In reality, they’re actually talking about selling the shares they receive upon exercise of their stock options. That is to say, option exercise is a prerequisite to a sale, and if you were granted options in an already established firm, it can be an expensive prerequisite.
During the pandemic we saw economic uncertainty which left many vested option holders without the cash necessary to exercise their stock options in the traditional manner. As a result, shareholders explored alternatives to the traditional methods of option exercise.
Read on for two alternative options, which allow option holders to exercise their options without paying upfront.
Exercising without cash? How?
There are two principal methods by which a vested option holder can exercise his or her stock options without the need to pay the exercise amount1 in cash directly to the company.
Net Exercise
In a net exercise, instead of the vested option holder, or a third-party purchaser, paying the company in cash to exercise the optionholder’s stock options, the option holder instead pays the company in vested stock options. That is, you surrender some portion of your vested stock options to exercise another portion of your vested stock options.
For example, you have 1,000 vested stock options in CoABC (an imaginary late-stage, pre-IPO company.) The exercise price, or “strike” price of your options is $20 per share. The fair market value of CoABC stock, as of the company’s most recent 409A valuation, is $40 per share. To exercise your 1,000 options, in cash, you would need $20,000 (1,000 vested options x $20).
Cashless exercise allows you to pay with vested options, which are worth $40. A $20,000 exercise price divided by $40 equals 500 shares. You will surrender 500 vested options to the company, and in return receive the remaining 500 vested shares.
In this option you were able to pay $0 instead of $20,000 out of pocket, by instead surrendering 500 vested options to get 500 vested shares.
As with most things in life, taxes will also factor in here2. Whether you have an incentive stock option (an ISO), where holders generally incur no tax liability upon exercise, or a non-qualified stock option (a NSO), where holders pay tax on the “gain” received upon exercise (here, the spread between the $40 fair market value and the $20 exercise price), any tax liability incurred upon option exercise can lead to additional options being withheld.
Cashless Exercise in Connection with a Secondary Sale (a "Same-Day Sale")
You may also be able to avoid paying out of pocket for your exercise by having a third-party purchaser, such as an EquityZen fund, pay your exercise amount on your behalf.
For this example, your exercise price is the same, but instead of receiving the $40 fair-market value price, you managed to negotiate a $50 per share purchase price with the EquityZen fund to sell all 1,000 shares. At the close of your transaction, the EquityZen fund simultaneously wires $20,000 (assuming no tax withholding) to CoABC for your exercise, and the balance of $30,0003 to you, the seller. Upon closing, CoABC would issue a share certificate for 1,000 shares in the name of the EquityZen fund.
Interested in exploring pre-IPO liquidity on EquityZen's marketplace?
How to Get Started
For Shareholders
If you’re not sure whether your company permits net or cashless exercise, a good place to start is the language of your option grant. You’ll want to pay particular attention to the “Method of Exercise”, “Method of Payment” or “Payment for Stock” sections.
If you see “cashless exercise” in any of these sections, that’s a good sign! Likewise, if there’s a section that describes a method of exercise by which you “surrender” either shares or options, that is a good indicator as well.
To know for sure what routes are available to you with respect to net exercise, cashless exercise, and secondary sales, contact your company’s stock administration team.
For Private Companies
EquityZen has facilitated dozens of same-day cashless exercise transactions in its ten years of business, working with private companies as well as leading pre-IPO law firms to ensure shareholders can gain access to liquidity without the undue burden of going out of pocket for large exercise amounts.
With the recent volatility in the public markets, we’ve seen an increase in the number of shareholders inquiring about potential cashless exercise transactions, as shareholders who would have previously liquidated public market positions to exercise options are no longer in a position to do so.
As with permitting employee and investor secondary sales more broadly, we have found that allowing employees to utilize net or cashless exercise as a means to exercise options either ahead of, or in connection with, a secondary sale, can serve as a strong employee morale and retention tool for private companies in an economic environment where more conventional methods of employee retention (raises, bonuses, etc.) may no longer be viable.
Interested in learning more? Sign up to explore selling your shares, check out our other blog posts, or reach out to support@equityzen.com.
Interested in exploring pre-IPO liquidity on EquityZen's marketplace?
NOTE: This post is for informational purposes only and does not constitute tax or legal advice.
[1] This sum can include both: (i) the product of: (x) your exercise price (your “strike” price) multiplied by (y) the number of options you intend to exercise; and (ii) any applicable tax withholding.
[2] The tax consequences of option exercise are complex and can vary across shareholders, companies, states, and the specific type of option you were granted. The tax commentary in this post is meant merely to be a superficial examination of standard stock option tax consequences. We recommend you consult your own tax advisor if you have questions about the tax consequences relating to your option exercise.
[3] The purchaser may also deduct any placement fees due on the transaction.
