Exercising Options: what you should know

Why does an employee have to pay to Exercise their Options?

If you’re reading this, it might be because you’ve received an offer as part of your employer’s Employee Share Option Plan (ESOP). Congrats!

ESOPs are a win-win for you and the company. You get a slice of equity which keeps you motivated to make the company a success. The harder you work, the more valuable your piece of cake becomes. And, once you become a shareholder, you’ll be entitled to a slice of the profits of any exit event, like a sale of the company.

In order to turn your options into shares, you'll eventually need to 'exercise your options'. No, this doesn't mean they need to hit the gym. We've summarised the answers to the questions we hear most often for you here!

What does it mean to 'Exercise your Options'?

Exercise refers to the process of converting a Vested Option into an ordinary share. An Option can be Exercised when the Option has Vested, and the Exercise Price is paid.

Exercise Period refers to the period in which an employee can Exercise Options. Often, an employee won’t Exercise Options straight after Vesting, and will wait to Exercise them later on (for example, at an exit).

Exercise Price means the amount to be paid by the employee to Exercise the Option. In many countries, an approved valuation is required to determine this price. This is often also referred to as a Strike Price.

Why does an employee have to pay to Exercise their Options?

The need to pay an Exercise Price often confuses ESOP recipients. And rightly so, it’s a little complicated. Let us explain.

Your Offer Letter will set out the Exercise Price which must be paid to Exercise the Options (to convert them into stocks). The Exercise Price usually represents the market value of the Options at the time of the offer.

However, one of the advantages of an ESOP can be the ability to use a valuation method that can drastically reduce the valuation (and your Exercise Price).

A company may be able to set the Exercise Price at $0.01 per option, even where the company is doing very well, if the relevant tax rules in your jurisdiction allow for it.

For example;

If an employee received $25k worth of options, it would not make sense for the employee to have to pay $25k cash to exercise those options. That’s why these valuation rules exist.

To resolve this problem, an ESOP can be structured such that:

  • the Exercise Price is calculated by an approved method, resulting in the Exercise Price being much lower than $25k ; or
  • the employee can hold off on exercising the options until there is value in doing so (for e.g. an exit event where the price they will receive will be much greater than the Exercise Price)

Alternatively, if you leave the company your employer could buy your Options back from you at the increased value. It’s usually at the company’s discretion as to whether they will buy the options back from you when you leave, so this is something to discuss with your employer.

TL;DR

Vested Options can be Exercised (or converted) into shares. To Exercise the Options, you will need to pay the Exercise Price. Once the Options become shares, they are afforded all the same rights as the shareholders (voting, dividends etc).

Generally, you won’t actually Exercise your Options, until there is immediate value in doing so – i.e. an Exit Event is likely to occur.

We suggest you read your Offer Letter together with the Plan Rules and discuss both with your employer. If you still have questions, we recommend seeking independent advice.

If you liked this article and want to learn more about your options, check out our comprehensive ESOP guide for employees.

This blog is designed and intended to provide general information in summary form on general topics. The contents do not constitute legal, financial or tax advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.