If the company does well, the employee also does well through an appreciating stock price.
However, employer stock options may also apply the proverbial golden handcuffs to an employee. Leave the company before the options vest and run the risk of forfeiting your stock options and all potential value. Stay until they vest, and be rewarded the ability to participate in the upside of the company.
It’s at this point, the point when the stock options vest, that employees have a real decision to make. Simply put, the decision is one of the following:
- Hold the options as is
- Exercise the options and hold the stock
- Exercise the options and sell the stock.
It’s at the time when the options vest that the (if not sooner) employee can first act on one of these three questions.
1 – Do I Want to Own Company Stock?
Stock options are provided as part of a compensation package. Said another way, they are compensation for the services you provide your employer.
However, stock options are very different from typical cash compensation, as stock options offer the recipient the right to purchase shares of company stock at a pre-determined price (the grant 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. This means that while the share price of the stock may appreciate above the grant price, the recipient has no right to exercise their shares.
Once the options vest, the recipient has the option to act. It’s at this point that they need to ask themselves this key question. Do I want to continue to hold my company options and/or shares? Or should I take my money and run (exercise and sell)?
If you want to hold the company stock, you can continue to hold the options as is, or you can exercise the options and hold the shares.
If the answer is “No, I do not want to hold company stock,” the best strategy will be to exercise the options and sell the stock. This is often a strategy implemented by those seeking to treat the value of stock options as compensation only.
2 – Can I Afford a Cash Exercise of Employee Stock Options?
When you exercise your employee stock options, you need to make an election to execute a cash exercise or a cashless exercise.
A cash exercise means that the exerciser of the stock options will pay cash for the value of the options and/or pay cash for the impending tax bill.
Depending on the value of your stock options, this transaction has the potential to create a large cash call. It may be so large, in fact, that it is possible you do not have the cash on hand.
In such a scenario (or a scenario for someone who simply doesn’t want to pay cash), a cashless exercise is possible. A cashless exercise requires no cash outlay to exercise the shares. Upon exercise, a portion of the shares are exercised and sold to cover the cost of the shares (and possibly the tax liability). The end result is that the person exercising the options owns fewer shares than the cash exercise alternative.
3 – What Other Cash Call May I Have?
If you are exercising incentive stock options, you may incur a second cash call come tax time.
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 the alternative minimum tax. The larger the bargain element, the larger the possible tax bill.
A good accountant can help you explore what your potential alternative minimum tax may be.
4 – 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.
What Now with Employer Stock Options
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.