Turning Pre-IPO Stock Options Into Cash

An offer that includes stock options often describes their value in terms of dollars. But an option isn't money, and it isn't even stock. It's the right to buy shares at a fixed price. Turning that right into cash takes several steps, and at a private company, you control only some of them.

Your options become shares when you exercise them: you pay your strike price, and the shares are yours. Shares become cash when someone buys them from you, or when the company is sold. Before an exit, selling is possible but limited. Some companies run tender offers, and private marketplaces match buyers and sellers, but both mostly involve later-stage companies, and a sale typically needs the company's approval. So the step you control is the first one: whether and when to exercise. That decision is where most of the cost, risk, and tax planning sits, and it's the focus of this module.

Turning options into cash costs you two things:

• the cost to exercise (your strike price times the number of shares)
• the tax on your gain.

How Stock Options Work covers the basics: vesting gives you the right to buy shares at your strike price, and the spread is the gain built in when you exercise. The cost to exercise works the same way for every option, and you always pay it when you exercise. How ISOs and NQSOs Differ explains the tax differences shown in the chains below. With the non-qualified stock option (NQSO) portion, the spread is taxed when you exercise, and any later gain is taxed when you sell. With the incentive stock option (ISO) portion, tax generally waits until you sell, though the alternative minimum tax (AMT) can apply when you exercise. And as Why Your Option Grant May Be Split Between ISOs and NQSOs showed, one grant can follow both chains.

Read together, the chains show one difference and one similarity. The difference is in the step you control, exercising: what it costs you depends on the type of option, as the next section explains. The similarity is in the step you don't control, selling: either way, the sale waits for a buyer and the company's approval. That’s what makes the decision to exercise hard. When you exercise, you pay now, on a date you choose, without knowing when, or whether, you'll be able to sell.

Deciding whether and when to exercise

At a public company, you control when you exercise your options and when you sell your shares (within your company's trading windows). At a private company, you control only the first step. Exercising means buying shares you probably can't sell for some time. So you're weighing four things at once: how much cash you can tie up, what tax you may owe before you can sell, the risk the shares lose value while you wait, and the deadlines that can force your hand.

How much cash you can tie up

Your cost to exercise is your strike price times the number of shares, paid in cash. Unlike a public company, you usually can't sell some of the shares to cover the cost. A private sale needs a buyer and the company's approval, and that takes time even when both are available. Whatever cash you pay stays tied up until you can sell.

What tax you may owe before you can sell

• Tax on the NQSO portion. The spread at the time you exercise is taxed as ordinary income in that year. At a private company, you'll usually need cash to pay that tax, on top of the cost to exercise.
• Possible tax on the ISO portion. There's no ordinary income tax when you exercise an ISO. But the spread counts as income under the AMT, a separate tax calculation that runs alongside the regular one and can produce a bill in the year you exercise.

The cost to exercise never changes: it's fixed by your strike price. The spread likely changes, because the 409A valuation is updated over time, typically once a year and after each funding round. When the company is growing, those updates tend to push the value up. (but it can also fall.) A higher 409A value means a larger spread, which also means more tax at exercise on the NQSO portion and more potential AMT on the ISO portion.

The risk the shares lose value while you wait

Whatever you pay to exercise is invested in one private company's common stock. Its value can fall. If the company fails, or is sold for less than investors put in, the shares may be worth little or nothing, since holders of preferred stock are typically paid first under their liquidation preference. The cash you paid to exercise, and any tax you paid at exercise, are at risk along with the shares.

The deadlines that can force your hand

• Option expiration. Every option has an expiration date on its grant notice, often ten years after the grant date. Fathcarr's original grant expires March 1, 2035. Options not exercised by then are gone.
• The exercise window after you leave. When you leave the company, vested options usually have to be exercised within a set period, commonly about 90 days, or they're forfeited. That can mean finding the full cost to exercise, and any tax, on short notice. Some companies offer longer windows. Separately, the tax code requires ISOs to be exercised within three months of leaving to keep ISO treatment. After that, they're taxed as NQSOs, even if the plan gives you longer.

Take the Fathcarr Technologies grant: 20,000 ISOs at a $10.00 strike price, with the first 5,000 vesting March 1, 2026. Here's what exercising those 5,000 looks like at two points in the same year.

