How to Understand Private Company Stock Options (2024)

Private companies issue stock options for a few reasons according to SmartAsset, such as providing competitive compensation and benefits packages that attract and retain top talent. While private companies may have shareholders, stock issues by private companies are not traded on the public exchanges. Private stock options are commonly associated with startup companies, especially in technology – where the goal is to create a highly valued company that will eventually go public.

Some companies decide to stay private in order to maintain control of the business. For example, SpaceX is a company focused on outer space travel that is not expected to go public in the near foreseeable future. Its founder, Elon Musk, would rather focus on the organizational mission rather than profitability at this time. At the same time, this lack of availability has driven intense speculation and demand for involvement with SpaceX, which then increases the value of SpaceX options.

What is a Stock Option?

A stock option is a contract that gives its owner the right, but not the obligation, to buy or sell shares of a corporation's stock at a predetermined price by a specified date. Private company stock options are call options, giving the holder the right to purchase shares of the company's stock at a specified price. This right to purchase – or "exercise" – stock options is often subject to a vesting schedule that defines when the options can be exercised. Stock options are often offered as compensation to motivate employees to adopt a personal investment in the company's success.

Why Do Private Companies Issue Stock Options?

A major reason companies issue stock options is because they are not considered business expenses on the books. Small companies such as private corporations often do not have the financial size to offer potential or high-performing employees salaries that are commensurate with their large, publicly traded corporate peers. They attract and keep employees through other means, including by giving them greater responsibility, flexibility and visibility. An additional way is through the offering of stock options. Private companies may also use stock options to pay vendors and consultants.

A startup or rapidly growing small business needs to conserve cash. A company can negotiate to pay its consultants and vendors in stock options to conserve cash. Not all vendors and consultants are receptive to payment in options, but those who are can save a company a significant amount of cash in the short term. Stock options used to pay for goods and services generally have no vesting requirements.

What are Common Types of Private Stock Options?

There are generally five types of company stock options available through a private company, according to the tech-focused wealth planning firm KB Financial Advisors. Each of these types of options come with risks as well as potential benefits. These five options include:

Employee stock options typically fall into two broad categories: outright award and performance-based award. The latter is also referred to as an incentive award. Companies either grant outright awards of stock options upfront or on a vesting schedule. They grant incentive stock options on the achievement of specific targets.

The taxation of the two differ. Employees who exercise their outright award options are taxed at their ordinary income tax rate. Incentive stock options are generally not taxed when exercised. Employees who then hold the stock for more than a year will pay capital gains tax on subsequent gains.

Be aware that the type of stocks offered to an employee may not have the same preference as those offered to investors, according to The Money Habit. This may mean that if the company liquidates, holders of preferred stock would take priority in getting their money back. There are many considerations when examining stock options. Consult with a financial professional for advice on valuating, selecting or exercising options based on your financial goals.

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