If you have been offered stock options by your employer, it’s tempting to see them as a ticket to riches. For some, this has been true, but it turns out that getting stock options is only the start.
How you choose to exercise stock 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 out.
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New to all of this? Consider starting with our primer: Stock Options: What Are They and How Do They Work?
Factors to Consider When Exercising Options
Key factors to consider include:
- when and how you can exercise your options
- the tax implications of exercising options
Deciding when to exercise stock options should be largely dictated by your vesting schedule. Vesting criteria restrict your ability to cash in on your options until you meet certain thresholds, which are typically based on your tenure at a company or performance level. Among private early-stage companies, a typical options package “vests” over four years. If there’s a cliff provision, you’ll 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 stock options. Most options expire 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, you may lose unvested options. All of these details should be in your stock option agreement.
Alternatives for Exercising Options
You have a few alternatives once you are ready to exercise your stock options. For starters, you could just come up with the cash to exercise the options, including any trading costs, and hold the stock. After you exercise, you’ll be eligible to receive stock dividends and could benefit from any potential appreciation in the stock’s price.
Another option is referred to as a “cashless exercise.” Here, you can decide to exercise your options and sell just enough of the stock to cover the costs you incurred to exercise the options. The proceeds you receive (or your gain) will be equal to the fair market value of the stock less the grant price, tax withholding and brokerage commissions and fees.
Yet another option is to sell all of the shares you receive immediately after you exercise your options at the going market price. This way, you won’t have any ongoing exposure to stock price volatility. Also, you won’t have to come up with the cash needed to exercise the options and pay transaction costs. But depending on the type of option, this could result in less favorable tax treatment.
What’s the Best Strategy for You?
Not surprisingly, the most important factor impacting your options outcome is the performance of the stock. In fact, performance drives the relative outcomes of each of the three strategies: early exercise with cash, cashless early exercise and waiting to exercise. In other words, while one strategy might turn out well for you if the stock price goes up, it could leave you in the lurch if the stock price goes down.
Here are some thoughts on when it makes the most sense to choose each strategy:
- Early exercise with cash— You might consider this strategy if you have the cash, the exercise price is low, and you think the company’s value will increase over time. Once you’ve exercised, one risk is that you own the stock and will see gains or losses depending on the value of the stock. Conversely, if you waited to exercise, you would still see a potential benefit if the stock price rose but wouldn’t have actually put your own money at risk. Another risk is the opportunity cost of the capital you use, because if you invest in the shares but they don’t increase very much (or if they lose value), you might have been better off investing in a diversified portfolio instead. Note that if you’re leaving a job at a start-up company, you may be forced to exercise within a few months using cash.
- Cashless early exercise— You might consider this strategy if your shares are liquid or if your company will buy them back. The main benefits are that 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. Also, you’re not putting your existing capital at risk.
- Wait to exercise — You might consider this strategy if you’re worried about the volatility of the stock or if the exercise price is expensive. A powerful feature of options is the ability to see profits without having to put your own money at risk. So if you’re not sure how profitable the company will be over time, you could always wait for the stock price to hopefully rise before exercising.
Next Steps for You
Deciding when and how to exercise stock options can get complicated. Therefore, we recommend that you speak with a financial advisor and/or tax expert about the details of your specific situation.
Understanding the type of equity you have and the associated tax implications are critical to your success – as is understanding the risk proposition of investing in an individual stock versus a diversified portfolio.
You can use free, online financial tools like Personal Capital’s to find out where you may have concentration risk. Nearly 3 million people use these tools to manage their money better. With the tools, you can:
- See all your financial accounts in one place, in real-time
- Use the Fee Analyzer to uncover hidden investment fees
- Compare your current portfolio allocation to your ideal target allocation
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