How to exercise your stock options | Equity 101 lesson 5 - YouTube

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’ 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 vests 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's 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 does she have 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.

you