Employees with private company stock options face major obstacles that public company employees do not face. Shares cannot be sold to cover the strike price or taxes.
To gain insight into what you can do and the growth of companies that fund private sector stock options, I am an independent financial adviser with over 25 years of experience in the financial industry. I relied on a Valerie Gospodarek, CFA. She specializes in supporting client executive compensation, including stock options, restricted stock, and deferred compensation plans.
What is the difference between exercising stock options in a private sector?
When you receive stock options from a company publicly Once traded, there is much greater flexibility in how to exercise them. From the various exercise methods available, you can choose a “cashless” or “cell-to-cover” exercise that does not require prepayment. In these types of exercises, two transactions actually occur, but in reality they occur at the same time and are often considered as one. The first transaction is to buy the stock at the strike price. The second transaction is to sell all these shares (or some of them in the case of a “covering” exercise) at the current market price and use the proceeds to pay for the share purchase in the first transaction. It will be configured. Withhold any required taxes (for non-qualified stock options, not incentive stock options).
Private companies can buy shares at the strike price, which is the first part of the exercise transaction. However, because the newly acquired shares do not have an open market for sale and are not registered with the SEC, the second part of the transaction (sale of shares) is used to raise funds for the first part (purchase of shares). And payment) cannot be made. tax).
How does this challenge for private sector employees affect their ability to maximize the benefits of stock options?
That is, you need to buy the stock at the strike price and figure out the cash you need to pay the withholding. The price to exercise (and the corresponding tax) can be high, and employees often do not have this large amount of cash readily available to cover these costs. Even if there are buyers of shares in these private companies, the company’s stock planning documents often limit these types of resale transactions.
Does your employer fund option exercises and corresponding taxes?
Private companies may offer loans to employees for the purpose of exercising options, but I generally do not recommend this alternative to clients. If the company goes bankrupt, the creditors of the company can and will probably be willing to repay these loans. At that point, option holders realize that they have no work and are obliged to repay a loan of worthless stock in the company’s stock.
you NS Use promissory notes from your employer to exercise stock options. This is a non-recourse note (that is, there is no personal responsibility if you default). It is not considered a tax exercise until the note is effectively paid. If the promissory note is in a third party (such as a bank) and the stock is pledged as collateral, even if the stock price falls and the loan is not fulfilled, this is considered an exercise and is standard at the time of exercise. Tax treatment applies.
How do you help clients think about whether to fund their exercises?
Clients need motivation as well as the ability to raise their own funds. Therefore, the first topic I usually discuss with clients is the company’s outlook, including the expected up / down potential of businesses and equities, and the expected timing of liquidity events (ie IPOs or acquisitions). ..
Most employees have usually been found to be fairly bullish on their employer’s outlook, so I often play the Devil’s advocate to soften the overly bullish outlook and reach more reasonable expectations. increase. As part of this discussion, I ask my clients how much they are willing to invest in a company, knowing that it can be zero.
The client must not only be content with the possibility of losing the entire investment, but also with the fact that it will not recoup the taxes paid to exercise the option, which is a present valueless stock. This is especially relevant if the employer is in the early stages and potential liquidity events are years ahead, but scenarios that all option holders need to consider before investing capital. is. If the risk of this loss keeps clients up late, it may make more sense to consider external funding.
If a client decides to raise their own money for exercise, how can it help them decide how to do it (eg from savings, borrowing from relatives, mortgage loans)?
If the client’s employer’s outlook is attractive and the client decides he or she is willing to accept the risk of investing his or her own funds, look at current savings and cash flows to see the client’s ability to raise funds. increase. Describes the pros and cons of using reserves to exercise options if it is determined that cash remains after the client’s costs have been met for the next 2-3 years.
If the expected timing of a stock liquidity event is less than a year and the potential upside is large, then instead of committing most of it, exercise it with your own funds and all potential upsides. It is advisable to maintain. External financial company. If the liquidity event is a year or two ahead, we will discuss the combination of self-financing and external funding.
If the client does not have the cash available to fund such an investment, but still makes sense for self-financing, then other assets that may be able to fund the exercise of the option. Examine you. In this case, if you are less likely to be listed than a privately held stock, you may have other taxable investments that trade with a loss or minimal profit. I generally don’t recommend clients taking out loans or cashing out of retirement plans to generate cash. These tend to be more expensive and risky ways to raise money.
With the advantages of using a traditional loan, especially a home equity loan if the primary residence has considerable equity, if the client does not have cash or other investments available to finance the exercise of the option. I will explain the disadvantages. However, while it is currently difficult to overcome low interest rates on home equity loans, many traditional lenders do not allow the proceeds of their loans to be used for investment and as a source of funding for exercising stock options. Restrict the use of. In addition, the client must be content with the fact that even if the company’s shares go to zero, it will still have to repay the loaned amount to buy the shares that are currently worthless.
Relatives may be willing to offer loans to their clients for the purpose of exercising stock options, and these loans may have more attractive terms than those from external financial companies. In this case, we will discuss not only the terms of the loan, but also how borrowing from a relative will affect future relationships with that relative. If the terms are better than what you should pay to an external company and you are confident that the client’s failure to accept and repay the loan will not compromise their relationship, I would probably take this alternative. I support you.
Any of these options …