Cashless Exercise: A Complete Guide for Employees and Employers

When you exercise stock options, you must pay the exercise price to convert your options into actual shares. For employee stock options, the exercise price is usually set below the stock’s current fair market value (FMV).

This built-in discount creates room for a mechanism known as cashless exercise.

Cashless exercise lets employees acquire stock without using their personal savings. Instead of paying cash up front, employees can use the value within their options to cover costs.

In this guide, we’ll break down how cashless exercises work, explore the different types of cashless exercises, and outline what both employees and employers need to consider before proceeding.

We will also briefly discuss non-recourse financing as an alternative to cashless exercises.

Types of Cashless Exercises

The two common types of cashless exercise are as follows:

Criteria	Same-day sale	Exercise and sell-to-cover
Cash received	Maximum	None
Shares retained	None	Majority
Complexity	Simple	Moderate
Future upside	None	Full participation
Tax impact	High (all gains taxed immediately)	Low (only sold portion taxed)
Best for	Employees with immediate liquidity needs	Employees with long-term conviction

Same-Day Sale

Just as the name suggests, in a same-day sale, the employee receives the stocks and sells them on the same day. Then, the employee pays the exercise price, other sale-related expenses, and taxes from the stock sale proceeds.

While the employee does receive cash from such a series of transactions, since they receive no stocks, they forfeit the chance to participate in the company’s future growth.

How it works

• Exercise 1,000 options at $5 per option (Total exercise cost: $5,000)
• Shares sold immediately at an FMV of $20 per share (Total proceeds: $20,000)
• After covering exercise costs and taxes, you retain the remaining cash
• You own zero shares

This method makes sense only when there’s a substantial gap between your exercise price and the current FMV. Otherwise, taxes and fees can consume most of your gains.

Exercise and Sell To Cover

The exercise and sell to cover form of cashless exercise is slightly complicated in comparison to the same-day sale. Here, the employee receives the stocks and sells a portion of them to cover the exercise price and other expenses. So, the employee gets to retain the remaining shares and participate in the future growth of the company.

How it works

• You exercise 1,000 options at $5 per option (Total exercise cost: $5,000)
• Sell about 250 to 300 shares at an FMV of $20 per share to cover the exercise cost and taxes
• Retain the remaining 700-750 shares worth $14,000-$15,000
• Maintain equity exposure and participate in future growth

This approach gives you the best of both worlds. You don’t deplete your savings, and you still own stock that can appreciate.

Key Considerations of cashless exercise for Employees

Before going ahead with a cashless exercise, as an employee, you must consider the following factors:

Liquidity Needs

If an employee has an urgent need for cash or cannot afford to reduce their existing savings, cashless exercises are the way to go. But, for other employees, a straightforward exercise would deliver more value. Even in the exercise and sell to cover method, the employee gives up a part of their holdings.

Expiration of Options

Stock options are valid only until the expiration date. Missing your deadline means losing years of earned compensation. If you can’t save enough to exercise all your options before they expire, cashless exercise ensures you capture at least some value rather than forfeiting them entirely.

Tax Considerations

Cashless exercise results in an immediate sale of stocks, which can expose you to immediate taxation on gains and short-term capital gains tax. In the US, the long-term capital gains tax rate ranges from 0% to 20% while short-term capital gains are taxed as per your ordinary income tax rate, which ranges from 10% to 37%.

Key Considerations Cashless Exercise for Employers

When you are deliberating whether to facilitate cashless exercise, you should consider the following four factors:

Cash Reserves

Facilitating cashless exits can deplete a company’s cash reserves substantially since the shares sold immediately by the employees must typically be bought by the company. A workaround for this issue involves major investors or founders acting as the counterparty in such transactions. Companies must also note that the exercise and sell to cover method is more cash efficient than the same-day sale.

Tax Considerations

In a cashless exercise, the stock options that are exercised and sold immediately will be treated as non-qualified stock option (NSO). This allows companies to claim tax deductions equal to the income recognized by the employees from the exercise. Here’s how you can calculate this tax deduction:

Tax deduction = Number of options exercised and sold immediately × (FMV − Exercise price)

This tax benefit can offset some of the cash outflow from facilitating cashless exercises.

Ownership Dilution

In private companies, employees are highly likely to simply sell the shares back to the company. These shares are then retired. So, founders and key investors do not experience any long-term threat to ownership. It does mean that the growth between exercise and buybacks or other forms of exits is shared by the employees, founders, and investors.

But cash exercise also leaves the window open for any party to solicit employee shareholders and increase their shareholding and influence within the company.

Managing Employee Expectations and Morale

If employees watch their options expire unexercised year after year, they’ll stop viewing equity as meaningful compensation. They may perceive options as deliberately overpriced or worthless.In such scenarios, offering cashless exercise demonstrates good faith and helps retain talent who might otherwise leave for companies with more accessible equity programs.

Option Financing: An Alternative to Cashless Exercise

Most companies do not facilitate cashless exercises since it depletes cash reserves. But this does not mean that you are out of options. One viable alternative would be applying for option financing to cover the exercise price.

In addition to traditional loans like personal loans, you could also go for non-recourse financing, where:

• Shares act as collateral
• No monthly payments are required
• Loan must be repaid only upon successful exit
• No personal liability

Whether you can secure non-recourse financing depends on your company’s financial prospects as well as your own financial condition.

Eqvista – Real-Time Insights for Agile Decision-Making!

Cashless exercise makes stock options more accessible for all employees by removing cash barriers. Whether you should choose a same-day sale or exercise and sell-to-cover depends on your financial situation and belief in the company.

On the other hand, employers can bolster confidence in equity programs through cashless exercises. Some of these costs can be offset by the tax deductions unlocked through NSO treatment.

Managing these programs effectively requires careful tracking of option grants, exercises, and FMV trends. As your team grows and equity transactions multiply, manual spreadsheets become error-prone and time-consuming.

Eqvista, a modern cap table management software, automates these processes to give you real-time visibility into ownership structures, tax implications, and dilution scenarios. Contact us to know more!