The choice to exercise your employee stock options can be a difficult one, regardless of whether you have incentive stock options or non-qualified stock options. Difficult because of the potential complexities of exercise and technical jargon required in the process.
Other issues may be particularly paralyzing due to behavioral influences. For example, personal beliefs that the company is doing well or the need desire to be seen as a team player may cause you to retain shares.
Behavioral considerations need to be coupled with personal financial planning goals. How does your potentially overly-concentrated position in one stock or your timeframe to retirement impact your decision to exercise and sell?
Whatever the specific driver, at some point you will likely want to exercise your stock options – assuming they are “in the money” of course. For this reason, here is a list of six strategies that you may consider in exercising and selling your options:
Stock Option Exercise 1 – Exercise and Sell as Soon as You Can
The first opportunity you will have to exercise your stock option(s) is when they vest. Until your shares vest, there is no option. The stock options are still a promise for the future. This changes when they vest. At this time, you obtain the right to exercise your stock options.
In this first strategy, you would exercise and sell your shares immediately upon vesting.
This strategy may work for someone whose goal is to convert “in the money” stock option value (or profit) into cash as soon as possible. Cash that can be redeployed into the market or for personal consumption (money you can actually use).
Stock Option Exercise 2 – Wait until Stock Options are Going to Expire
The other end of the stock option spectrum is someone who waits until their options will expire before exercising.
Stock options are issued with an expiration date. If you go beyond this date without exercising, any “in the money” value in the option will be lost. Therefore regardless of anything else, it likely makes sense to exercise.
This exercise option is often used by someone who simply hasn’t made a decision prior to this point in time and will lose everything if they don’t act. It can also be implemented by someone who has intentionally waited until this point for any number of reasons.
Stock Option Exercise 3 – Exercise and Hold
Exercise and hold can be considered anything that falls between “exercise and sell as soon as you can” and “Wait until the Bitter End.”
This strategy can be implemented based on any number of criteria, but it is likely implemented by someone who has made an active decision to hold shares. This can be a tax decision, a market timing decision, or a strategic financial planning decision.
Depending on the type of stock options (incentive stock or non qualified stock options), the tax and timing implementation of an exercise and hold may have different implications.
Stock Option Exercise 4 – Exercise and Sell as Your Concentrated Position Increases
It’s possible that stock options are awarded every year as part of a compensation package. As such, it’s possible that, over time, what begins as a small portion of your net worth evolves into something more significant.
One financial concern that may arise as a result of an increased position in one stock is concentration risk*. Concentration risk is the risk of having too many eggs in one basket.
This risk may be further heightened by your age and life-stage. For example, an employee approaching retirement may be more averse to concentration risk than an employee who is in their thirties.
Concentration risk may also be influenced by your net worth. Someone with a net worth of $100,000 invested in one stock may feel different than someone with a net worth of $10,000,000 in one stock.
Ultimately, concentration risk for any reason should be identified and addressed. If during this process you realize you are averse to this risk, the resulting action may be to exercise your stock options. Often, a second step will be to allocate the proceeds to a more suitable investment portfolio.
Stock Option Exercise 5 – Rolling Exercise of Stock Options
Dollar cost averaging is a popular topic in financial planning. Basically, dollar cost averaging is investing a certain amount of dollars on a set schedule over a period of time+. One common dollar cost averaging solution in which many participate is contributing to a 401(k) retirement plan.
Each pay period, money is deducted from payroll and contributed to a retirement plan. One result of these systematic investments is buying investments during up periods and during down periods.
One could argue implementing a similar strategy with stock options may be a good idea. In lieu of an early exercise or an exercise at expiration, a strategy could be implemented to exercise X% of the options over X years. For example, let’s assume you have 1,000 stock options that are vested. A rolling exercise could require exercising 25% of the shares (or 250 shares) per year for the next four years (this assumes the shares are “in the money”).
This rolling exercise creates a systematic process that allows you to participate in the upside and downside of the stock but also removes emotional decision making that may force a bad decision during periods of market volatility.
Furthermore, this strategy may spread taxes over a series of years or may allow for more strategic decision making in the future.
Stock Option Exercise 6 – Exercise When You Have “Enough”
When evaluating your stock options, it’s important to consider two values: the paper value and the after tax value.
The paper value is often the value you see on an account statement. This value is the pre-tax value of your stock options based on a current per-share price. Often, this paper value includes the value of both vested and non-vested shares, so it’s important to separate the two.
Paper value often does not account for taxes owed upon exercise. I call it paper value because that is all it is. You can’t do anything with paper value. To turn paper value into real value, you’ll likely need to exercise and sell your shares.
After-tax value is a clearer representation of the actual dollars received should you exercise and sell your stock options. This is the amount available to fund your lifestyle, to spend in retirement, or to save for another day.
A good time to exercise your stock options may be when this after-tax value is “enough.” Enough is likely a personal decision. Enough may be the amount required to fund a comfortable retirement, fund a college expense, or buy a second home. For others, enough may be the amount required to generate generational wealth.
But once you have enough, is it worth taking the risk of losing it?
Financial Planning For Employee Stock Options
Whatever the reason for exercising employee stock options, I encourage you to know what those strategies are. Equally important, these strategies should be explored within the context of a financial plan and retirement strategy.
While there is likely no right answer for everyone, each strategy above has its own advantages and disadvantages that should be considered prior to pulling any one trigger.
*Diversification does not guarantee a profit or protect against a loss.
+A plan of regular investing does not assure a profit or protect against loss in a declining market.