If you’ve been offered stock options as part of a compensation package at a startup, it may seem like a no-brainer to accept. And that’s usually true — as long as you clearly understand how to turn the initial piece of paper that grants you those options into a tangible investment on which you don’t have to pay income tax rates. 

It’s common to assume you should hang onto that paper and let it grow for as long as possible. But if you do, you could be in for a rude awakening when it comes time to cash in.

The smarter path is to become an investor by converting your options certificate into shares of stock and watching them appreciate.

Converting from options holder to stockholder

Why is it important to turn your options into shares of stock?

Options can’t be sold, but shares can.

If there’s a big event that affects your company, you may want to exit. With just a piece of paper, you can’t do that. Shares, on the other hand, can be sold instantly.

It’s also possible that your stock options have an expiration date, in which case you’d be forced to make a decision at a moment when you could be cash-strapped.

Even if none of the above apply, we still say it’s a good idea to convert options into shares at a time when it makes good financial sense (the value of the stock is above the price you’ll pay), and ideally when you’re comfortable holding onto your shares and allowing them to grow as an investment.

The price you pay when you convert your paper into an asset is called the strike price. This is the price at which you can purchase a share of the company’s stock — generally a lot lower than the current market price.

Why taxes are on your side when you convert your options

The moment you decide to turn in your piece of paper and buy shares of stock at the strike price, taxation comes into play.

Because stock options are considered compensation (you’ve earned them in exchange for work), any gains you enjoy from owning said options also fall under the umbrella of compensation.

The difference between the current fair market value of the shares of stock you purchase and the amount you pay for them is considered income, and taxed accordingly.

Therefore, you can see why it might become a burden to keep options for many years, then one day try to convert when you think you’re going to get a great deal on company stock. You could end up with an unexpected tax bill if you didn’t plan your conversion timing wisely!

Bottom line: Become an investor early!

If you convert to a stockholder when you only have to pay a relatively small income tax bill on your earnings, you can turn compensatory holdings into an investment — and pay the advantageous tax rates that come with owning one.

The future appreciation potential of your stock could make up for any up-front taxes you paid when you handed over your options certificate.

Too often, we see people waiting until they’re forced to engage in a stock transaction and missing out on the capital gains treatment.

This article is based on an episode of the WTFAQ Podcast. Get straightforward answers to all your startup questions from Wiss CPA Matthew Barbieri.