When you exercise your employee stock options, you’ll likely do one of the following:
- A cash exercise, or
- A cashless exercise
Knowing your options is easy. Evaluating whether to employ a cash vs. cashless exercise of your employee stock options can be difficult.
Not only can the math behind what actually happens during a cash or a cashless exercise be tricky, but the decision will likely impact your cashflow, your investment risk profile, and how many shares of stock you will hold after the exercise is complete.
If you find yourself holding employee stock options, you should know what a cash exercise and a cashless exercise are. You should also educate yourself on the advantages and disadvantages of each.
It’s possible that a large portion of your net worth is tied up in company stock options, so you owe it to yourself to evaluate and execute a strategy that maximizes your value (within your stated goals).
Option 1 – A Cash Exercise
If your goal is to own as many shares of the employee stock as possible post-exercise, a cash exercise is the best option. The process of a cash exercise entails the following:
- You buy shares of company stock at the grant price of your employee stock options.
- The price you pay for your shares is the grant price multiplied by the amount of shares you exercise.
- Because this is a cash exercise, you need to give your company an amount of cash equal to number 2 above. You likely need to write a check for the cost of the shares and give it to your employer. This is an out-of-pocket cost that you will need to have readily available.
Depending on the number of vested options you can exercise and the grant price at which you can exercise them, the out-of-pocket cost of a cash exercise can reach into the hundreds of thousands of dollars.
Unfortunately, most of us don’t have hundreds of thousands of dollars just sitting around. For this reason, many employees find themselves “priced out” of this option, forcing them to employ a cashless exercise or an outright sale of the stock.
If you are one of the lucky ones with that sort of cash on hand, here are a few things to know before you do a cash exercise:
- A cash exercise maximizes the total amount of shares owned outright post-exercise
- It typically results in anti-diversification. The shares your exercise and hold may lead to a concentrated position of company stock that encompasses a large percentage of your net worth. Concentrated stock positions are something that should be continually evaluated for their pros and cons.
- If you have incentive stock options, a cash exercise increases the likelihood that you will be subject to the alternative minimum tax.
- A cash exercise often requires the use of cash on hand, or the liquidation of other assets to pay the up-front cost of buying the shares.
Typically, clients who choose a cash exercise are optimistic that the value of the company stock will go up. Therefore, they plan to hold the company stock in the medium- and long-term. By holding company stock, you expose your portfolio to both the upside and downside risk of the markets.
If the stock price goes up, you win. If the stock price goes down, you lose.
Option 2 – Cashless Exercise
If the goal is to retain some shares post exercise but not all shares, then a cashless exercise is a good alternative strategy. A cashless exercise is often the default option if you don’t have hundreds of thousands of dollars readily available (AKA, most of us).
A few highlights of a cashless exercise:
- You buy shares of the company stock via the employee stock option at the grant price of your stock options.
- The price you pay for your shares is the grant price multiplied by the amount of shares you wish to buy.
- You will need to pay for the shares of stock. Instead of writing a check for the shares as you do with a cash exercise, you pay for your shares of stock… with other shares of stock.
- You’ll immediately exercise and sell some of your shares. In addition, you exercise and hold others.
- The amount you exercise and sell will be dependent on a number of factors, including your grant price, the current stock price of your company stock, and your personal goals.
A cashless exercise can be designed to cover only the cost of the shares for which you need to purchase, the tax liability you will incur on the exercise of your shares, or both. Again, the choice of how many shares you wish to buy and hold and how many shares to buy and sell depends on the grant price of your shares, and the current price of the stock.
Now that you understand some of those details, let’s take a moment to understand what this all means:
- A cashless exercise is exactly what it sounds like – you are not required to use any of your own money to exercise your stock options. You use a portion of the imbedded value of your stock options to exercise the rest.
- A cashless exercise doesn’t maximize or minimize the amount of shares you own outright. You likely end up “somewhere in the middle.”
- It’s possible that you’ll still own a concentrated position in the company’s stock, but it will not be as concentrated as you would be left with from a cash exercise.
- If you have incentive stock options, then a cashless exercise may still lead to an alternative minimum tax hit, but that hit will be lower than that of a cash exercise.
What Next with a Cash or a Cashless Exercise
In its simplest form, the decision on whether to do a cash or a cash exercise boils down to this question: do you have enough cash on hand to cover the cost of the exercise?
If you said yes, then ask this follow-up question: Do you really want to spend that cash to buy the shares?
If the answer is “yes” again, a cash exercise may be a good strategy to maximize your company stock holding. If you answered “no” to both questions or to the second, you may be forced into a cashless exercise.
That being said, your decision shouldn’t be based only on whether or not you have the cash to buy the shares. The decision should be made with consideration into how many shares of stock you want to hold, how close you are to retirement (or other financial goals), and your overall attitude towards investment risk.
Once you balance these answers against your ability to do a cash exercise or not, you can begin to determine what the best exercise strategy may be.
None of the information in this document should be considered as tax or legal advice. You should consult your tax and legal advisors for information concerning your individual situation. Diversification does not guarantee a profit or protect against a loss.