As part of your compensation, you may receive stock options. Here’s an example: upon being hired at a startup, you sign a contract with details on the terms of the stock options. The contract says you will receive 20,000 shares over a four-year vesting period. The grant date is the date the stock is issued to you, typically your first day of work.  You’ll be able to buy those shares once your options vest. The options typically vest systematically, over a period of time stipulated in your contract. In this case, you will be able to exercise all 20,000 options in four years. If your options vest annually, then 5,000 shares would be exercisable each year for the next 4 years.  

Before any of your options vest, however, you may  have to wait for a “cliff.” This is the waiting period before anything happens. If your contract includes a one-year cliff, you will need to stay at the company for at least a year before your options start to vest. 

You can exercise your options, meaning buying shares of company stock, once they have vested. Your options have no value until you exercise them. The cost of those options, often referred to as the grant price, strike price, or exercise price, is set in your initial contract and never changes.

If you’re concerned about having to put up the cash to buy all of your options, worry not! There are plenty of ways to exercise your options: you can make an exercise-and-sell transaction, where you purchase your options and sell them immediately. Another option is through an exercise-and-sell-to-cover transaction where you sell just enough to cover your purchase and hold the rest. 

Keep in mind your options do expire, so be sure to review your contract to make sure you don’t miss the opportunity to exercise your stock options.

There are a number of factors that determine when you exercise your stock options. If you believe your company will go public, you’ll want to wait until it does. However, if your company never goes public, or you rush to exercise prior to it doing so, your shares could end up being worthless. 

If your company does go public, exercise your options only when the market price of the stock is above your exercise price. At this point, it’s about evaluating your stocks to best determine when you would benefit from exercising. Discussing your stock options with a financial advisor, particularly when to exercise, can make all the difference such that you don’t end up paying more in capital gains or on income taxes.

When exercising or selling your stock options, you will typically have to pay taxes. There are two types of stock options, which ultimately determine how you’ll have to pay taxes. The first and most common are non-qualified stock options (NQSOs). These do not receive special tax treatment from the federal government, while incentive stock options (ISOs) are given to executives and receive special tax treatment. 

NQSOs are taxed as regular income, which is reported on your W-2. The amount taxed will be the difference between the stock’s market value and your exercise price and is known as the compensation element. Once you exercise and own the shares, there may be additional tax if you sell the shares at a gain. Depending on how long you hold the shares will determine if it’s a short-term gain or a long-term gain. 

While you won’t pay taxes when exercising ISOs, you will need to pay taxes on the sale of the shares. Once more, depending on when you sell, you will have short or long-term capital gains.