Strategies For When To Exercise Your Stock Options

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If you have been offered stock options by your employer, it’s tempting to see them as a ticket to riches. For some, that’s been true. You don’t have to think hard for recent examples in Silicon Valley.

However, getting the options is only a start. In reality, there has been many a slip between the cup and the lip. It turns out, the way you manage the options is important if you hope to successfully cash in on them. Not all stock option holders are laughing all the way to the bank.

The devil with stock options is in the details, as many employees who were given stock options during the dot-com boom of the 1990s and early 2000s found (you can read the Daily Capital post about equity compensation to see how this played out for individuals). You will have to be conversant with the terms of your option grant and the vesting schedule, decide when to exercise and how to exercise, and be aware of the tax implications. If you are not savvy about such aspects, you might find yourself caught on the wrong foot – such as owing a large tax bill on worthless options.

In the following post, I review the key factors to consider when you’re deciding when and how to exercise your options. You need to keep in mind:

  • When you can exercise
  • How you can exercise
  • Tax implications

I’ll conclude with some examples to illustrate how these factors combine to impact your exercising decision, which may shine some light for you on how to navigate your decision-making process. Given the array of equity compensation structures out there with varied terms and tax consequences, it’s best to consult a professional for your unique situation. But read on to figure out the basics so you can begin to hatch your own exercise strategy.

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When You Can Exercise

When you can exercise your options is largely dictated by your vesting schedule. As is noted in Daily Capital’s Equity Compensation Primer, vesting criteria restrict your ability to cash in on your options until you meet certain pre-specified thresholds – typically based on time spent at a company or on performance. Among private early stage companies, a typical options package “vests” over four years. If there’s a cliff provision, that means you need to wait for a specified period of time before the first year’s options vest. After that, the rest of the options typically vest monthly.

There are also time limits on when you can exercise or access your options. First, options expire after ten years from the date of grant. Further, if you are laid off before you are vested in your options or your company is acquired by another company, you may lose your unvested options. All of these details should be in your stock option agreement, but if the fine print is too dense to get through, your CFO or HR group should be able to answer your questions.

How You Can Exercise

Once you are actually ready to exercise your options, you have a few ways of doing it. For one, you could just come up with the cash to exercise the options, including any trading costs, and get the stock in exchange. As I note in the next section, this gets you the best tax treatment (NB: also, once you own the stock, you are also eligible to receive any dividends on them).

Your second option is referred to as a “cashless exercise.” That means, you can decide to exercise your options and sell just enough of the stock that you receive to cover the costs you incurred to exercise.

Your third option is to sell all of the shares you receive immediately after you exercise at the going market price. This way, you won’t have any ongoing exposure to the stock price volatility. Also, you won’t have to come up with the upfront cash you need to exercise the options and for the transaction costs. But your tax implications are the worst.

Tax Implications

The tax rules that apply to stock options are complex, so here are some rules of thumb.

If you can afford to wait to hit certain milestones, your tax treatment will be better. You will receive the most favorable tax treatment if you wait for two years from grant date and one year from date of exercise to sell your shares. This way, any profit you generate from the sale of your stock will be taxed as long-term capital gains. (NB: you also are subject to taxation when you exercise. For nonqualified stock options (NSO’s), that means ordinary income tax on the difference between the market value at time of exercise and the strike price.  For incentive stock options (ISO’s), that same spread is subject to AMT. For more information on the difference between NSO’s and ISO’s, see the Daily Capital Equity Compensation Primer).

Exercising or selling before milestones can mean ordinary income treatment (higher taxes). If you sell in any of the other scenarios in terms of time from grant or exercise (in the same calendar year of exercising, within a year of exercising or after more than a year, but less than two years from grant date), you’ll have more complicated and higher taxes.

So, What’s the Best Exercise Strategy for You?

It turns out the biggest factor – the x-factor – that impacts your outcome is, of course, the performance of the stock. In fact, performance drives the relative outcomes of the three strategies – first, early exercise with cash, and second, cashless early exercise, and third, waiting to exercise. In other words, one strategy will turn out well for you if the stock price goes up, but might leave you in the lurch if it goes down.

For readers who don’t want to go through the math, skip to the end for results. For readers who want to get to the nitty-gritty, read on to see some carefully spelled out scenarios that show the pluses and minuses of each approach. We look at the fictional cases of Tom and Jane, who worked at companies during the dot com boom. To keep it simple, we use the same equity compensation packages and timeframes.

Equity_Compensation_TableTom’s company share price climbed steadily upward over the timeframe we examine, while Jane’s, as you can see below, did not do as well.

Stock_Price_Comparison

In the following section, we see Tom and Jane’s outcomes across the three strategies.

