Stock Option Financing

‍TL;DR: Early-exercising your stock options or exercising before your options expire may be the best financial decision for you, but you may not have sufficient cash on hand. Stock option financing may be one way to fund your exercising event. There are multiple ways to get financing including taking out a personal loan from a bank, borrowing against equity in your home if you have one, borrowing against securities, or using a non-recourse loan. The right one for you will depend on your financial situation, source of funds, and appetite for risk. 

Common Experiences You May Face as a Startup Employee…

Scenario 1: Your company has granted you stock options and you’ve decided you want to exercise them. Maybe you want to start the clock on long-term cap gains or are simply bullish on your company. 

Scenario 2: You've recently left a company or are considering leaving soon and your options are at risk of expiring so you need to exercise them now.

In both scenarios, there may be a problem: you don’t have the cash on hand to exercise or pay for the resulting tax bill. Or you do have the liquidity, but it may not be financially prudent to use your liquidity to pay for exercising your stock options. If your company is public, you can finance your exercise events with the gains from a sale, but what are your financing options if your company is still private? 

How can I finance exercising my options?

For holders of private stock, there are a few different ways to fund your exercise event: 

1. Wait for a liquidity event. Exercising your options is a tax strategy. If you can negotiate extended strike windows, you can wait until there is a liquidity event. You will likely pay more in taxes, but you will not put any personal capital or assets at risk.

2. Use cash reserves. Cash is the most liquid and accessible asset, especially when it’s housed in a savings or checking account. The biggest advantage of paying for your exercise event in cash is that withdrawal from these accounts won’t be taxed or carry an interest rate (as opposed to other alternatives like selling securities to withdraw money from an investment account or taking out a loan). However, most people do not have sufficient cash reserves to cover exercise events if their strike price is high or they were granted many options. Depending on your financial situation, by withdrawing cash, you run the risk of dissolving your savings. 

3. Sell public stock held in a taxable brokerage account. Selling public stock can provide easy and fast liquidity. If you’re bullish about your company, withdrawing from your brokerage account might sound appealing to you, especially if your investments yield losses or low returns. Keep in mind that selling securities can result in tax implications. It’s important to weigh the cost of incurred taxes relative to the funds you want to free up. Note: it’s generally not recommended to withdraw funds from a tax-advantaged investment account (e.g. Roth IRA, Traditional IRA, 401(k)) due to tax penalties and other implications. To understand the tax implications of allocating liquid assets into an illiquid opportunity like exercising your options, consult with a financial advisor. 

4. Borrow from friends and/or family. If people close to you can loan you funds, this might seem like a no-brainer. Keep in mind that money lent between friends or family can trigger tax consequences. For more information, you can see the implications of intrafamily loans here.

5. Take out a loan… 

• Personal/Unsecured Loan. You can get a loan from a bank or consumer-lending startup. These are loans that are not collateralized against assets. The bank will look at your income, liquid assets, total net worth, and overall financial picture to underwrite you. The downside is you typically can’t borrow that much (these loans usually top out at $60-100k) which doesn’t help if you have a large exercise bill. Personal loans can also come with very high interest rates (~20% or higher). Keep in mind that these loans are full recourse, meaning if the value of your shares tank or your company never exits, you’re still on the hook for the loan. 

• Non-recourse loan. With this type of loan, borrowers can use their company equity as collateral in exchange for cash to cover exercise costs and estimated taxes. The borrower is expected to repay the loan with the profits from a sale event after their company IPOs. The big upside is that if their company fails, the borrower won’t owe anything out of pocket. Besides the fees involved (origination fee: ~2-5% and annual interest rate of ~5-10%), borrowers should consider the upside they’d be giving up. For example, the repayment of the loan amount may require ~5%-25% of the upside at a future liquidity event. Lenders for these types of loans perform an intensive vetting process. They usually look for later-stage companies that they believe will have a successful exit. Note that there may be tax limitations with non-recourse loans per Internal Revenue Service (IRS) regulations; however, there are loan providers that structure this as other instruments like non-recourse forward contracts. 

• Home Equity Line of Credit (HELOC). If you own a home, you may be able to borrow against equity in your home. These loans typically have better interest rates ~4-6% (indexed to the prime rate plus a spread) compared to other loans. You can also usually borrow a larger amount because you’re using your home as collateral. The downside is that your house is on the line, meaning if your shares become worthless, you’ll still be responsible for making these payments until the loan is paid off or risk losing your house.

• Margin Loan. AKA a securities based line of credit, this loan allows borrowers to use their securities as collateral. There are some limitations as to which accounts you can draw from and how you use the funds. For example, you can’t pledge assets from retirement accounts, like IRAs or 401(k)s. If the securities you pledge as collateral lose value, you may be paying out of pocket to cover the deficit. (This is known as a margin call). Keep in mind that some lenders may require a minimum advance, and you can expect interest rates of ~2-9%. 

Bottom Line

If you’re in need of financing options to exercise your equity (and/or to pay for the associated taxes), there are a few different avenues to explore. It’s important to understand the overall costs and risks associated with each route. Consult with your Financial Advisor to determine the best option for you.