5 Methods for Financing the Exercise of ISOs or NSOs
For as long as tech companies exist, tech companies will continue to offer employee stock options. Under the umbrella of employee stock options you’ll find Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs).
One of the challenges of receiving either ISOs or NSOs is that before you can actually receive any value from them, you will need to exercise them (i.e. purchase shares). Depending on several factors specific to your situation, the exercise price you will need to pay could either be dirt cheap or could break the bank.
Because not everyone can afford to pay cash for their options, we’re often asked, “What are some ways I can finance the exercise of my options?” or “What loan can I get to exercise my options?”
The purpose of this article is to provide you with five different methods to finance the exercise of your options and to discuss some of the pros and cons of each.
Method #1 for Financing ISO and NSO Exercise - Pay Cash
The first and most common method for financing an ISO or NSO exercise is to pay cash.
This option is so obvious that you may be annoyed to be reading it here; however, the reality is that while paying cash to finance the exercise of ISOs and NSOs is the most common method, it comes with some cons that are often overlooked.
Pros of Paying Cash to Finance ISO and NSO Exercise
It’s simple. As long as you have the cash to exercise an ISO or NSO, it’s simple to arrange for the exercise.
There are no interest charges. Paying cash to exercise ISO and NSOs means that you would not owe anyone any interest.
You won’t have to give up equity. We’ll get into this a bit later in the article, but should you decide to go with an option other than paying cash, it’s common that you’ll need to give up a (sometimes sizable) slice of your equity pie.
Cons of Paying Cash to Finance ISO and NSO Exercise
You won’t see your cash again until you sell. This applies to every form of financing option but, especially if you’re putting up your cash, you’ll want to have a really good idea of what that future timeline looks like.
Your capital is at risk. Exercising ISOs or NSOs with your cash means that if the company you work for goes under, the only thing you’ll be able to receive is some capital losses on your tax return. Some of the methods to finance the exercise of ISOs and NSOs do not require any risk on your part, but (as we’ll discuss later) will require some forfeiture of future gains.
You might need your cash for other things. Everyone’s situation is different, but coming out of pocket to exercise tens of thousands of ISOs or NSOs may not be in your budget.
Method #2 for Financing ISO and NSO Exercises - Tender Shares Via Net Exercise or Stock Swap
This is technically two methods rolled into one. Net Exercises and Stock Swaps are different methods built on the same idea. Not all companies allow these methods, so you’ll want to check with HR or the Equity Plan Administrator to see if either is available.
A Net Exercise allows employees to exercise ISOs or NSOs by letting the company withhold shares for you.
A Stock Swap is where the company allows employees to pay the option price by offering other shares that you own outright.
Pros of Tendering Shares to Finance ISO and NSO Exercise
You won’t have to fork over any cash. If keeping cash on hand is a priority, this method allows you to give up shares instead of cash.
You can get a benefit before the company goes public. Tendering shares to exercise ISOs or NSOs can happen before a company goes public, which means you’re able to extract a benefit before you’d normally be able to. This benefit is even greater if the current market value of your shares is higher than your exercise price.
You can tender shares but keep tax preferential treatment (sometimes). Swapping shares can be a complicated process, but it’s possible to offer up shares from a previous ISO exercise to exercise NSOs, but then designate the NSOs you’ve received, back to the ISO designation you used to have. (This one is super tricky, so please consult with a tax advisor and your company’s legal team to ensure this option is available to you.)
Cons of Tendering Shares to Finance ISO and NSO Exercise
Giving up shares means you’ll give up some future appreciation. The reason you are exercising ISOs or NSOs is because they’ve appreciated a lot or are expected to appreciate. Giving up shares means that if the stock price increases significantly, you’ll miss out on some growth.
It’s complex. Depending on the way it’s carried out, it can add significant complexity in both administration and taxes.
Method #3 for Financing ISO and NSO Exercises - Use EquityBee, SecFI, or ESOFund
If you’ve Googled information about your stock options, you’ve likely noticed that EquityBee, SecFI, and ESOFund are all at the top of the paid search results. Each operates a bit differently, but the basic gist is the same. They provide you the cash to exercise your options and pay taxes and, in exchange, they’ll either ask for some percentage of the equity you’ll own or they’ll ask that you give them cash equivalent to some return of investment they’re seeking.
Pros of Using an EquityBee (or Equivalent) to Finance ISO and NSO Exercises
You don’t need to use your own cash. In most instances, these companies will not require you to front any cash. This means that you can keep your emergency fund intact and take advantage of any growth in your company’s share price.
They take on all of the risk. Usually these deals are structured in such a way that you won’t owe them money if your company never IPOs or it goes out of business. So if you’re okay giving up some return for zero risk on your part, it could be a good option.
