Opening Story
Jane joined a fast-growing startup five years ago. Her offer included 1,000 stock options at a strike price of $5 per share, vesting over four years. The company grows quickly and now its shares are valued at roughly $20 per share. Jane’s grant has fully vested and she is wondering: what does it mean to exercise her options? How does she turn that grant into real shares and potential cash? This blog will walk you through exactly that—what exercising stock options means, how it works, when to do it, and what to watch out for.
What Are Stock Options?
Before we dig into the “exercise” part, let’s refresh the broader concept of employee stock options.
- A stock option is a right (but not an obligation) granted by your employer to purchase a certain number of shares of company stock at a preset price—this is often called the strike price or exercise price.
- Usually when the option is granted you do not yet own the shares—what you own is the option (a promise/contract).
- There are several key terms:
- Grant: the date when you receive the option award.
- Vesting schedule: the timeline or conditions (e.g., years of service, performance) after which your options become exercisable.
- Expiration date: the deadline by which the option must be exercised, or it becomes worthless.
- Example: Suppose you’re granted 1,000 options at $5/share, vesting 250 per year for four years. After three years you’ve vested 750; your company’s share value is now $20. But until you exercise, you don’t own the shares—you simply have the right to buy them at $5.
Exercise Defined — What It Means to Exercise Your Stock Options
So what exactly does “exercise” mean?
- To exercise your options means you use your right under the option contract to buy the underlying shares at your strike price, regardless of current market value.
- Only after you pay the strike price (and satisfy any other required steps) do you convert the option into actual shares and become a shareholder.
- Example: Using our earlier scenario, Jane decided to exercise her full 1,000 options at $5 each, paying $5,000. She receives 1,000 shares. If the company share value remains $20, her “paper value” is $20,000, so the “gain” (if she were to sell) would be $15,000 before taxes and fees. If the company later falls to $8, she still owns the shares, but her market value is lower—so risk is present.
- Important nuance: Granting options ≠ owning shares. Many employees conflate “they gave me 1,000 shares” with “I already own 1,000 shares”—the reality is you must exercise and often wait for liquidity before you realize value.
- Example: Jane only truly owns shares once she exercises.
How You Can Exercise — Methods of Exercising
There are multiple ways to carry out an exercise, and the one chosen can affect your cost, tax, and risk. Here are the common methods:
- Cash exercise (exercise & hold): you pay the full strike price in cash and hold the shares. Pros: you hold more shares, potentially greater upside. Cons: you must front the cash and risk owning shares in a possibly volatile company.
- Cashless exercise / sell-to-cover: you exercise by buying shares, but simultaneously sell just enough shares to cover the exercise cost, taxes, and fees; you retain the remainder shares. Example: Jane exercises 1,000 options at $5 = $5,000 cost plus fees. If the share value is $20, she sells ~270 shares to cover the cost, then keeps ~730 shares.
- Immediate full sell (cashless complete): exercise and immediately sell all the shares to pay the cost, fees, and taxes, pocketing the remainder cash. Pros: quick liquidity, minimal holding risk. Cons: you lose potential future upside.
- Early exercise: Some companies allow you to exercise options before they vest. This can provide tax advantages or lock in low strike prices but carries the risk of losing unvested shares if you leave early.
Timing & Lifecycle Issues — When Should You Exercise?
Deciding when to exercise is just as important as how. Key considerations include:
- Vesting completion: You can only exercise vested options.
- Post-termination window: Many companies impose a 90-day exercise period after leaving employment. If you miss it, options expire.
- Company public vs private: Liquidity differs greatly between public and private companies.
- Market price vs strike price spread: Exercising when market value is much higher than strike price gives greater potential gain.
- Tax timing: Some exercises can trigger tax events.
- Risk of holding shares: Holding shares exposes you to company-specific risk. Staggering exercises can reduce this risk.
- Liquidity programs: Some private companies now offer secondary markets or bridge liquidity programs to make exercising more flexible.
Tax & Legal Dynamics — What You Need to Know
Taxes and legal structure are critical considerations:
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Options are broadly classified into:
- Incentive Stock Options (ISOs): may offer favourable tax treatment if holding periods are met.
- Non‑Qualified Stock Options (NSOs): typically taxed as ordinary income when exercised.
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According to the Internal Revenue Service (IRS) Tax Topic 427: Stock Options,
“If your employer grants you a statutory stock option, you generally don’t include any amount in your gross income when you receive or exercise the option. … For non‑statutory stock options … you must include in income the fair market value of the stock received minus the amount paid for the option when you exercise.”
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Example: Suppose you have 1,000 options at a strike of $5, and current FMV is $20 at exercise. If they are NSOs, the spread ($15 × 1,000 = $15,000) is taxed as ordinary income. If they are ISOs and you meet holding‑period rules, you may instead pay long‑term capital gains tax when you sell.
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Section 83(b) election: When you early‑exercise unvested shares, you may file an election under Code §83(b) within 30 days of the transfer to be taxed now rather than later. The IRS provides the official form “Form 15620 – Election to Include in Gross Income in Year of Transfer Under §83(b)” (Rev. 4‑2025).
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Other legal issues: vesting triggers, repurchase rights by the company (especially in startups) if you leave early, forfeiture risk, etc.
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Best practice: always consult a tax advisor before exercising—tax outcome depends heavily on your option type, personal income, the timing of exercise/hold, and company status.
After You Exercise — What Happens Next?
After exercising, you now own shares and become a shareholder. Options include:
- Holding shares to seek appreciation
- Selling shares to realize gains
- Monitoring taxes (capital gains, AMT, ordinary income) Risks include:
- Share price decline
- Illiquidity in private companies
- Company repurchase rights if you leave
Practical Tips for Employees
- Understand your grant documents: number of options, strike price, vesting schedule, expiration date, and early exercise options.
- Check liquidity: public company vs private company, secondary markets.
- Use calculator tools:
- Options Profit Calculator to estimate potential gains
- Options Calculator to analyse IV, Greeks, and fair value
- Consider tax impact and consult advisors
- Stagger exercises to manage risk
- Align exercise strategy with cash flow and personal tolerance
- Track upcoming liquidity events (IPO, acquisition)
Summary
Exercising stock options converts paper rights into actual shares, unlocking potential wealth. Success depends on careful consideration of timing, cost, tax, company trajectory, and risk. Using the right tools and consulting advisors ensures you make informed decisions and maximize your equity compensation.