An employee stock option is an agreement that allows for the purchase of a specified number of shares of company stock by an employee at a stated price and for a certain period of time. If the market value of the stock price appreciates above the stated exercise price (the price at which you can purchase the stock via your option), the stock options are “in the money.” The option holder can then exercise the option and buy the shares at a price that is now lower than the current market price.
If the current price of the stock falls below the exercise price, the options are “out of money.” In this situation, the option holder would not exercise their right to the option. Why pay more for something than you need to?
We might suggest that an employer provide the stock options offer as a free opportunity to participate in the growth of company stock. Stock options give the option holder both the right to exercise or the right not to exercise the option. They know exactly what the stock is worth, what they will need to pay when they exercise the option, and what their profit will be from the transaction.
If the stock price goes up, the value of the stock options goes up with it. At the point in time of their choosing (post vest and pre-expiration—see definitions below), the option holder can then exercise the option, buying the shares at the pre-determined price that was provided by the stock option. Ideally, stock options can be a vehicle that generates considerable wealth for the option holder.
However, if the stock price does not appreciate, the options simply expire at no cost to the option holder.
Key Stock Option Terms
Before we continue, let’s first define some commonly used terms and concepts that are associated with stock options.
- Grant Date – This is the day that you receive your stock options.
- Exercise Price – Also known as the strike price, the exercise price is the price at which you can buy the shares of stock. Regardless of the future value of that particular stock, the option holder will have the right to buy the shares at the grant price rather than the current, actual price.
- Vest Date – This is the day that you can exercise your right to buy the shares at the grant price. Prior to this day, you do not have the right to exercise your option to buy your shares.
- Vesting Schedule – Incentive stock options are issued with a schedule that details when the options become vested. Working from the grant date, the vesting schedule will detail when some or all of your options vest.
- Expiration date – This is the last day that you can exercise your options. If you do not exercise them, the options expire regardless of whether there was value in them or not.
- Bargain Element – This is the difference between the grant price and the exercise price. For incentive stock options, the bargain element may be an adjustment item for calculating AMT.
- In the Money – A term used when the current market price of the stock exceeds the exercise price, this means that the options holder can buy something at a lower price than what they can sell it for.
- Out of the Money – This is a term used when the current market price is below the exercise price. In this sense, the option has no current value.
Incentive Stock Option and Non Qualified Stock Option
Employer stock options are divided into two distinct types: non-qualified stock options and incentive stock options. While both types of stock options offer a “free look” at the upside of company stock, and both afford control over when to exercise, many employees prefer incentive stock options. Incentive stock options have the benefit of potentially preferential tax treatment when compared to their non-qualified stock option counterparts. Two distinct tax features of incentive stock options are below:
- When you exercise and hold your stock options shares past the end of the calendar year (as opposed to exercising your options and selling the shares right away), no earned income is reported in the year of exercise. With non-qualified options, the difference between the exercise price and the grant price is included as income in the year of exercise, regardless of whether or not you hold the shares or sell them.
- When you exercise and sell incentive stock options as a qualifying disposition (more on this below), the entire realized gain—from the exercise price to the final sales price—is taxed at preferential long-term capital gains rates. With a non-qualified stock option, the gain from the grant price to the exercise price is taxed as ordinary income.
These tax planning opportunities of incentive stock options are advantageous in that you may pay a lower tax rate on the gain of incentive stock options than you will with non-qualified stock options, all else being equal. However, incentive stock options come with the added complexity of the alternative minimum tax (AMT).
In addition to your regular tax calculation, AMT is a tax calculation that takes place each year you file a tax return. As a taxpayer, you owe the IRS the higher of either your regular tax or the AMT, and often the AMT calculation is the lower of the two calculations.
The exercise of incentive stock options often causes the AMT calculation to be the higher of the two. In fact, it’s possible that the exercise of incentive stock options can lead to the AMT being so significantly higher that finding the cash to pay the pending tax bill will be a major concern.
Are Employer Stock Options Risk Free?
Employer stock options do not have any requirements that the employee exercise the option to buy any shares. In addition, there is no cost to the employee when they are given the stock option grant. Finally, there is no obligation at any time during the life of the option. From this lack of requirements to exercise the options, one could suggest an employee stock option is a risk-free investment—an investment that allows the option holder “free” upside in the market with nothing lost should the stock price go down.
Using an example to illustrate, let’s assume that you have been offered 10,000 shares of XYZ stock with a grant price of $1.00 per share. When this stock option is granted by the employer, no tax is due and no cash exchanges hands.
Over time, of course, the stock price will adjust as priced by the markets. If the market price of the stock falls below $1.00 per share, the option holder will naturally choose not to exercise the option to buy the shares. Why pay $1.00 for a share of stock when you can go buy it somewhere else for less? Eventually, at the expiration date, the stock options will expire, making them worthless to the employee.
