Stock options in private companies are an attractive form of equity compensation for employees. In order to stay competitive, many companies are recognizing the importance of retaining and attracting top talent by providing equity in the form of stock options. Stock options refer to a contract between an employee and a company that grants the employee the right, but not the obligation, to purchase a certain number of shares of stock at a specific price (or “exercise price”) after a specified date in the future. But what does it really mean to finance stock option exercises? Well, this article will cover the concept of financing stock option exercises and discuss various methods used to finance stock option exercises.
Finance stock option exercise in private companies
The term finance in reference to stock options simply means the methods used to pay for the purchase of stock in a private company. However, you might be wondering what is stock options exercise, how does stock options exercise works in private companies, and why do you need to pay for option exercising? To better understand the concept of financing stock option exercises, you will need to know the basics of stock options.
What is a stock option?
A stock option is a contract that gives the holder (called the option holder) the right, but not the obligation, to purchase a fixed number of shares at a set price (called the exercise price) for a specific period of time. With respect to private companies, the majority of companies provide stock options in order to attract and retain top talent within the company. Usually, companies grant stock options to employees, senior management, consultants, or advisors as a means of rewarding them for adding value to the company.
Understand exercising stock options
Stock options are granted to employees with a vesting period which is the length of time that the employee has to wait before they are allowed to purchase (exercise) the stock. While exercise in this regard means actually buying the stock at a predetermined price. The price at which the employee is allowed to purchase the company stock is called the exercise price or strike price. This price is generally based on the fair market value (FMV) of the company stock on the date that the stock options were granted to the employee.
How does exercising stock options work in private companies?
The key is to understand how stock options work and then how you can use them to get your hands on the company’s shares before they expire. Since stock options are only effective when the employee exercises their options due to the fact that at the time of exercising, the employee is acquiring the shares and typically will become a shareholder.
Exercising stock options is the process of buying the stock held by an option holder at the exercise price or strike price on or before the expiration date. Generally, there is a vesting term after which the employee must wait before they are able to acquire shares. After meeting certain conditions, vesting period or expiration date, the option holder exercises the options and is required to pay the strike price in order to acquire the stock.
When and why to exercise stock options?
The time to exercise stock options depends on the terms of the option, the vesting period and the expiry date of the stock options. According to the employee, they must exercise the options before the expiration. The expiration date is the last day on which you can exercise your stock options, after which the option is worthless.
While an employee would want to exercise the options for many reasons, such as to become a shareholder of the company, feel valued, improve their financials, or for other personal or business reasons. However, it is essential to note that stock options give the right and not the obligation to purchase shares. It is at the discretion of the option holder whether they wish to exercise their stock options or not.
How to finance stock option exercise?
Well, when your employee is ready to exercise their stock options, the next question that comes to mind is how they are going to pay the strike price to acquire the shares. As a matter of fact, the employee has the option to finance stock option exercises through a variety of methods depending on their financial situation, their liquidity needs, and other factors. Basically, after the options are exercised, according to the employee, they might want to hold on to the shares for some time, or they might need to sell the shares immediately to get their hands on cash.
Typically, based on this, the option holder will either borrow money from an outside lender in order to hold the stock or will choose to sell the stock instantly to cover the cost of the exercise. Therefore, it is important to evaluate the employee’s liquidity requirements and timeframe to decide which stock option exercise financing method to use.
Importance of finance stock option exercise
Why is it important to finance stock option exercises? The answer is fairly simple. Without having enough funds to exercise the options, the employee will not be able to acquire shares in the company. This might end up negatively affecting the employee on many levels, such as their reputation, morale, financials, and company image.
So, to simply put it, the finance stock option exercise is important because it helps the employee transition from an option holder to a shareholder in the company. While financing stock option exercises, there are various options available for the employee. However, the employee should be aware of their financial needs, as well as how they would like to hold on to their shares before deciding which stock options financing method to use.