Strategy 1: Exercise Early With Cash

First, let’s look at Tom. As we know, Tom was granted 50,000 incentive stock options by gladiator.com. After getting the grant in December 1996, his first shares vested two years later (20,000 shares).

Tom exercised 10,000 shares right away. He exercised another 12,500 shares (10,000 plus another three months’ worth) in March of 1999. He paid for both in cash, which totaled $225,000 at the $10 exercise price. He decided to hold onto the 20,000 shares until he could get better tax treatment. Fortunately, over that time period, the stock price did fantastically. He sold the remaining shares in March 2000 – just in time before the dot com bubble burst.

Here’s how Tom’s decision to exercise early and often strategy played out (note that the table simplifies the AMT calculation as 26% of the bargain element and does not take into account future AMT credits, which make the picture rosier):

Excersing Options Early_Tom

Second, let’s look at Jane. As we know, Jane was also granted 50,000 incentive stock options by tulipmania.com. Like Tom, when the cliff ended in December 1999 (two years after they were granted), 20,000 shares vested. She followed the same pattern as Tom, exercising 10,000 shares in December at the strike price of $10 per share, and 12,500 in March of 1999. Like Tom, she paid for all of her shares in cash.

Thinking it better to hold onto shares (rather than sell) to get better tax treatment, Jane waited. Unfortunately, the tulipmania.com stock took a tumble in the summer of 1999 and never rebounded. By the time Jane could pay capital gains rates, the stock had fallen from a high of over $40 to $5. Not expecting a rebound, she sold her shares. In the table below, you can see how that played out for her (figures rounded to the nearest hundred):

Excersing Options Early_Jane

After that, the company’s stock started trading at pennies and the company ultimately went out of business, making the rest of her options worthless.

So how did Jane fare overall? As you can see, her cost of exercising ($225,000) and her AMT liability ($78,000) were greater than her eventual proceeds ($112,500). All in all, she was out nearly $200,000. While this is not the complete picture – Jane can use her capital loss to offset other potential gains, and she may get an AMT credit – it was certainly not a rosy picture.

Strategy 2: Cashless Early Exercise

So what would have happened to Tom and Jane if they had followed that same strategy, but employed the “cashless exercise” tactic?

We’ve re-done the tables showing Tom and Jane selling a portion of their shares to cover the exercise cost (who can just pony up $225,000 in cash, anyway?) in December 1998 and March 1999, and waiting to sell the remainder in March 2000.

Tom’s Cashless Early Exercise

Cashless Exercise_Tom

Jane’s Cashless Early Exercise

Cashless Exercise_Jane

As you can see, Tom did relatively worse than when exercising with cash, and Jane did relatively better. Why is that the case? For Tom: because his share price was so much higher in March, he left that share price appreciation on the table by selling early. For Jane: because her share price was healthier earlier, selling early allowed her to take some gains off the table before the share price plummeted.

(Again, note that Jane has some capital losses that she can use to offset capital gains elsewhere in her portfolio.  She’also s left with recoverable AMT credits, making this scenario slightly better).

Strategy 3: Wait to Exercise

What if Jane and Tom had waited to exercise instead?

If Tom had waited until March 2000 to exercise his 20,000 options, the gladiator.com stock price would have been up to $50 by then. If he were to sell all the shares immediately, he’d have to pay income tax rate. But as you can see, he would still be up $520,000.

Waiting to Exercise and Sell Options_Tom

For Jane, waiting to exercise may have been the best case scenario. Let’s say Jane she was skeptical about the prospects for tulipmania.com’s stock price. So, she decides to wait and watch for a year rather than take the risk of investing in a startup whose prospects did not seem rosy to her. Although things looked promising in 1999, things had fizzled for tulipmania.com by early 2000. By not exercising, Jane would have been able to avert a loss.

Waiting to Exercise and Sell Options_Jane

SUMMARY

On the whole, Tom did well because gladiator.com did well. Here’s a list of his potential outcomes in our hypothetical scenario:

  • Exercise Early with Cash – $702,750
  • Wait to Exercise – $520,000
  • Cashless Early Exercise – $471,500

Jane, on the other hand, did not do well because her options were backed by a company that did not succeed. As we see, waiting to exercise did the best in our simplified scenarios (again, note that she may have gotten some of her AMT back in the other scenarios, causing them to be more equal):

  • Wait to Exercise – $0
  • Cashless Early Exercise – ($30,167)
  • Exercise Early with Cash – (190,500)

TAKEAWAYS

So is the takeaway, work at a company with a great-performing stock? As we know, you can’t know how your stock price will perform. So how do you navigate the uncertainty and hatch a great strategy?