But what if the market value appreciates to $50 per share? The option holder can then exercise the option to buy shares at $1.00 per share and sell them immediately for $50, at a gain of $49 per share. Multiply $49 by 10,000 shares, and you have a gain of $490,000.
In one sense, this is a risk-free investment with a $490,000 gain (because of the zero cost and zero obligation); but as you can imagine, this is only part of the story.
Are Stock Options High Risk?
While it’s reasonably easy to suggest that the $490,000 gain above was risk-free, it’s equally easy to suggest that stock options can also be high risk. Why? Because this newly generated wealth is subject to change as the stock price changes. In fact, if the stock price goes back down to $1 per share before the employee exercises their options, the entire $490,000 value could be wiped out.
Assuming the options are vested, the option holder likely has a right to exercise their stock options at any point. However, they are not required to exercise them. Generally speaking, the option holder has one of three options with their vested shares:
- The Do-Nothing Strategy (continue to hold the options) – Doing nothing means risking that the stock price may change and impact the value of the options. In effect, doing nothing is an active strategy and an active decision to retain investment risk.
- The Diversify Strategy (exercise and sell) – In effect, this captures “paper wealth” and turns it into “real wealth.” This strategy is intended to transfer stock option wealth into cash. That cash can then be used for other consumption (i.e., buying stuff) or saving goals.
- The Tax Planning/Investment Planning Strategy (exercise and hold) – In addition to purchasing the shares and paying the AMT, both of which may require a significant outlay of cash, this strategy has the employee hold either some or all of the shares in an effort to obtain preferential tax treatment and/or with hopes that the stock will appreciate.
Because the stock option holder has a choice, a decision can be made to either act or not act. Holding options that are in the money when you can exercise and sell them is an active decision to retain single stock risk.
As the value of a high-risk single stock position increases and becomes a larger part of your overall portfolio, or as it becomes more critical to the success of your financial plan, the risk of retaining the stock options also increases.
Incentive Stock Option and Non Qualified Stock Option Value
The discussion regarding high-risk incentive stock options can be boiled down to value. How much value do you have in the stock options?
Value, as discussed here, can be defined and calculated in several different ways.
In its simplest terms, value can be calculated as the market price less the exercise price multiplied by the number of shares. Using our example above, each share has a value of $49, which is the difference between the current market value and the exercise price.
Prior to liquidating the shares, value is simply “paper value.” Paper value is value that can change either positively or negatively with the changes in the stock price.
In addition to paper value, stock option value can be calculated using formulas that consider the price volatility of the stock and/or the amount of time until the expiration of the option.
If we assume a stock with high price volatility, it would be reasonable to assume a wider range of projected outcomes and a greater range of potential future value.
It’s also reasonable to assume that stock options with a longer time before expiration may lead to greater price variability, all else being equal. Short time horizons (options nearing exercise) have less time for price variability and are therefore generally more accurately valued in terms of current and future value.
Eventually, an informed stock option holder will exercise “in the money” shares. Assuming an exercise and hold, the value remains as paper value since it was purchased through the exercise but not sold. The held shares remain subject to continuing price volatility.
One could argue that the total value of the exercised and held stock options has now gone down, as cash is likely needed to exercise the shares and pay AMT. Because of these two required cash outlays, one could suggest that the value of the exercised and held shares is less than the unexercised value.
It’s not until the exercised shares are sold that paper value becomes realized value. Value, after a final sale of stock and requisite taxes are paid, is after-tax value. After-tax value is the remaining amount available that the option holder can use for consumption or investment.
It’s worth taking a minute to discuss concentration risk—the risk of having a significant portion of assets invested in one stock. It’s not uncommon for an employee to receive stock option grants several times over the course of their employment. As the number of the grants get bigger, the frequency increases. This is coupled with an appreciating stock price, and it’s possible that an employee can quickly amass an employer stock position that equates to a considerable percentage of one’s net worth.
Concentration in one company stock may cut both ways. In one sense, the risk of having all your eggs in one basket is a risk that not many would want to take. That wealth can easily be wiped out by a decreasing stock price. On the other hand, owning a large position in a rapidly appreciating stock can generate considerable wealth.
So what is the right answer?
If you consult many of the financial planning handbooks out there, they will suggest that no more than 10%–15% of your net worth should be tied up in a single company stock. To be fair, this rule of thumb is prudent advice that should be part of a larger discussion.
More specifically, the larger discussion of concentration risk should be addressed at a personal level. For example, someone with a $50 million net worth may have a different take on concentration risk than someone with a $2 million net worth.
As with many things in financial planning, there are many possible answers. However, it is safe to say that concentration risk should be identified first. Once this has been identified, plans should be considered to either eliminate, mitigate, or retain the single stock risk based on personal financial goals, time horizons, and objectives.
*Diversification does not guarantee a profit or protect against a loss.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.
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.