Loan to exercise stock options

An employee stock option gives you the right to buy ("exercise") a certain number of shares of your employer's stock at a stated price (the "award," "strike," or "exercise" price) over a certain period of time (the "exercise" period).
Incentive stock options (ISOs) in which the employee is able to defer taxation until the shares bought with the option are sold. The company does not receive a tax deduction for this type of option.
Nonqualified stock options (NSOs) in which the employee must pay income tax on the 'spread' between the value of the stock and the amount paid for the option. The company may receive a tax deduction on the 'spread'.
Employee stock options come in two basic flavors: nonqualified stock options and qualified, or "incentive," stock options (ISOs). ISOs qualify for special tax treatment. For example, gains may be taxed at capital gains rates instead of higher, ordinary income rates. Incentive options go primarily to upper management, and employees usually get the nonqualified variety.
How do Stock options work? An option is created that specifies that the owner of the option may 'exercise' the 'right' to purchase a company's stock at a certain price (the 'grant' price) by a certain (expiration) date in the future. Usually the price of the option (the 'grant' price) is set to the market price of the stock at the time the option was sold. If the underlying stock increases in value, the option becomes more valuable. If the underlying stock decreases below the 'grant' price or stays the same in value as the 'grant' price, then the option becomes worthless.
They provide employees the right, but not the obligation, to purchase shares of their employer's stock at a certain price for a certain period of time. Options are usually granted at the current market price of the stock and last for up to 10 years. To encourage employees to stick around and help the company grow, options typically carry a four to five year vesting period, but each company sets its own parameters.
There are three main ways to exercise options:
You can pay cash, swap employer stock you already own or borrow money from a stockbroker while simultaneously selling enough shares to cover your costs.
It's usually smart to hold options as long as you can.
Conventional wisdom holds that you should sit on your options until they are about to expire to allow the stock to appreciate and, therefore, maximize your gain. In the aftermath of the tech stock swoon, that logic may need some revision. In any event, you should not exercise options unless you have something better to do with the realized gain.
There may be compelling reasons to exercise early.
Among them: You have lost faith in your employer's prospects; you are overweighted on company stock and want to diversify for safety; you want to lock in a low-cost basis for nonqualified options; you want to avoid catapulting into a higher tax bracket by waiting.
Tax consequences can be tricky.
Unlike the case with nonqualified options, an ISO spread at exercise is considered a preference item for purposes of calculating the dreaded alternative minimum tax (AMT), increasing taxable income for AMT purposes.
How do Stock options work? An option is created that specifies that the owner of the option may 'exercise' the 'right' to purchase a company's stock at a certain price (the 'grant' price) by a certain (expiration) date in the future. Usually the price of the option (the 'grant' price) is set to the market price of the stock at the time the option was sold. If the underlying stock increases in value, the option becomes more valuable. If the underlying stock decreases below the 'grant' price or stays the same in value as the 'grant' price, then the option becomes worthless.
They provide employees the right, but not the obligation, to purchase shares of their employer's stock at a certain price for a certain period of time. Options are usually granted at the current market price of the stock and last for up to 10 years. To encourage employees to stick around and help the company grow, options typically carry a four to five year vesting period, but each company sets its own parameters.
Allows a company to share ownership with the employees. Used to align the interests of the employees with those of the company.
In a down market, because they quickly become valueless Dilution of ownership overstatement of operating income.
Nonqualified Stock Options.
Grants the option to buy stock at a fixed price for a fixed exercise period; gains from grant to exercise taxed at income-tax rates.
Aligns executive and shareholder interests. Company receives tax deduction. No charge to earnings.
Dilutes EPS Executive investment is required May incent short-term stock-price manipulation.
Outright grant of shares to executives with restrictions to sale, transfer, or pledging; shares forfeited if executive terminates employment; value of shares as restrictions lapse taxed as ordinary income.
Aligns executive and shareholder interests. No executive investment required. If stock appreciates after grant, company's tax deduction exceeds fixed charge to earnings.
Immediate dilution of EPS for total shares granted. Fair-market value charged to earnings over restriction period.
Grants contingent shares of stock or a fixed cash value at beginning of performance period; executive earns a portion of grant as performance goals are hit.
Aligns executives and shareholders if stock is used. Performance oriented. No executive investment required. Company receives tax deduction at payout.
Charge to earnings, marked to market. Difficulty in setting performance targets.

