how do stock options work in a privately-held company

How stock options work in a privately held company

Quick answer: "how do stock options work in a privately held company" refers to employee or service‑provider equity compensation in private (non‑public) firms — options are granted as a right to buy common shares at a set strike price, vest over time, require an exercise to convert into shares, face valuation and liquidity limits (no public market), and have specific U.S. tax consequences and exit outcomes.

This article answers the central question — how do stock options work in a privately held company — with a step‑by‑step overview tailored for employees, founders, and service providers. You will learn core terms, the differences between ISOs and NSOs, how strike prices are set (409A/FMV), how and when to exercise, tax implications (including 83(b) and AMT), liquidity routes (secondary sales, IPO, M&A), and practical decision frameworks. Where relevant, this guide cites industry resources and suggests actions you can take to manage risk and tax exposure.

As of 2024-06-01, according to Carta’s public guide on employee stock options, the topics covered here reflect common U.S. private‑company practices and tax rules. As of 2024-05-15, Nasdaq Private Market and EquityZen resources confirm the same liquidity and secondary market constraints discussed below.

Basic concepts and terminology

If you’re asking how do stock options work in a privately held company, start with the vocabulary. These are the building blocks for understanding grants and decisions.

• Grant: the formal award of options to you under the company’s stock plan.
• Option: a contractual right to buy a specified number of shares at a predetermined price (the strike or exercise price).
• Strike / Exercise price: the per‑share price you pay when you exercise the option to acquire stock.
• Vesting: the schedule by which your right to exercise options becomes earned (e.g., over four years with a one‑year cliff).
• Exercise: the act of paying the strike price (and any taxes) to convert options into actual shares.
• Expiration: the final date options can be exercised; options lapse afterward.
• Option pool: the shares reserved by the company for employee grants and other incentives.
• Common vs. preferred shares: employees normally receive common stock upon exercise; investors typically hold preferred shares with special rights.
• Bargain element: the difference between FMV (fair market value) and the strike price at exercise — important for tax calculations.
• Cap table impact: issuing shares upon exercise dilutes existing shareholders and changes ownership percentages.

Option vs. share vs. restricted stock/RSU

Options are a right, not an ownership stake. Exercising turns that right into shares (common stock), with voting and economic rights thereafter.

• Options: give the right to buy shares later at a predetermined price.
• Shares (common stock): actual ownership; entitles holders to dividends (if any) and vote if provided.
• RSUs (Restricted Stock Units): a promise to deliver shares (or cash) at vesting; no exercise step, usually taxed as ordinary income when delivered.
• Restricted stock: actual shares issued up front but subject to vesting and transfer restrictions; often eligible for an 83(b) election.

Understanding the difference helps answer "how do stock options work in a privately held company" in practice: options defer ownership until exercise and are more common in early startups where granting ownership immediately would be administratively or tax‑wise undesirable.

Types of option awards commonly used in private companies

Private companies generally grant two primary types of options for U.S. recipients, plus other equity instruments.

• Incentive Stock Options (ISOs): tax‑preferred for employees only, subject to strict rules (grant limits, holding periods, and AMT exposure). ISOs can yield capital gains treatment if holding rules are met.
• Non‑Qualified Stock Options (NSOs/NQSOs): more flexible, can be granted to anyone (employees, consultants, advisors), and trigger ordinary income on exercise equal to the bargain element.
• Stock Appreciation Rights (SARs) and Phantom Equity: alternatives that pay the increase in value without requiring share transfer; sometimes used to avoid dilution or complexity.

How do stock options work in a privately held company depends partly on the award type: ISOs may have favorable tax outcomes but are constrained (and create possible AMT issues); NSOs are simpler but usually result in taxable ordinary income at exercise.

The grant: strike price, number of options, and documentation

A grant letter or option agreement specifies:

• Number of options awarded.
• Strike/exercise price (per share).
• Grant date and plan under which the grant is made.
• Vesting schedule, exercise window, and expiration.
• Transferability and repurchase rights.

The company’s stock option plan (approved by the board and sometimes shareholders) sets the rules. Read both the plan and your individual grant agreement to answer personal questions about "how do stock options work in a privately held company" — these documents determine your rights and obligations.

Valuation and how the exercise (strike) price is set — 409A and FMV

Private companies must set a defensible FMV for common stock to avoid adverse tax consequences. In the U.S., companies typically use a 409A valuation from a qualified independent appraiser.