We believe that arming yourself with the knowledge of when you can access your shares, how you can exercise your options and the tax implication of selling strategies, you’re already on track to make a better decision.

Consider the pluses and minuses of each strategy:

  • Consider exercising early with cash if you have it. It starts the clock early on capital gains. The main risk, as we’ve seen, is the loss or opportunity cost of the capital that you use. Note that if you’re leaving a start-up job, you may be forced to go this route.
  • Consider a cashless exercise if your shares are liquid or if your company will buy them back. The benefits are: you won’t have to pony up the cash and you’ll be hedging by taking some of your shares off the table if the share price goes down. You may pay more tax but you’re not putting your existing capital at risk.
  • Wait if you’re worried about the volatility of the stock. You’re stuck paying ordinary income tax by exercising and selling all at the same time, but it may be a better alternative to stomaching any volatility. The plus is that if the share price goes down, you won’t be in an AMT hole (but you might have missed out on some gains too).

What really helps is speaking to a professional. A financial advisor or tax planner can help you walk through the mechanics of these scenarios, and how they apply to your unique situation. Schedule an appointment with a Personal Capital advisor to talk through your equity compensation scheme and making the most of your options.

 

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Poonkulali Thangavelu

Poonkulali Thangavelu

Armed with an MBA and over ten years experience in financial journalism, Poonka seeks to break new stories and bring fresh perspective to her readers. Her expertise is in real estate, investing and employer benefits.

7 comments

  1. Financial Samurai

    Curious to know, but isn’t the cashless exercise and waiting to do a cashless exercise seem like the most prudent strategy?

    Why would one pony up all the cash, pay the taxes, and then not sell? I guess the 20% tax rate is very attractive if you are in a higher tax bracket. However, it would seem prudent to exercise and sell within a short period of time due to all the risk involved.

    Thoughts?

    Reply
  2. Poonka

    Yes Sam, looks like the exercise early with cash strategy is the most risky. You are investing additional money betting on the company that you could have invested elsewhere and diversified your portfolio. However, it also tends to offer the best return if the stock does well.

    Those looking to hedge their bets would prefer to do the cashless exercise or wait a bit to see how the stock does before exercising.

    Reply
    • Financial Samurai

      I re-read this post, and I have to say this is a great post for anybody who is in the situation of figuring out when to exercise their options.

      I believe the best strategy is to do the Cashless Early Exercise. Pony up all that cash to then lose would be devastating. The final option of Waiting To Exercise is the most conservative and makes the most sense for those who want the least amount of risk, and those in companies that don’t have a sound business model e.g. vaporware companies that could be gone tomorrow due to a change in trend.

      Reply
      • Max

        Why do you advocate for Cashless Early Exercise? It seems in this example that even Tom made out better with Waiting To Exercise ($520k vs $471.5k). And he exercised fewer shares overall (20k vs 22.5k). This is because with Cashless Early Exercise he had to sell shares at a lower price to cover his exercise cost. And of course Jane did best with Waiting to Exercise because she saw that the options were worthless.

        Can you construct a situation where Cashless Early Exercise would be better than Waiting to Exercise?

        Reply
  3. Jono Tunney

    Your advice is good but doesn’t hammer home the most relevant points.

    1) how much economic value is destroyed by early exercise of option – depends on how far in the money the option is and how much time is left to expiry. There is simple option math here.

    2) how can one optimize the trade off between tax consequence and specific company risk.

    Here is the sweet spot for most situations.

    Exercise with CASH on Jan 1 and wait until dec 31 OF THE SAME YEAR. If the stock has gone down significantly sell prior to year end so that you don’t incur AMT treatment that could possibly exceed the total value of your stock AND THE IRS COULD COME AFTER YOUR HOUSE – this has happened. If your stock has not moved or gone up, then your holding period is now over a year ( need to wait one day until jan 1) and you get long term capital gains treatment.

    And you for sure SELL SELL SELL regardless of how great you think your high growth ( probably overpriced ) tech company is. It is called diversification and it is one of the most important lessons in investing. Don’t own your company stock if you don’t have to.

    Reply
  4. Mike

    How would you weigh dividends in these examples? You don’t receive dividends unless you exercise the options.

    Reply
  5. gurmit

    The scenarios are based on as if the person knew future with a crustal ball. No one can predict what will happen in future and follow accordingly. My question and many other of employees have what happens when option is exercised:

    in 2010 NQ 1000 Granted at $10
    in 2015 I choose to exercise. price is $30. I choose to cash out.
    I get $20000 gain. What is reported on W-2 ands 1099-B
    What if I convert the gain to stock then what is reported on W-2 and 1099-B

    Reply

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