Playing with Fire: Loans to Exercise Options.
There is a current debate as to whether we are in a period of high valuations, irrational exuberance or a down-right bubble. I don’t know, but I have seen one artifact from the actual bubble rear its ugly head in recent times: the use of loans to exercise stock options. In short, it is an extraordinarily dangerous thing to do with potentially very damaging consequences.
The Basics.
Currently, the federal long term capital gains rate is capped at 20 percent and the income tax rate for top earners is 39 percent. In general, individuals who sell shares that have been held for at least one year are taxed at the lower cap gains rate, while those who sell shares that have been held for less than a year are taxed at the higher income tax rate. This means if your clients receive a stock option and don’t exercise it in advance, they will be taxed at a rate that is 20 percent higher. Accordingly, for startup employees there can be a big tax benefit to purchasing shares so that the lower rate will apply upon a successful exit.
Unfortunately, with today’s high valuations, many employees are unable to afford to exercise their stock options. This is particularly true for higher level employees joining promising startups that already have traction. These folks tend to have large option grants—and such companies have expensive shares—so exercising options is often cost prohibitive for all but the wealthiest employees.
One potential workaround is a loan. A company can loan its employees money to exercise their options. In these situations the money doesn’t even change hands. The employee signs a note promising to pay the company the required exercise amount sometime in the future and the employee uses that note to pay the exercise price of the option. The transaction is neutral to the company and the employee’s tax position is improved. What could possibly be wrong with this?
For one thing, from the Internal Revenue Service’s perspective, the long term capital gains holding period only begins when the shares are “purchased.” If the purported purchase is made by use of a loan, that purchase will only be considered valid if the borrower has a personal liability to pay all or a substantial part of such indebtedness. So if the loan is a nonrecourse loan ( i. e. , the company can only go after the shares as collateral if the loan is not repaid), the IRS does not regard this as a sale. Accordingly, the note holder (the company) must have recourse to the assets of the buyer (the employee) to start the capital gains clock ticking ( i. e. , the borrower will be personally liable for at least a substantial portion of the loan).
The Reality.
Employees entering into such transactions have often gotten comfortable that the loan isn’t “real”; in their minds, the company is certain to be successful so the loan will easily be repaid from the massive proceeds of a stock sale in the inevitable IPO, or (worst case) profitable acquisition. If anything were to go wrong, the management team would work something out with the impacted employees. The problem is what happens when the ship goes down.
While everyone thinks that their startup will be a success, the fact is that many, many startups fail. While some do so in tidy ways that involve the orderly repayment of creditors or an acqui-hire, many simply fold up shop without repaying their creditors. Even with well-intentioned management, startups often find themselves shutting their doors in a situation with assets worth far less than their liabilities. When that happens, the creditors effectively own the company (whether through a formal bankruptcy or another process) and appoint a person acting on their behalf to comb through all the company’s assets to see how they can recover the money they are owed. The loans that employees used to exercise their options are among those assets. Unsurprisingly, the creditors want these notes to be repaid.
I’m writing this because I’ve seen this go wrong—badly wrong. When the technology bubble burst in 2001, many people who had used loans to exercise options ended up being very surprised when those loans came due. First off, the shares that they owned were worthless. Secondly, the board and officers had often resigned en masse, leaving the affairs of the company to be run by a committee of creditors (or a person appointed by such a committee).
These creditor committees were relentless in their desire and ability to extract assets from noteholders. They foreclosed on people’s houses and cars, put liens on bank accounts, and sought garnishment of future wages. The former board members and officers had no authority to stop this process. During this period, I received numerous distressed calls from former employees of once high-flying companies. They were generally shocked to find out that they had to repay the money that they had borrowed.
If your clients have the assets to pay the loan off, but would prefer to put the cash to work elsewhere, it might be a reasonable risk to use a loan to exercise stock options. The bottom line, however, is that your clients should only borrow this money if they can afford to pay it back. That seems like common sense, but in good times such as these, our collective common sense seems to fail us. This problem is compounded by the survivor-biased reporting of employees of successful companies who wish (with the benefit of 20/20 hindsight) that they had exercised their options early. It’s great to exercise options as a tax planning device, but don’t let the tax tail wag the economic dog.

