What does it mean to exercise stock options?
Exercising stock options means purchasing the company’s common stock at a future date at the pre-set price.
For a stock option, you don’t own the company shares right away in most situations on day one when you’re granted. Instead, you have the right, not the obligation, to exercise (i.e. purchase) the stock option at the pre-set price – called exercise price or strike price – once certain conditions are met in the future. The exercise price usually is the fair market value (FMV) of the stock at the time the option is issued.
Exercising stock options is a key milestone in a stock option's life cycle. If you don't exercise your options before they expire, you'll lose them. That means you may miss an opportunity to build wealth if your company stock is trading above your exercise price. Sadly, it's not uncommon for stock options holders to leave their options unexercised. So, make sure you know your options - When do they vest? What is the deadline to take advantage of the granted options? What are the ways available to exercise them?
When can you exercise stock options?
You generally can exercise your stock options anytime upon vesting (i.e. when certain requirements are met) until they expire.
Vesting can be time-based and/or milestone-based. In time-based vesting, the shares of your stock options, for example, can only be exercised once you have stayed with your company for certain years. After certain years have passed, the option shares are finally vested and you have the right to exercise these vested option shares until the expiry date – typically within a 10-year window
Some companies will allow for early exercise (i.e. before vesting) which will be discussed later.
Factors to consider before exercising stock options
Although you can exercise your options upon vesting until their expiry date, there are some considerations to determine if it’s the right time to do so.
1. Value of your stock options – In-the-money or underwater
It may only make sense to exercise in-the-money stock options because this allows you to sell some or all right away to get a guaranteed profit.
In the money: Current stock price > Exercise price of your options. It means your options have value.
Underwater: Current stock price < Exercise price of your options. It means your options are worthless.
For example, if the current stock price is $10 and your exercise price is $5. By exercising your options and selling them immediately, you can get a $5 per share profit ($10 – $5). The profit can be used to cover the costs that have to be paid on exercise (exercise price, tax, fees etc) instead of paying them out of pocket.
2. Liquidity of your shares
If your company is private, you’ll need to use your funds to exercise your private company stock options instead of easily selling the shares on a stock exchange for profit to cover the exercise costs. It could also be risky when you’re paying cash for shares that may never become liquid.
3. Your financial situation
If you want immediate cash, exercising your stock options and selling them right away can help you pay down debt, start a business, purchase a car, etc.
Besides, many financial advisors recommend a diversified financial portfolio. So, if you own too much of your company stock (no more than 10-15% of your total portfolio), you may want to exercise your stock options and sell the shares to diversify the money.
4. Tax implications
Tax implications of exercising stock options
Exercise of incentive stock options (ISOs)
ISOs aren’t subject to ordinary income tax at the time of exercise. However, the exercise of ISOs can be subject to alternative minimum tax (AMT) if there is a significant on-paper gain (the difference between the value at exercise and the exercise price).
Exercise of Non-qualified stock options (NSOs)
For NSOs, the bargain element of your stock options (the difference between the value at exercise and the exercise price ) is taxed as compensation. You’ll need to pay the ordinary income tax on it when exercising your stock options. For example,
- Stock price on exercise: $10
- Exercise price: $5 / share
- No. of option shares to be exercised: 100
Taxable ordinary income for NSOs: ($10 – $5) x 100 shares = $500
How to exercise stock options?
There are different ways to exercise your stock options. Regardless of the way you choose, there are some costs which have to be paid on exercise:
- Exercise cost (=exercise price x no. of shares)
- Fees/commissions, e.g. broker fees, wire fees
- Tax
Our intuitive equity compensation software simplifies the process of exercising stock options and allows participants to choose how to cover these costs when submitting an exercise request. When they log in to their accounts, they are guided through the process with our online “Exercise Wizard” when they decide to exercise their stock options. Talk to us if you have any questions about exercising employee stock options.
