of a scam, but they can also work out if you're an active player in the game.

It just takes planning, attentiveness, a bit of luck, and a lot of research. Close relationships with co-workers in the same situation is also invaluable.

Or you could just sit on them and maybe one day they'll hatch on their own, but that takes a lot more luck.

My goal here is only to have given an end-to-end overview (if lacking in detail) of what the rules of the game are, and with that knowledge you can decide on the best strategy for yourself.

This site is a mirror of my gemini capsule. The equivalent gemini page can be found here, and you can learn more about gemini at my 🚀 What is Gemini? page.