• 409A valuation: an independent appraisal to determine FMV of common stock for option pricing and tax compliance.
• How often: commonly updated every 12 months or sooner after a material event (financing round, major valuation change).
• Why it matters: setting a strike price below FMV can create immediate tax liabilities and penalties for option recipients and plan sponsors.

If you’re wondering how do stock options work in a privately held company, know this: the strike price is usually set at or above the 409A FMV to avoid taxable issues. A defensible 409A reduces audit risk and protects ISOs/NSOs from adverse adjustments.

Vesting schedules and acceleration

Typical vesting patterns in private companies:

• Four‑year vesting with a one‑year cliff (25% after year one, then monthly or quarterly thereafter).
• Alternative schedules: senior hires might get accelerated vesting or milestone‑based vesting.

Acceleration triggers:

• Single‑trigger: immediate vesting upon a qualifying event (e.g., acquisition) — less common because it can be costly or opposed by investors.
• Double‑trigger: acceleration occurs after a change of control plus termination without cause (more common and investor‑friendly).

Vesting impacts the answer to "how do stock options work in a privately held company" because unvested options are usually forfeited on departure unless early exercise is allowed or special acceleration applies.

Mechanics of exercising options

Exercising options means: you pay the strike price (and sometimes taxes) and the company issues shares to you.

Common exercise methods:

• Cash exercise: paying the full strike price in cash.
• Cashless exercise / same‑day sale: not typically available in private companies unless there is liquidity (secondary market or company buyback), where shares are sold immediately to cover strike and taxes.
• Sell‑to‑cover: a partial sale to cover exercise costs when liquidity exists.
• Early exercise: some companies allow exercising unvested options early; this creates vested shares subject to repurchase (and may enable an 83(b) election).

When figuring out how do stock options work in a privately held company, remember: exercising creates actual ownership but also exposes you to liquidity and tax timing issues because you now hold illiquid shares (unless a secondary/liquidity event occurs).

Post‑termination exercise periods and expiration

Typical rules:

• Standard post‑termination exercise (PTE) window: 90 days for most option plans — after that, unexercised vested options typically expire.
• Extended exercise programs: some companies offer 1‑2 year extensions or unlimited post‑termination exercise (rare but increasingly offered to attract talent).
• Expiration date: typically 10 years from grant date, but plan rules may vary.

For employees asking how do stock options work in a privately held company, pay attention to the PTE window — failing to exercise within it can result in losing vested options forever. Companies sometimes charge accelerated repurchase rights or impose repurchase at cost for terminated employees.

Tax treatment (U.S. focus) and elections

Taxes are one of the most important considerations when learning how do stock options work in a privately held company.

ISOs vs. NSOs overview:

• NSOs: on exercise, the bargain element (FMV at exercise minus strike price) is taxable as ordinary income and subject to payroll withholding for employees; employer reports income on Form W‑2.
• ISOs: no regular income tax on exercise for qualifying ISOs, but the bargain element may trigger the Alternative Minimum Tax (AMT). If you hold ISO shares for at least two years from grant and one year from exercise before selling, gains can qualify for long‑term capital gains.

83(b) election:

• If you early‑exercise options and the company issues restricted shares, you can file an 83(b) election (within 30 days of issuance) to be taxed on the value at exercise (often low), enabling future appreciation to be taxed as capital gains if holding requirements are met.
• Risks: if the company fails, an 83(b) election does not entitle you to a refund of taxes paid; file carefully.

Reporting and withholding:

• Employers typically must withhold for NSOs; ISOs have different reporting rules but may require withholding on disqualifying dispositions.

Given complexity, ask a qualified tax advisor about your specific situation. The way taxes are applied is a core part of any answer to how do stock options work in a privately held company.

Liquidity: selling private company shares and secondary markets

Major constraints in private companies:

• No public market: shares are illiquid until a qualified liquidity event (IPO or sale) or permitted secondary sale.
• Transfer restrictions: plan and charter often restrict transfers and require board approval.
• Right of first refusal (ROFR): the company or investors may have ROFR, allowing them to buy shares before a third party.
• Company buybacks and tender offers: some companies occasionally purchase shares back from employees.
• Private secondary markets: platforms and brokers may facilitate private share sales subject to company approval.

Understanding how do stock options work in a privately held company includes knowing that monetization options can be limited and contingent on board/investor consent and market conditions.