Cashless Exercise of Nonqualified Options.
Tax rules for cashless exercise of nonqualified stock options.
Some employers make it easier for option holders to exercise their options by providing a method of "cashless exercise." Usually the company makes arrangements with a brokerage firm, which loans the money needed to buy the stock. The brokerage firm sells some or all of the stock immediately, with part of the proceeds being used to repay the loan — often on the same day the loan was made. The remaining proceeds (net of any withholding and brokerage commissions or other fees) are paid to the option holder.
Not all companies permit this method of exercise. Some companies want to encourage option holders to retain the stock so they'll have an ongoing stake in the business. Others may be concerned that sales executed in this manner will depress the price of their stock. Review your option documents, or check with the company, to see if this method is available.
Tax consequences.
In general, the tax consequences of a cashless exercise are the same as the tax consequences of two separate steps:
Exercising the option. This step generally requires you to report ordinary compensation income. If you're an employee, a withholding requirement applies as well. The income (and withholding, if any) will be reported to you on Form W-2 (if you're an employee) or Form 1099-MISC (if you're not). For details see Exercising Nonqualified Stock Options. Selling the stock. This step requires you to report capital gain or loss (which in this case is obviously short-term). You'll receive Form 1099-B telling you the amount of the proceeds (not the amount of gain or loss) from the sale. For details see Sale of Nonqualified Option Stock.
Frequently asked questions.
We often see confusion on the following points:
Q: My gain from exercising the option appears on my Form W-2 as wages — but Form 1099-B reports the full amount of proceeds, including the gain. Why is the same amount reported twice?
A: The same amount is reported twice, but it's not taxed twice. Form 1099-B shows how much you received for selling the stock. When you figure your gain or loss, the amount reported on your W-2 is treated as an additional amount paid for the stock. (In other words, it increases your basis.) The effect is to reduce your gain or increase your loss, so you're not double taxed. See Sale of Stock from Nonqualified Options.
Q: Why do I have gain or loss when I sold the stock at the same time I exercised?
A: Usually there's a small gain or loss to report, for two reasons. First, the amount reported on your W-2 as income is usually based on the stock's average price for the day you exercised your option, but the broker may have sold at a price slightly above or below that average price. And second, your sale proceeds are likely to be reduced by a brokerage commission, which can produce a small loss. But any gain or loss should be minimal.

Loan to exercise stock options

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Standardized loan options to purchase employee stock options.
I am curious whether there are standardized loans (kind of like margin loans) that are issued to purchase employee stock options.
E. g. let's say I have little or no cash available but have 10,000 options strike price $1. The company is publicly traded, so the asset is liquid immediately (i. e. better collateral). In order for me to take advantage of the options, I would need $10,000 + the tax withholdings and all the other costs. But I would be able to sell the shares immediately.
I would think this would be a loan of little or no risk. In the above scenario, are there common solutions in the financial markets to allow a low cash option holder take advantage of the opportunity? Better yet, do brokerages nowadays offer all-in-one transactions to buy the options and sell the shares for you all in one strike so that you don't have to do multiple transactions from multiple banks/brokerages?
What you want is a cashless transaction. It's part of the normal process. My employer gives me 1000 options at $1, I never need to come up with the money, the shares are bought and sold in one set of transactions, and if the stock is worth $10, I see $9000 less tax withholding, hit the account. No need for me to come up with that $1000.