The cash to buy the shares is the same. The spread is nearly three times larger after the funding round. Because these are ISOs, there's no ordinary income tax at exercise either way, but the larger spread means more potential AMT. If they were NQSOs, exercising after August 20 would take the $50,000 cost to exercise plus cash for the tax on the $20,000 spread.

That's the reasoning behind a common move: exercising vested options ahead of an expected funding round, to lock in the smaller spread. The rationale is valid, but there are three considerations before you pull the trigger:

• The funding round prices preferred stock, not your common stock. The new 409A value for your common stock will usually rise, but it typically stays below the price investors pay.
• The window can close before you act. The tax on your spread is based on the stock's fair market value on the day you exercise. Once a round is underway, often from the signing of a term sheet, the old 409A value may no longer count, and some companies pause exercises until a new valuation is done. Executives who learn about a round early may find the window has already closed.
• A higher valuation is a signal, not a guaranteed sale. The round itself is investors buying newly issued preferred stock from the company, not your shares. Some companies pair a round with a tender offer that lets employees sell some shares, often at or near the round's price. However, that's the company's choice. It's usually capped at a portion of your holdings and former employees are often excluded. Finally, each new round adds more preferred stock, with its liquidation preference, ahead of your common stock if the company is later sold.

At its core, the decision to exercise vested options is a trade between tax and risk. Exercising sooner usually means less tax, because the spread is smaller, but it ties up cash in shares you can't easily sell that could lose value. Waiting keeps your cash free, but if the company's value keeps rising, so does the tax you'll need to pay when you do exercise.

These decisions turn on your own tax situation, so it's worth talking with a tax advisor before you exercise.

What the holding periods change

For the NQSO portion, the tax at exercise is already settled. When you sell, any gain since exercise is a capital gain, and it's long-term if you've held the shares for more than a year.

For the ISO portion, the timing of the sale decides how the whole gain is taxed. The better result requires holding the shares at least two years from the grant date and one year from the date you exercise.

• Hold through both periods (a qualifying disposition): the entire gain, from strike price to sale price, is taxed as long-term capital gains.
• Sell earlier (a disqualifying disposition): the spread at exercise is taxed as ordinary income after all, and only the gain above it is a capital gain.

This is where the two steps interact. Holding long enough for the ISO advantage means owning shares you can't easily sell while their value moves. And the sale often isn't timed by you at all: it happens when a buyer appears. How ISOs and NQSOs Differ walks through the tax on each path with a worked example.

The last link in the chain, selling, depends on someone being willing to buy. At a private company, that can happen in a few ways, and the company has a say in each of them.

• A company-run tender offer. The company arranges to buy some employee shares, itself or through outside investors, at a price it sets. It decides who can sell and how much. A tender offer has become more common in recent years, mostly at later-stage companies.
• A private marketplace sale. Marketplaces and brokers match sellers of private-company shares with buyers, mostly institutional and high-net-worth investors. This kind of secondary transaction typically needs the company's approval, and the company often holds a right of first refusal: the right to buy your shares itself on the same terms. Prices are negotiated, aren't publicly visible, and can differ from both the 409A value and the price investors paid in the last funding round.
• An IPO. Once the company is public, there's a market for the shares. Sales are typically restricted for a period after the offering under a lock-up period, and then shares can be sold like any public stock.
• An acquisition. The deal terms decide what happens. Shares you already own are bought at the deal price, after preferred stockholders receive what they're owed. Vested options are often cashed out without your exercising them: you receive the difference between the deal price and your strike price. They can also be converted into the buyer's options, or cancelled if the deal price is below your strike price.

Each path has its own timing, restrictions, and tax consequences. What they share is that none of them is on a schedule you set.

Stock options at a private company become cash in two steps: you exercise the option to purchase shares at the strike price, and later someone buys your shares. You decide the first step. The second depends on a buyer and, at a private company, on the company's approval. Everything you weigh about exercising, from the cash it takes and the tax it may trigger to the deadlines that can force your hand, comes from that gap between the step you control and the one you don't. Knowing which options are ISOs and which are NQSOs tells you how each step is taxed. Knowing your deadlines tells you how long you can wait.