It’s one thing to vest your shares, but it’s another thing to actually own them. It’s actually a common misconception, especially among employees who are getting stock options for the first time, that once those options vest, the shares just automatically belong to them.
This isn’t the case. So in this lesson, we’re going to continue down the road with Iris, and learn about exercising, which is the process by which you come to actually own your shares.
Stock options are not stock. That’s a big misconception. When you’re granted stock options, it doesn’t actually mean you own shares. Instead, what you have been given is the option to purchase those shares at a specified price. And that’s what exercising is. It’s the mechanism by which you purchase your stock.
So if you want to think about it in really simple terms, exercising just means purchasing your options. When Iris exercises her options, she hands money over to the company. And in exchange, the company gives her a stock certificate. This certificate is Iris’s proof that she officially owns shares of the company. So she has to make sure she holds on to it.
Last lesson, we went through an example of vesting, which is the trigger that allows Iris to exercise her options. Again, just to put it really simply, when Iris vest options, she can then purchase her shares. If you take another look at Iris’ equity grant agreement, right here, it says that her exercise price is a dollar per share. That’s also known as her strike price or her grant price. It’s a fixed amount that she has to pay in order to buy one share of a company stock.
Now, when it comes to the strike price, a lot of people tend to ask: Does the strike price change as the company grows? It’s a great question. And of course, we hope that the value of the company grows over time, but when it comes to this specific equity grant that Iris has been given, the answer is no. The strike price does not change as the company grows. When Iris receives her grant, the strike price is fixed for the entire batch of options she’s getting.
What this means is as time goes by and she vests more and more of these options, she’ll still be able to buy them at this fixed price—even if the company grows and the shares become more valuable.
Another question we get asked a lot is: How is the strike price determined? Well, every so often, your company will go through a thing called a 409A valuation. Basically this is where an analysis of the company’s financials is done to determine what the value of a share of common stock actually is. This value is called the fair market value, or FMV, of the company’s common stock. And that value, the FMV, is typically the price that they’ll issue options at.
We’ll get into how valuations work a little later. But right now, the big thing to know is that companies typically get them done every 12 months or so, or when there’s a major material event that happens, like another fundraise. So when you’re hired at a company and they grant you stock options, your strike price for those options is usually set at the company’s fair market value at that point in time.
Now, if you are granted another grant, that could have a different strike price. So make sure you’re paying attention to each grant specifically for what the strike price and the FMV are.
OK, this is a lot of fancy info, but let’s get down to the big question: How does it all amount to profit for you? In order to understand that, we have to understand the spread or gain that you have with your options before you can make the decision to exercise. Earlier, we talked about the value of the company growing over time. And if you remember, when Iris received her equity grant, her exercise price or strike price was $1. But if we look back at the chart, you can see that over the course of four years, the value of one share of the company is now at $5. The amount between those two is $4 and that’s what we would call the spread or the gain.
So this spread is extremely important and you’re always going to want to think about it. The reason for that is because it can determine the tax implications when you exercise. Basically that gain could mean taxes down the line. So you always want to be aware of it and plan for it when you think about exercising your options.
OK, take that notion of spread and lock it away in your brain, because we’re going to come back to it later when we talk about taxes.
It’s one thing to vest your shares, but it’s another thing to actually own them. So what if Iris leaves her company before she’s exercised her options? This is where a thing called the post-termination exercise period, or PTEP, comes into play. Most companies will give you a set period of time after you leave the company to exercise options you’ve vested. If Iris doesn’t exercise her options before this window closes, then those options will expire and go back into the company stock option pool.
Most commonly, this post-termination exercise period stays open for around 90 days from the employee’s last day, but it varies from company to company. We’ve seen windows that are a lot shorter and we’ve seen ones that are a lot longer. So if Iris ever wants to leave the company, it’s important for her to take a look at her contract and figure out how long she has to exercise her options after she leaves. If she does want to exercise, will she have the capital to do so once she’s no longer working at the company?
In the example with Iris, we talked about vesting being the trigger that allows her to exercise her options. And in most cases, that’s exactly how it works, but some companies will allow you to exercise options before you actually vest. This is called an early exercise.
OK, but how does that work? I mean, you haven’t vested your shares yet, so how can you exercise them? Well, with early exercising, your company is essentially letting you buy everything today, but you still have to vest and earn the actual shares over time—which is like, OK, that’s great, but why would you even want to do that? Think of it as your company doing you a solid and letting you actually purchase the shares when your tax implications are way lower. If the company continues to grow over time, that early exercise that the company is providing you could save you a lot of money on taxes.
Early exercising can be a super-advantageous strategy, but it’s not all upside. The downside is that it’s a lot more risky. Again, not all companies continue to grow over time. So if you’ve paid for the options and paid taxes on those options, and the company goes to zero, you’re not able to claim or recoup any of those losses. This actually happened to a lot of people during the dot-com bust in the early 2000s. They early exercised their options, but when the bubble burst and their companies went out of business, they lost everything they put in and there was no way to get it back.
So the thing about early exercising is: It’s a personal decision and it should be determined by how much risk you want to take. Remember, it’s always good to check with your financial and legal advisors to figure out the best move for you.
If you do want to exercise early, there’s one thing that you have to absolutely make sure that you do. It’s called filing an 83(b) election. And it’s something that you do in conjunction with doing an early exercise. So if you’re wondering what an 83(b) election actually is, it’s just a form that you have to fill out. Just a piece of paper. So what does this paperwork actually do? Well, once you fill it out and send it to the IRS, it tells them that you’d like to pay taxes now, instead of later when you vest. Because remember, you’re paying for the shares now, but you still have to vest them over time.
In the case of Iris, let’s say she chose to exercise right when she received her grant. If you remember, her strike price was $1. And at the time that she receives her grant, the fair market value of a share is $1. So therefore the spread is zero. And in this moment, her taxable implication is zero. If Iris early exercises and files an 83(b) election, she’s telling the IRS, “Tax me now at zero right now, as opposed to when I vest, when the fair market value could be greater than a dollar and my taxes could be higher.”
One last quick note on 83(b) elections: You have to fill them out within 30 days of exercise. If you file it after the 30-day window, it doesn’t count.
So how do you file an 83(b) election? Well, there are a couple ways to do it. Our advice is to ask your company about their preferred method as the laws around how you can file an 83(b) election are changing as our government adapts to the digital world.
All right. That was a lot. You now know all the basics about your equity grant.