What does it mean to exercise stock options?

Exercising stock options

Exercising stock options refers to an employee purchasing shares in the company for which they work. These options are granted to them as part of their compensation package and are particularly common at tech companies. Stock options typically come with a predetermined price, known as the "strike price," and a specified period, or "exercise period," during which the employee can exercise them.

Upon deciding to exercise stock options, the employee pays the strike price for each share, thus acquiring equity in the company. Suppose the current market price of the shares is higher than the strike price. In that case, the employee can gain financially by selling the shares immediately or holding onto them in anticipation of additional appreciation.

Stock options serve a dual purpose:

  • A form of incentive for the employee, potentially leading to financial gain contingent on the company's success.
  • The promotion of employee retention, as stock options often come with vesting schedules that require a certain length of employment before they can be exercised.

For employees, exercising stock options carries some risks. The market price may fall below the strike price, resulting in a loss if the shares are sold. The cost of purchasing shares and potential tax implications must also be considered. 

What is a cash exercise of stock options?

A cash exercise of stock options refers to the traditional method by which an employee exercises their stock options. With this approach, the employee pays the necessary cash to buy shares at the strike price, which is predetermined and typically below the current market price (see above).

For example, if an employee has the option to buy 1,000 shares at a strike price of $10, they will need $10,000 to carry out a cash transaction. After this transaction, the employee owns these shares outright and can choose to sell them or retain them.

A cash exercise requires the employee to have enough liquidity to pay the strike price upfront for all the shares they wish to purchase. It's also essential for the employee to consider potential tax implications, which can be significant and are often levied on the difference between the market value of the shares at the time of exercise and the strike price.

In short, a cash exercise of stock options directly turns options into ownership, demanding upfront cash payment from the option holder. 

What is an early exercise of stock options?

The early exercise of stock options refers to the opportunity to exercise these options before expiration. In most cases, this refers to American-style options, which can often be exercised at any point during the agreed-upon term. Conversely, European-style options almost always require the employee to wait until the end of the period. 

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