A cashless exercise is a transaction in which employee stock options are exercised without making any cash payment. Such a transaction utilizes a broker to provide a short-term loan so that the employee exercising the options has enough money to do so. Once the loan to exercise the options is in place, the employee then sells enough shares to pay back the broker for the loan, broker fees, and taxes. The person exercising the options then possesses the shares.
Breaking Down Cashless Exercise
Cashless exercise, also referred to as a "same-day sale," is similar to buying on margin. A cashless exercise is done primarily with public companies because they have a secondary market to provide easy liquidity. It may sometimes be used with private companies, however. Cashless transactions such as this have become the most popular way to exercise options for employees who are eligible to participate in an employee stock option plan (ESOP). In many such plans, employees are not required to convert their options all at once. It can make sense to hold back on a portion of options to set aside money to pay taxes on capital gains, however.
Cashless Exercise: Step by Step
- An employee decides to exercises their option to purchase a quantity of shares. A broker is enlisted to provide a short-term loan to fund the purchase.
- A quantity of shares sufficient to pay for transaction costs and any tax bill associated with the transaction must be sold.
- The employee receives the stock and any cash remaining after the sale is executed, taxes are paid, and the broker is paid back for the loan, as well as its commission.
- Proceeds from such an exercise would receive favorable tax treatment provided that a few conditions are met, such as whether the employee had held the shares for at least one year from the exercise date and two years from the grant date. If those requirements are not met, the proceeds would then be treated as ordinary income, as it would constitute a disqualifying disposition.
Most private companies cannot accommodate a cashless exercise because they lack a secondary market for liquidity. Instead, they may be able to assist with a cashless exercise by using promissory notes, a surrender of stock or net exercising. Promissory notes are essentially loans, similar to the loan a broker would provide in a regular cashless exercise. Surrender of stock—assuming the employee holds shares of common stock in the private company—involves giving up enough shares to equal the fair market value of the option shares. Similarly, net exercising trades in a portion of option shares to buy shares outright.