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Exercising Stock Options

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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 the 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 shares when your stock options are granted.

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 options 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 excise (i.e. before vesting) which will be discussed later.

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Life Cycle of Options: Grant>Vesting>Exercise>Sale

Factors to consider before exercising stock options

Although you can exercise your options upon vesting until their expiry date, there’re some considerations to determine if it’s the right time to do so.

1. Value of your options – In-the-money or underwater

It may only make sense to exercise in-the-money options because when you exercise them, you can 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 stock options instead of easily selling them 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 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

See the next section.

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 stock price at exercise and the exercise price).

To avoid AMT, you can exercise and sell your options in the same calendar year. But, you will need to pay short-term capital gains tax (CGT) when selling within the same calendar year. The tax rate of short-term gains is typically higher than that of long-term gains that occur when you hold on to your shares.

Exercise of Non-qualified stock options (NSOs)

For NSOs, the bargain element of your stock option (difference between the stock price at exercise and the exercise price) is taxed as compensation which you’ll need to pay the ordinary income tax on it. For example,

  • Stock price on exercise: $10
  • Exercise price: $5 / share
  • No. of shares to be exercised: 100

Taxable ordinary income for NSOs: ($10 – $5) x 100 shares = $500

How to exercise stock options?

There’re different ways to exercise your stock options. Regardless of the way you choose, there’re 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 exercise process 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 personal funds to cover the associated costs. 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 (Sticking with the same numbers):
– No of 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 shares.

2. Sell some to cover

You exercise your stock options by selling the shares. The goal here is to cover the costs associated with the exercise by selling shares equal to the costs without making an upfront payment. The remaining stock balance will then be issued to you.

Example (Sticking with the same numbers):
– Exercise cost: $500 (=$5 exercise price x100 shares)
– Fees/commissions: $20
– Tax: $148.25 (like above)
The total exercise cost is $500+$20+$148.25 = $668.25

In this case, you don’t have to pay the total cost, $668.25, Instead, you only need to sell 67 shares [$668.25/$10 (FMV on exercise)] to cover the total cost. After selling 67 shares, you have 33 shares (100-67) left.

3. Exercise & Sell All

You exercise your stock options by selling the shares 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.

Example (Sticking with the same numbers):
– Exercise cost: $500 (=$5 exercise price x100 shares)
– Fees/commissions: $55
– Tax: $148.25 (like above)
– Sell price: $10
The total exercise cost is $500+$55+$148.25 = $703.25

In this case, you sell all 100 shares. Your sale proceeds are $1000 [$10 (sale price) x 100]. After selling all shares, your remaining proceeds are $331.75 ($1000 – $703.25) 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 shares equal to the associated costs before award issuance.

Example (Sticking with the same numbers):
– Exercise cost: $500 (=$5 exercise price x100 shares)
– Tax: $148.25 (like above)
The total exercise cost is $500+$+$148.25 = $648.25

In this case, 65 shares ($648.25/10) 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 options?

Early exercise of an option is to exercise your unvested options.

In a typical stock option life cycle we discussed, vesting is followed by excise. But in some cases, companies may allow employees to exercise their stock options early, prior to vesting (Check your option grant agreement). There’re 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 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 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 value, but not the commissions, fees and tax you paid.

How we can help

At Global Shares, we’ve 15 years of experience helping companies of all sizes and locations manage and administer their stock option plans and equity compensation plans. 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.

Please Note: This publication contains general information only and Global Shares is not, through this article, issuing any advice, be it legal, financial, tax-related, business-related, professional or other. The Global Shares Academy is not a substitute for professional advice and should not be used as such. Global Shares does not assume any liability for reliance on the information provided herein.

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