You can usually negotiate the percentage they take. As more of these companies pop up, it’s likely to lead to more bargaining power for option holders. You may not be willing to give up 15% of your equity to keep your cash liquid and avoid some risk but, if you were only required to give up 5% or 6%, that might just tip the scale for you.
Your company may not need to be involved. In the case of EquityBee, your company won’t ever be notified about how you’re financing the exercise of your options.
Cons of Using an EquityBee (or Equivalent) to Finance ISO and NSO Exercises
They take a cut of your profits. To stay in business, companies need to make money. These companies make money by taking a portion of the future profits.
Providing them with all the necessary information they need can be a bit cumbersome. We’ve helped people through the process and it can be inconvenient and time-consuming (especially if you’re trying to shop around).
They may not be interested in companies that are 2-4 years out from IPO. Companies that offer financing for option exercises are looking for a pretty clear path to a payday. If there’s a lot of uncertainty, you can expect that they’ll charge you for it.
Method #4 for Financing ISO and NSO Exercises - Use Margin on Your Investment Account
If you have a brokerage account, you can ask your broker (Vanguard, Fidelity, Charles Schwab, etc.) to add Margin to your account. All Margin does is give you the ability to borrow against your portfolio. There are percentage limits that you can go up to, and that can vary, but if you’re planning to borrow against your portfolio to exercise options, you’re limited to 50% of your investment balance.
We want to call out that this method is not risk-free and brokerages will charge interest. If the value of your portfolio drops significantly, the brokerage has the right to sell your investments to pay off some or all of your margin balance.
What’s nice is that you can find good margin rates out there. M1 Finance is an up-and-coming brokerage and they are offering very competitive rates, even with the recent interest rate hikes you’ve probably heard about.
Pros of Using Margin to Finance ISO and NSO Exercises
The interest rates are usually pretty affordable. With all the competition out there, the interest rates you can lock in are usually reasonable.
Dividends and interest earned should automatically be applied to the margin balance. If you have a sizable investment account, you can set your dividends and interest to automatically pay down your margin balance.
The interest you’re charged should be deductible. Assuming you itemize deductions, there’s a good chance that the interest you’re incurring from having a margin balance is deductible. Note that there are some limits, but your CPA or TurboTax should be able to help you with this.
You don’t have to sell investments. If you’re tight on cash and would need to sell investments to fund your exercises, margin can be a great option because it allows you to put off having to sell other appreciating investments.
Cons of Using Margin to Finance ISO and NSO Exercises
You have to have other investments. This is only an option to you if you have an investment account with a pretty sizable balance.
You will have to pay interest. Just like with any loan, you’ll have to pay interest. The rates are usually fair, but still, nobody likes paying interest.
Interest rates go up based on the fed funds rate. Most brokers will offer a rate that is some percentage higher than what the fed funds rate is. In a rising-interest-rate environment (like the one we’re in now), this means that your margin interest rate will go up as rates rise.
You could become subject to a margin call. If the investments you’ve borrowed against drop in value and your outstanding margin balance is more than 50% of your current account value, your brokerage may sell off investments to pay down your balance.
Method #5 for Financing ISO and NSO Exercises - Use a Home Equity Line of Credit (HELOC) to Finance ISO and NSO Exercises
If you own a home you can create a line of credit that’s backed by the equity in your house. Most people use them for home renovations or other repairs, but a HELOC can be used to help finance the exercise of ISOs and NSOs.
This method should only be considered if you’re in a strong enough financial situation to be able to repay the HELOC even if your option exercises were to become worthless.
Pros of Using a HELOC to Finance ISO and NSO Exercises
Rates tend to be affordable. Usually the interest rates on a HELOC are pretty affordable since this type of loan is collateralized by your house.
They are easy to set up. HELOCs are easy to set up and you aren’t limited to just your mortgage provider. You’re able to shop rates to find something competitive.
Cons of Using a HELOC to Finance ISO and NSO Exercises
You could lose your house if you don’t repay the HELOC. This is probably the biggest Con discussed in this article. You don’t ever want to be in this position, so please only use this method if you can afford to pay down the HELOC without too much difficulty.
Typically results in a hard-pull on your credit. As with any loan, the lender will need to check your credit which can lead to a short-term ding on your credit score.
Final Thoughts on Financing ISO and NSO Exercises
We’ve discussed five methods to finance ISO and NSO exercises, but there are others. It’s possible to do other sorts of pledged-asset lines or even create an agreement with a family member. Each individual’s situation is different and it’s up to you to evaluate which of the many options will work best for you. We’re here to help, but also highly recommend seeking out a fee-only advisor or a CPA with expertise in this area. Happy to provide you a referral if needed.