Exit events and option outcomes (IPO, M&A, liquidation)

How options convert at exits:

• IPO: companies often convert options into the right to purchase publicly tradable shares; vesting may continue or accelerate depending on plan terms and lock‑ups.
• M&A (acquisition): outcomes include cashing out options (cash payment for vested/unvested options), assumption of options by acquirer, or acceleration/repurchase. Double‑trigger acceleration is common.
• Liquidation: in a liquidation, preferred shareholders often have preference; common shareholders (including employee option holders after exercise) may receive little or nothing.

Exit scenarios answer a critical part of how do stock options work in a privately held company: options only have value if the underlying common stock has value and sufficient proceeds flow to common holders after preferences are satisfied.

Financing option exercises and managing cash/tax needs

Employees often lack the cash to exercise options and pay taxes. Common approaches:

• Personal funds: pay cash for strike price and taxes.
• Loans: borrow from banks, friends, or specialized lenders to fund exercise (risky if company fails).
• Exercise financing: third‑party lenders provide loans secured by the shares (requires board approval and can create lien issues).
• Sell‑to‑cover on a secondary: if a secondary market exists, sell enough shares to pay strike and taxes.
• Company loan programs: some companies provide loans or buybacks to help employees exercise.

Tax planning:

• Time exercises to manage AMT exposure for ISOs.
• Use an 83(b) election on early exercises when appropriate.
• Diversify: avoid overconcentration of net worth in employer equity.

Answering how do stock options work in a privately held company includes these practical funding and tax planning steps — exercises are not just mechanical but financial decisions with risk.

Employer perspective: plan design, dilution, accounting and governance

Why companies grant options:

• Attract and retain talent, align employee incentives with company performance, and conserve cash.

Plan design choices:

• Size of option pool determines dilution; investors negotiate pool size during financing rounds.
• Board approvals and grant administration are required to maintain governance and compliance.

Accounting and expense:

• ASC 718 / stock‑based compensation: companies must estimate the fair value of awards and record expense, which affects reported earnings.

Governance issues:

• Repricings, plan amendments, and grant policies require board oversight and, sometimes, shareholder approval.

Understanding how do stock options work in a privately held company includes recognizing the company’s trade‑offs between dilution, cost, and incentives.

Common contractual terms, restrictions and corporate mechanics

Typical clauses in grants and plans:

• Transferability: usually prohibited except by will or family transfer.
• Repurchase / right to buy back: company may repurchase shares upon termination at cost or fair value.
• Forfeiture: unvested options are typically forfeited on termination.
• Repricing: companies may reprice or exchange underwater options subject to board and, sometimes, shareholder approval.
• Change‑in‑control provisions: define acceleration or treatment of options upon sale or IPO.

These mechanics determine the practical answers to how do stock options work in a privately held company for ordinary employees and executives.

Practical strategies and decision factors for option holders

When deciding whether and when to exercise or sell, consider:

• Strike price relative to FMV and upside potential.
• Liquidity prospects: is there a near‑term secondary, IPO, or buyout likelihood?
• Tax consequences: NSO ordinary income, ISO AMT risk, and 83(b) timing.
• Diversification needs: avoid overexposure to employer stock.
• Personal cash flow and risk tolerance: can you afford to lock up funds in illiquid shares?

A simple decision framework:

1. Confirm grant details and FMV (409A).
2. Model tax outcomes under likely scenarios (NSO exercise today vs later; ISO AMT outcomes).
3. Assess liquidity timeline and probabilities.
4. Consult a tax advisor, and consider exercising only when benefits outweigh liquidity and tax risks.

This pragmatic approach helps answer "how do stock options work in a privately held company" as applied to personal financial planning.

Example calculations and illustrative scenarios

1. Intrinsic value and simple gain (post‑liquidity):

• Grant: 10,000 options at $1.00 strike. Post‑IPO share price: $10.00.
• Gross intrinsic value at sale: (10 - 1) * 10,000 = $90,000.

1. NSO exercise taxable income example:

• If FMV at exercise is $5 and strike is $1 on 10,000 NSOs, ordinary income = (5−1) * 10,000 = $40,000, reported on W‑2.

1. ISO + AMT example (simplified):

• ISO bargain element at exercise (if exercised and not sold) may be added to AMT income. If bargain element is large, AMT may be triggered even though no regular tax event occurred.

