Employee stock options may be issued as part of an employee compensation package. Companies may offer this type of equity compensation as a way to both reward key employees and retain top talent.
If the company does well and the stock price increases, the employee can benefit because their employee stock options are worth more. Employees with more value in their employee stock options may also benefit an employer. This is because the value of the options may encourage that employee to stay at the company longer and/or work harder. This is proverbially known as the golden handcuffs.
Leave the company before your employee stock options vest, (or before you have the right to act on your option), and you run the risk of forfeiting the potential value of said employee stock option. Remain with the company until the options vest, and you may be rewarded with the ability to buy shares of company stock via the employee stock option at a price lower than the current share price.
In many instances, there may not be many decisions with pre-vested stock options. It’s more of a waiting game. Once employee stock options vest, however, there is a real decision that may need to be made. One that might have a material impact on your financial plan, income tax, cashflow, and investment risk profile.
Very simply, this decision is to do one of the following (or a combination of some sort):
- Do nothing and continue to hold the employee stock option unexercised.
- Exercise the employee stock option and retain the company stock.
- Exercise the employee stock option and sell the stock.
To determine the right move for you, you may want to start by asking these four questions.
1 – Do You Want to Own Company Stock After the Employee Stock Options Vest?
Employee stock options are provided as part of a compensation package. But options are very different from typical cash compensation.
Holding employee stock 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 employee stock options often has no right to exercise the shares (even if the share price of the stock appreciates above the exercise price).
After the vesting date, you need to ask yourself if you want to continue to hold your employee stock options and/or shares — or should you exercise and sell the shares, taking the value and redeploying it into other assets?
If you want to hold the company stock, the decisions may become more complicated. You can continue to hold the unexercised employee stock options as is. Or, you can exercise the employee stock options and hold the shares. Depending on the type of options you have and your appetite for income tax and investment risk, 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 that may be implemented by employees seeking to treat the value of employee stock options as if it were the same as their regular paycheck.
2 – Can You Afford a Cash Exercise of Employee Stock Options?
When you exercise your employee stock options, you need to decide if you’ll execute a cash exercise, a cashless exercise, or something in between.
A cash exercise means that you’ll pay cash for the total exercise price of the employee stock option. It may also include paying cash for the pending tax liability, if any. Depending on the value of your employee stock options and the type of stock option you exercise, the cash required to exercise your employee stock options can be big.
If you do not have the requisite amount of cash on hand — or simply didn’t want to use 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 your employee stock options. When you exercise, a portion of the shares are exercised and held and a portion of the shares are exercised and sold. The proceeds from the sold shares are specifically used to pay for the cost of the shares themselves (and possibly some or all of the pending the tax liability).
If you do a cashless exercise, it likely means that you won’t have to bring cash to the table to make the transaction. It also means, however, that you’ll end up with less shares held post exercise than if you did a cash exercise.
There is not often a perfect answer as to what is a better option, a cash or a cashless exercise. The better answer is the one that allow you to meet your personal financial planning goals and objectives.
3 – What Other Cash Call May You Have When You Exercise Your Employee Stock Options?
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 exercise price of the option and the fair market value at exercise 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. However, our example is simplified for illustration purposes, and your figures may be different.
A good accountant or financial advisor may be able to help you explore what your potential alternative minimum tax may be.
4 – Do You 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 reallocation some of your employee stock options to another asset
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 employee stock options may help eliminate concentration risk. Concentration risk not only when evaluating your position in a single stock, but also concentration risk when considering your overall financial wellbeing.
What Now with Your Employee Stock Options?
Employee stock options can be a fantastic opportunity to generate increase wealth under the right circumstances. However, with great opportunity comes great responsibility.
When your employee 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.