Employee stock options are often issued as part of an employee compensation package. Companies often offer this type of equity comp as a way to both reward key employees and retain top talent.
If the company does well, the employee also does well through an appreciating stock price. However, employee stock options may also apply the proverbial golden handcuffs to an employee.
Leave the company before the options vest, and you run the risk of forfeiting your stock options and all the current and potential value. Stay until they vest, and you could be rewarded the ability to participate in the upside of the company.
Employees have a real decision to make once they hit that point and the options vest. You can do one of the following at this time:
- Hold the options as is
- Exercise the options and hold the stock
- Exercise the options and sell the stock.
To determine the right move for you, you may want to start by asking these four questions.
Do I Want to Own Company Stock?
Stock options are provided as part of a compensation package. But options are very different from typical cash compensation.
Holding options means you have the right to purchase shares of company stock at a predetermined price (called the exercise price) sometime in the future. That sometime in the future is known as the vesting date.
Prior to reaching the vesting date, the recipient of the options has no right to exercise the shares (even if the share price of the stock appreciates above the grant price).
After the vesting date, you need to ask yourself if you want to continue to hold your company options and/or shares — or should you take the in-the-money value and run (i.e. exercise and sell)?
If you want to hold the company stock, the decisions may become more complicated. You can continue to hold the unexercised options as is or you can exercise the options and hold the shares. Depending on the type of options and your appetite for tax, the outcomes can be varied.
If the answer is, “No, I do not want to hold company stock,” the best strategy may be to exercise the options and sell the shares. This is often a strategy implemented by employees seeking to treat the value of stock options as compensation only.
Can I Afford a Cash Exercise?
A cash exercise means that you’ll pay cash for the value of the options and/or pay cash for the pending tax bill. Depending on the value of your stock options, this transaction has the potential to create a large cash call.
If you didn’t have this amount of cash on hand — or simply didn’t want to use so much cash to cover the exercise — you might want to consider doing a cashless exercise instead.
A cashless exercise typically requires no cash outlay to exercise the shares. When you exercise, a portion of the shares are exercised and sold specifically to cover the cost of the shares (and possibly the tax liability).
Doing a cashless exercise means you won’t have to front so much cash to make the transaction, but you’ll also end up with less shares than if you did a cash exercise.
There is not typically a better answer when comparing a cash versus cashless exercise. The better answer is the one that allow you to meet your personal goals and objectives.
What Other Cash Call May I Have?
As mentioned above, exercising your options might trigger some tax consequences. In addition to the regular income tax of which you may be aware, you might also need to pay the alternative minimum tax, or AMT.
When you exercise incentive stock options, the value between the grant price and the exercise price is an AMT preference item known as the bargain element. Depending on the size of the bargain element, you may be subject to paying the alternative minimum tax.
Generally speaking, the bargain element of incentive stock options is taxed at a flat 26% or 28%. For example, if you have $100,000 of bargain element and we assume a 26% tax bracket, you will be subject to $26,000 in AMT. If your bargain element is $500,000 and we assume a 28% tax bracket, you will be subject to $140,000 in AMT.
As you can see from the simple example, the larger the bargain element, the larger the possible tax bill.
A good accountant or financial advisor may be able to help you explore what your potential alternative minimum tax may be.
Do I Own Too Much Company Stock?
One rule of thumb in financial planning suggests that a reasonable allocation to employer stock is 10-15%. If you find a large portion of your net worth is allocated to company stock, it may be a good time to consider diversifying*.
Additionally, you may want to consider how much of your financial health is tied up in one company. Your job, your income, your benefits, your social circle, and your net worth are a sizeable part of your life.
What happens if the said company takes a turn for the worse? Are you comfortable having all your eggs in one basket?
Selling some or all of your company stock can eliminate concentration risk. Concentration risk not only when evaluating your asset allocation*, but also concentration risk when considering your overall financial wellbeing.
Employer stock options can be a fantastic opportunity to generate substantial wealth. However, with great opportunity comes great responsibility.
When your stock options vest, it’s important to consider what actions you can take to be sure your decisions are consistent with your overall financial plan.
*Asset allocation or diversification do not guarantee a profit or protect against a loss.
The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Tax services are not offered through, or supervised by, The Lincoln Investment Companies.