Financing Stock Option Exercises In Private Companies: Insights From A Top Financial Advisor

Employees with stock options in a private company face a big obstacle that employees in public companies do not: you cannot sell the stock to fund the exercise price and any taxes.

For insights on what you can do, and the growth in firms that provide financing to exercise private company stock options, I turned to Valerie Gospodarek, CFA, an independent financial advisor with over 25 years of experience in the finance industry. She specializes in helping clients with their executive compensation, including stock options, restricted stock, and deferred compensation plans.

What is different about exercising stock options in a private company?

When you receive stock options from a company that is publicly traded, you have much greater flexibility in how to exercise them. Among the various exercise methods available, you can choose a “cashless” or “sell-to-cover” exercise, requiring no upfront payment. With these types of exercises, two transactions actually take place, although they happen practically simultaneously and are often viewed as just one. The first transaction consists of purchasing the shares at the exercise price. The second transaction consists of then selling all those shares (or a portion of, in the case of a “sell-to-cover” exercise) at the current market price and using the proceeds to pay for the share purchase in the first transaction and withhold any required taxes (for nonqualified stock options, not for incentive stock options).

With a private company, you can execute the first part of the exercise transaction—purchasing the shares at the exercise price. However, because the shares just acquired have no public market in which they can be sold and are not registered with the SEC, you cannot use the second part of the transaction (selling the shares) to finance the first part (purchasing the shares and paying any taxes).

How does this challenge for private company employees affect their ability to maximize the benefits of stock options?

It means you must come up with the cash required to both purchase the shares at the exercise price and pay for any tax withholdings. The price to exercise (and the corresponding taxes) can be significant, and often employees don’t have this large sum of cash readily available to cover these costs. Even if purchasers for these private company shares exist, the company’s stock plan documents often restrict these types of resale transactions.

Do employers provide any financing for option exercises and the corresponding taxes?

Private companies may provide loans to their employees for the purpose of exercising their options, but I do not generally recommend this alternative to my clients. Should the company fail, creditors of the company can, and most likely will, aggressively seek repayment of these loans. At that point, the optionholders then find themselves without a job AND obligated to repay a loan on worthless shares of the company’s stock.

It is worth knowing that if you do use a promissory note from your employer to exercise your stock options and it is a nonrecourse note (i.e. no personal liability if you default), it is not considered an exercise for tax purposes until the note is substantially paid. When the promissory note is with a third party (e.g. a bank) and the stock is pledged as collateral, this is considered an exercise and the standard tax treatment at exercise applies, even if the stock price drops and you default on the loan.

How do you help a client think through whether to self-finance an exercise?

Clients not only need to have the ability to self-finance, but also the willingness. Therefore, the first topic I typically discuss with clients is their prospects for the company, including their expected upside/downside potential for the business and stock, and the anticipated timing for a liquidity event (i.e. IPO or acquisition).

I’ve found that most employees are typically quite bullish about their employer’s prospects, so I often play devil’s advocate to try to temper their overly bullish outlook and come to more reasonable expectations. As part of this discussion, I ask the client how much they would be willing to invest in their company knowing that there is a chance that it could go to zero.

Clients must not only be comfortable with the possibility of losing their entire investment, but also with the fact that they will not get back any of the taxes they paid to exercise those options that are now worthless shares of stock. While this is particularly relevant if the employer is in its early stages and any potential liquidity event is several years away, it is a scenario that all optionholders should consider before investing their own capital. If this risk of loss will keep the client up at night, then it likely makes more sense to consider outside financing.

When a client decides to self-finance the exercise, how do you help them decide how to do it (e.g. from savings, borrowing from relatives, a home equity loan)?

When we have determined that a client’s employer’s prospects are attractive and that the client is willing to accept the risk of investing their own funds, then we will review the client’s ability to self-finance by looking at their current savings and cashflows. When it’s determined that there is cash remaining after a client’s expenses are met for the next 2–3 years, we will discuss the pros and cons of using their reserves to exercise their options.

If the anticipated timing for a liquidity event for the stock is within a year and the potential upside is significant, then I will likely recommend that they self-finance the exercise and retain all the potential upside, rather than committing a significant portion of it to an outside financing company. If the liquidity event is 1–2 years away, we will discuss a combination of self-financing and outside financing.

If clients do not have cash available to fund such an investment, but it still makes sense to self-finance, we will then look at their other assets that might be able to fund the option exercise. In this case, they may have other taxable investments trading at losses or minimal gains where the upside potential is less than that of their private company stock. I generally do not recommend that clients take loans against, or cash out, retirement plans to generate cash, as these tend to be more expensive and risky ways to raise funds.

If clients do not have cash or other investments available to finance their option exercises, we will then discuss the advantages and disadvantages of using traditional loans, especially home equity loans if they have significant equity in their primary residence. However, while it is difficult to beat the low interest rates on home equity loans currently, many traditional lenders will not allow for loan proceeds to be used for investments, limiting their use as a source of funds to exercise stock options. In addition, clients must be comfortable with the fact that should their company stock go to zero, they still need to repay the amount they were loaned to purchase those now worthless shares.