1. Monetary payment (Hold all shares)
You use your own funds to exercise your option shares. You first pay the costs either by check, wire transfer or payroll. Then, you would receive the shares of company stock. This situation is where you decide to hold all shares when exercising your stock options.
Example :
– No. of option shares to be exercised: 100
– Exercise cost: $500 (=$5 exercise price x100 shares)
– Tax: Taxable ordinary income x Tax rate(%)
($10-$5) x 500 x 29.65% = $148.25
The total exercise cost is $500+$148.25 = $648.25
So, in this case, you need to pay $648.25 to exercise all 100 option shares.
2. Sell some to cover
You exercise your option shares by selling the shares equal to the associated costs without making an upfront payment. The remaining stock balance will then be issued to you.
Assuming the total exercise cost is the same: You don’t have to pay the total cost, $648.25, Instead, you only need to sell 65 shares [$648.25/$10 (FMV when you exercise your options)] to cover the total cost. After selling 65 shares, you have 35 shares (100-65) left.
3. Exercise & Sell All
You exercise your option shares by selling, like idea 2, but this method also generates immediate cash. You don’t need to make an upfront payment as the associated costs are paid with the sale proceeds. The net proceeds in cash are then distributed to you.
In this case, you sell all 100 shares at $10. Your sale proceeds are $1000 [$10 x 100]. After selling all shares, your remaining proceeds are $351.75 [$1000 – $648.25(total exercise cost)] and you have no shares left.
4. Withhold to Cover Exercise
Typically used by private companies, this exercise method is similar to sell to cover except that your company keeps the number of option shares equal to the associated costs before award issuance.
In this case, 65 shares [$648.25/$10 (FMV when you exercise your options)] are withheld to cover the total exercise cost. It means you have 35 shares left (100 shares – 65 shares).
What is an early exercise of stock options?
Early exercise of a stock option is to exercise your unvested options.
In a typical stock option life cycle we discussed, vesting is followed by exercise. But in some cases, companies may allow employees to exercise their stock options early, prior to vesting (Check your option grant agreement). There are some pros and cons of early exercise.
PROS:
1. Start your holding period sooner to enjoy favorable tax treatment:
The earlier you start exercising your stock options, the sooner you finish your holding period. The holding period for qualifying for the favorable long-term CGT rate is at least 1 year after exercising and at least 2 years after the grant date.
2. Little to no tax on exercise as the spread is $0 or minimal:
Spread = FMV on exercise – exercise price, where the spread is taxable.
If you exercise your stock options right after granting, the stock price on exercise will be almost the same, if not exactly the same, as the exercise price. It’ll significantly reduce the spread or there may be an opportunity to have a $0 spread.
(Note: You must file an 83(b) election with IRS within 30 days of exercising to take advantage of it)
CONS / RISKS:
1. Use your own money to exercise options:
When early exercising your stock options, you can’t sell some of your shares to cover the associated costs on exercise. So, you have to have enough cash on hand to pay the costs (e.g exercise costs, tax, commissions, fees etc)
2. Stock price may not increase:
If the stock price remains lower than your exercise price, then you cannot sell for a profit. The tax you already paid with an 83(b) election can’t be refunded.
3. Unvested shares can be repurchased when you leave the company:
In this case, your company repurchases your unvested shares usually at your exercise price or the current price, but not the commissions, fees and tax you paid.
Chris concluded that it is understandable some participants may have held off on exercising their options due to fear of making decisions. So, employers should provide access to some guidance and education - particularly in areas like tax and financial planning. Ideally, this education would result in building a greater perceived value around options and help keep employees happy and motivated rather than looking for their next opportunity.
How we can help
At Global Shares, we’ve 15 years of experience helping companies of all sizes and locations manage and administer their employee stock options and other equity compensation plans. We can also assist you in designing a communication package that explains and educates your employees on how employee equity benefits them.
Our automated cloud-based software program alleviates all past administrative complexities, saving your team time and effort and at the same time improving accuracy.
Have questions about our stock option software and services? Request a free demo to find out more about how we can help you take your equity compensation plans to the next level.