Example of finance stock option exercise
An example of financing stock option exercises will help you better understand the concept. In the following example, we will take a look at an employee who is preparing to exercise their stock options, and with the help of a brokerage firm, the employee will instantly sell the shares to cover the cost of the exercise, known as cashless exercise stock options.
For instance, assume the employee has a stock option with a vesting period of one year and an exercise price of $10 per share. As per the agreement, the number of shares is 1,000. Further, at the time of exercising, the fair market value (FMV) of shares is now $25 per share. The employee chooses to use a brokerage loan to finance the exercise. Immediately after the exercise, they obtain a profit of $15 per share or an amount of $15,000. Well, this profit is instantly used by the employee to repay the loan that was earlier granted to facilitate the stock option exercise from the brokerage firm.
Ways to finance stock option exercise
Now that you know why it is important to finance stock option exercises and have an understanding of how to do it, the next question that comes to mind is, what are the methods to finance stock option exercises? Following are a few of the techniques that can be used to finance stock option exercises:
- Self-finance – The employee can finance the exercise on their own by using funds that are available such as cash, relatives, and other personal loans. It is important to note that the employee must be aware of their liquidity requirements prior to self-financing. Depending on the risk capabilities, financial situations, and other factors, the employee will either decide to sell off the shares instantly or hold on to the shares for an extended period of time.
- Loan from financing companies – Sometimes, employees are able to get a loan in order to finance the exercise. This can be done through financing companies, and likewise, there is a contractual agreement between the option holder and the financing company. However, an employee may be required to give up a certain number of shares to the financing company as a form of security or mortgage.
How do self-financing and outside financing differ from each other?
While both self-financing and outside financing aims to achieve the same goal, they both are quite different in nature. Here are a few of the differences between self-financing and outside financing:
- In the case of self-financing, there is no involvement of a third party, such as a broker or a lending company. The option holder uses their own cash to perform the exercise. While outside financing, on the other hand, involves an external source of funds and a third-party such as a financing company or another entity is involved.
- Another difference is the self-financing method does not involve any kind of loan security or mortgage due to the fact that the employee uses their own funds to finance the exercise. In contrast, under the outside financing method, a third party might require a certain number of shares as collateral or a mortgage.
- No additional terms or conditions are required for the self-financing method as compared to outside financing, where the borrower might be required to sign an agreement or contract that has certain terms and conditions imposed on it. Thus, self-financing is considered a more flexible method when compared to outside financing.
Which financing should you choose for your stock option exercise?
Now that you know about the various ways to finance stock option exercises, it is important to evaluate which financing method best suits the needs of the employees. It all depends on the employee, their financial situation, liquidity requirements, the vesting period of their stock options, and a number of other factors.
If the employee has sufficient funds and is ready to take on the risk associated with the future value of the stock, they may opt for self-funding. However, if the employee does not have sufficient funds for the exercise, they might take a loan from a financing company and pay back the loan in a specified timeframe.
Pros and cons of outside financing
For employees who prefer outside financing, there might be a number of advantages and disadvantages. Following are some of the pros and cons of outside financing:
- Employees can choose from a wide variety of financing companies, including Quid, Equity Bee, SecFi, ESO Fund, and Liquid Stock. It is important to research, compare, and find the best financing company for stock option exercise.
- Outside financing offers quick, flexible, and easy credit options for employees who require capital at short notice for their stock option exercises. This is particularly good for employees who do not have sufficient funds and need to exercise their stock options immediately.
- Employees are required to give up a certain number of shares as collateral or mortgage when they opt for outside financing. The number of shares given out depends on the agreement with the financing company, and it varies from one company to another.
- A contractual agreement is in place with outside financing companies, and it might have certain terms and conditions that have to be met. Such terms are usually stipulated in order for the financing company to loan money to the employee.
How does tax treatment work when choosing outside financing?
Typically, the tax treatment works in the same way as under any other financing. However, some of the agreements can provide capital losses to be used to offset gains from the sale of shares by counting the amount that the option holder pays to the financing business above the initial financing amount. Employees may contact their tax advisors in order to understand how outside financing works with regard to the tax rules.
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