Relatives may be willing to provide loans to clients for the purpose of exercising their stock options, and these loans may have more attractive terms than those from outside financing companies. If this is the case, we will discuss not only the terms of the loan, but how borrowing from a relative may affect their future relationship with that relative. If the terms are better than what would be owed to an outside company, and the client is confident that accepting and possibly not repaying the loan will not damage their relationship if the company fails, then I will likely support this alternative.

If none of these alternatives for self-financing or family financing make sense for the client, then we will discuss funding the exercise wholly with outside financing.

Have there always been outside companies that specialize in provide financing for exercising stock options?

A whole cottage industry has sprouted up over the past decade that provides financing capital to private company optionholders. This industry has become quite large over time, with one of the largest financing companies having provided funding to employees at 80% of all US-based “unicorn” startups just since January 2020.

What are some of these providers of outside financing for private company option exercises?

Some of the larger, more prominent providers include (in alphabetical order) Equity Bee, ESO Fund, Liquid Stock, Quid, and SecFi. An internet search of “stock option financing” and/or “stock option lenders” will result in these and several other financing firms.

How does this type of financing work? Are these financing companies actually investing in the stock options or just lending to employees to exercise them?

These financing companies may provide the financing themselves if they manage a private equity or hedge fund for this purpose, or they may just act as an intermediary, connecting investors to optionholders. Either way, the financing company delivers the funds employees need to exercise their options themselves and pay the corresponding taxes.

It is important to note that these financings are not traditional loans that have annual percentage rates and fixed repayment dates. They are contractual agreements where the optionholder agrees to repay the funds (plus fees and some of the stock’s upside—more on this later) after the stock becomes liquid, such as after an IPO.

Many of these financings are “nonrecourse,” meaning that should the company fail, the optionholder is not responsible for paying back the financing amount. Because the financing company is bearing the risk of not being repaid, it will want to review the optionholder’s company for its potential upside, similar to how investors research which publicly traded stocks to invest. This may or may not require that the optionholder’s company share nonpublic information, including financial data.

The contract between the financing company and the optionholder is initially based upon the optionholder’s willingness to repay the financing amount plus the agreed upon upside and fees, since most shares acquired upon exercise are not typically able to be used as collateral due to restrictions in the company’s stock plan documents. The financing amount plus the agreed upon upside and fees are generally repaid after any lockup period has expired and the optionholder is able to dispose of their shares in the public market.

Do the terms of these agreements differ by the company providing the financing?

There are nuances in how each company structures their financing. For example, some may charge an additional fee for “brokering” a deal, in other words finding investors interested in providing the financing. In these cases, that fee would be in addition to the upside paid at the end of the lockup period. Other financing firms may only agree to provide financing if the optionholder’s employer agrees to allow it access to other optionholders within their company. Still other firms may require the shares become collateral for the financing once any lockup period has ended.

Does an employee lose some of the upside in using this outside financing?

Yes. Optionholders can generally expect to give up one quarter to one half of the stock’s upside on average, including fees, with these types of financings. For an example of how this works, see Exhibit 3 in Stock-Option Financing in Pre-IPO Companies (Rock Center for Corporate Governance at Stanford University Working Paper Forthcoming).

This upside (and fees) is what the financing company receives for taking on the risk of the company potentially failing, as discussed earlier. Every financing deal will be priced differently depending upon the specific circumstances, including, but not limited to, the perceived upside of the stock, the length of time expected until a liquidity event for the stock occurs, and the amount of financing provided.

Does using outside financing change the tax treatment at exercise?

Generally speaking, no, but some of the arrangements may allow for the amount paid by the optionholder to the financing company above the initial financing amount to qualify as a capital loss, potentially offsetting gains from selling shares. These financing structures are complicated, though, so I always recommend that clients consult with a tax professional who specializes in stock compensation before entering into any stock option financing contracts.

What are the pros and cons of using an outside financing company to exercise?

One of the largest advantages is optionholders’ ability to exercise their options without having to self-finance with what could be a very significant outlay of cash. This is of particular benefit if employees are facing potential forfeiture of their vested options without the funds to exercise them, for instance if leaving their company for another job. Another benefit is not losing one’s own money or having to repay a nonrecourse financing should the employee’s company fail and the stock goes to zero. Lastly, obtaining outside financing may allow the optionholder to exercise their options earlier than without that funding. Taxes can be significantly lower by exercising early, particularly when the stock price is low after grant. Early exercises also start the capital gains holding period for future sales of the stock to qualify for the lower long-term capital gains tax treatment (versus ordinary income).

Giving up a portion of the stock’s upside (plus fees) if the stock ends up being very successful is obviously the biggest detractor to receiving outside financing. In addition, the added tax complexity that can arise from complicated structures used by outside companies in providing financing can result in significant tax consulting and preparation fees.

Additional Resources

See the section Pre-IPO at myStockOptions.com for more information and insights on financial planning for employees in private and pre-IPO companies. myStockOptions has also held a special webinar on these topics: Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition (available on demand at the link).