For early employees at a company that grows and eventually goes public, pre-IPO stock options can represent meaningful financial upside. But the decisions around those private company options often have to be made before the company has a public market price and before there is any easy way to sell the shares for cash.
That is one reason pre-IPO stock options can feel very different from public-company equity. Exercising can create a tax bill before any liquidity exists to pay it, while holding can mean carrying concentrated, illiquid stock in a company whose future value is uncertain.
For that reason, it’s important for employees at startups and private companies to understand the type of options they have, their strike price, expiration, and fair market value before making an exercise decision.
Pre-IPO stock options are options to buy shares in a private company that has not yet gone public. Like any stock option, they give the holder the right to purchase company stock at a set price, known as the strike price or exercise price, for a defined period.
A typical grant comes with a few key terms.
The important distinction is between holding an option and owning freely tradable shares.
A public-company employee who exercises an option generally receives stock that may be sold on the open market, subject to any applicable trading windows, lockups, or company restrictions. A pre-IPO employee who exercises receives private company shares that typically cannot be sold until a liquidity event occurs, such as an IPO or acquisition.
The option may have substantial paper value, but converting that paper value to cash often depends on events outside your control.
Pre-IPO equity rarely presents a single, clear choice, leaving employees with several interrelated decisions.
Exercise now or wait: Exercising early can start the clock on certain tax holding periods and may lock in a lower strike-to-value spread, but it requires cash and creates risk if the company’s value later declines or liquidity never arrives. Waiting preserves cash and flexibility but may mean a larger spread and tax bill later, or a rush to exercise before expiration.
Sell if liquidity is available: Some private companies offer tender offers or secondary sale opportunities that allow employees to sell a portion of their shares before an IPO. When available, these create a decision about whether and how much to sell.
Hold after a liquidity event: Once an IPO or other event makes shares sellable, the question becomes how much to hold versus diversify.
Manage taxes and cash needs: Each of these decisions carries tax consequences and cash requirements that interact with the rest of your financial situation.
Evaluate concentration and personal risk: Underlying all of it is the question of how much of your net worth should be tied to a single private company.
The tax treatment of a pre-IPO option depends significantly on whether it is an incentive stock option (ISO) or a non-qualified stock option (NSO), as the two are taxed differently.
For employees, exercising an NSO generally creates ordinary income on the spread between the strike price and the fair market value at exercise, and that income is typically subject to withholding.
Exercising an ISO generally does not create ordinary income for regular tax purposes, but the spread may be treated as a preference item for Alternative Minimum Tax (AMT) purposes. For an employee exercising a large block of ISOs in a private company, that AMT exposure may create a meaningful tax liability in the year of exercise, even if no shares have been sold.
This is the central challenge of pre-IPO exercise: the tax can come due before there is any cash from a sale. That’s why it is so important to model your potential tax exposures before taking any action.
A defining feature of pre-IPO equity is the gap between a share’s stated value and an employee’s ability to turn that value into cash.
Private company shares are often valued using a 409A valuation, an appraisal that helps establish the fair market value of the company’s common stock.
What it does not do is predict or assure a future market price. The 409A valuation is an estimate of current fair value, not a prediction of what shares will be worth at an IPO or sale.
Several factors compound this uncertainty:
An option position that looks valuable on paper may not produce cash for years, if ever, and decisions to spend cash now on exercise costs and taxes should account for that gap.
When a liquidity event approaches, the planning considerations shift. The decision is no longer purely hypothetical, and several factors come into play.
Timing: The window around an IPO or tender offer often involves specific dates for lockup expirations and trading windows. Knowing those dates in advance allows for planning rather than reacting.
Concentration: A liquidity event is often the first real opportunity to reduce a concentrated position. How much to sell and how much to hold becomes a central question: how much conviction in the company is worth the risk of keeping too much net worth tied to a single stock?
Trading windows: Public companies typically restrict when employees can trade around earnings and other events. Pre-IPO employees who become public-company shareholders inherit these restrictions, which can limit when shares may be sold.
Tax planning: A liquidity event may generate significant taxable income or gains in a single year. Spreading sales across tax years, coordinating with other income, and understanding the holding-period treatment of the shares can all affect the after-tax result.
Plan restrictions: The specific terms of the company’s equity plan, including lockups, blackout periods, and any company-imposed limits, govern what is actually possible.
An option that made sense to hold while illiquid may warrant a different approach once it can be sold, and the planning that happens before the event tends to create more options than reacting after it.
There is no single right answer. Exercising pre-IPO options requires cash for both the exercise cost and any resulting taxes, and it means holding shares that may remain illiquid for years. Whether it makes sense depends on the option type, the size of the spread, the cash available, your conviction in the company, and how much of your net worth would be concentrated in one stock.
Usually, options themselves cannot be sold. To realize value, employees typically have to exercise the options to acquire shares and then sell those shares when a permitted liquidity path is available. In a private company, this is usually only possible during a liquidity event such as an IPO or acquisition, or through a tender offer or secondary sale.
It depends on the option type. For employees, NSOs generally create ordinary income on the spread between the strike price and fair market value at exercise, subject to withholding. ISOs generally do not create regular income tax at exercise, but the spread may be a preference item for Alternative Minimum Tax purposes.
After an IPO, vested options can generally be exercised and the resulting shares may eventually be sold on the public market, though lockup periods often prevent sales for a set period of time after the offering.
The primary risk is paying cash to acquire shares that may not convert to cash for years, if ever. If the company’s value later declines or no liquidity event occurs, you may be left having paid to exercise and having paid taxes on paper value that never materialized.
The views and opinions expressed in this article reflect general educational perspectives as of the date of publication and are subject to change without notice. This material is provided for informational and educational purposes only and does not constitute investment, tax, or legal advice, or a recommendation to buy or sell any security. Tax laws, rates, and rules governing the strategies described, including capital gains rates, charitable deduction limits, exchange fund requirements, and hedging tax treatment, may change. Tax-loss harvesting and similar strategies involve tradeoffs, may not be appropriate for all investors, and tax benefits depend on individual circumstances and are not guaranteed. The examples and scenarios described are for illustrative purposes only, do not represent actual client results, and individual results will vary. We recommend consulting a qualified financial professional, tax adviser, or attorney before acting on any information presented here.
Go deeper
Traditional financial tools weren’t designed for that. We’re building one that is. Be among the first to experience it.