1. Vesting timeline example:

• Grant date: Jan 1. Four‑year schedule with 1‑year cliff. After 18 months you vest 25% + 6 months of monthly vesting = x options vested. This affects ability to exercise and exposure.

Real calculations should use exact FMV, strike, and personal tax rates. These examples illustrate the mechanics behind "how do stock options work in a privately held company".

Risks, limitations and frequently encountered pitfalls

Major risks:

• Illiquidity: inability to sell shares when needed.
• Valuation uncertainty: 409A updates may raise FMV, increasing tax at exercise.
• Tax surprises: AMT for ISOs, ordinary income for NSOs, and missed 83(b) deadlines.
• Company failure: equity can become worthless.
• Expiration risk: failing to exercise before expiry or PTE window can forfeit value.

Avoid common pitfalls by understanding plan documents, tracking deadlines (83(b) 30‑day window, PTE windows), and consulting advisors.

Special topics and advanced issues

• Early exercise + 83(b): can lock in low tax basis early but carries risk if the company fails.
• Option exchanges: companies sometimes exchange old underwater options for new grants; legal and tax consequences exist.
• Extended exercise programs: some companies offer longer PTE windows to attract talent.
• Secondary market compliance: private sales often require legal reviews and securities compliance; board approval is typical.
• International tax/residency: non‑U.S. employees face different tax rules and withholding obligations; consult local counsel.

These advanced topics refine the general answer to how do stock options work in a privately held company for special cases.

Frequently asked questions (FAQ)

Q: What is my strike price? A: The grant letter and option agreement specify the strike/exercise price. It is often set at or above the company’s 409A FMV on the grant date.

Q: Can I sell my shares if the company is private? A: Only with company approval, and subject to ROFR and transfer restrictions. Secondary markets or company buybacks are possible but not guaranteed.

Q: What happens if I leave the company? A: Vesting stops, and you typically have a limited PTE period (often 90 days) to exercise vested options; unvested options are usually forfeited.

Q: How long do options last after termination? A: Standard is 90 days, but some companies offer extensions; check your plan and grant agreement.

Q: Should I file an 83(b)? A: Only if you have early‑exercised into restricted shares and expect meaningful appreciation; filing must occur within 30 days of issuance. Consult a tax advisor.

Further reading and primary resources

• Company plan documents and your grant agreement (primary authority for your rights).
• 409A valuation firms and tax advisors for FMV and tax planning.
• Industry guides (Carta, Nasdaq Private Market, EquityZen, NerdWallet) for practical explanations and liquidity market insights.

As of 2024-06-01, Carta’s public guide remains a core primer for option mechanics. As of 2024-05-15, Nasdaq Private Market and EquityZen provide practical secondary liquidity context. For up‑to‑date regulation and tax details, consult IRS guidance and a qualified tax professional.

Glossary

• 409A: IRS code section governing nonqualified deferred compensation and valuations for private company stock.
• FMV (Fair Market Value): appraised value of common stock used to set strike prices.
• ISO: Incentive Stock Option.
• NSO/NQSO: Non‑Qualified Stock Option.
• AMT: Alternative Minimum Tax.
• ROFR: Right of First Refusal.
• Cliff: initial period before any vesting occurs.
• Vesting: schedule by which options become exercisable.

Next steps and resources

If you want to act on your options: read your grant agreement and company plan, get your latest 409A valuation, and consult a tax advisor. For managing exercised shares and secure custody, consider Bitget Wallet for secure storage, and explore Bitget services for trading when shares become liquid on approved markets.

Explore Bitget resources and talk with your HR or equity administrator to confirm plan specifics and to learn if your company supports secondary transactions or exercise financing.

Further practical help: contact your company’s stock plan administrator, request a copy of the 409A, and speak with a qualified tax advisor before major exercises or 83(b) elections.

Closing invitation

Want tailored guidance on your specific grant? Review your grant documents, track key deadlines (83(b) 30 days, PTE windows), and consult a tax professional. To secure and manage tokens or crypto proceeds from future liquidity events, consider Bitget Wallet and Bitget exchange services as part of your broader financial toolkit.

Remember: knowing how do stock options work in a privately held company is the first step; managing liquidity, taxes, and concentration is where planning pays off.

Sources and recommended reading (selected): Carta; Nasdaq Private Market; NerdWallet; EquityZen; Morgan Stanley at Work; J.P. Morgan Workplace Solutions; Industry tax guides. As of the dates cited earlier, these provide practical guides and market context.