Daniel Zajac, CFP®

Incentive Stock Options and Executive Compensation

Employee Stock Options

What Happens to Your Employee Stock Options When You Leave Your Company?

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Even if you don’t have plans to leave anytime soon, it’s not unreasonable to consider what happens to your employee stock options when no longer work for your current employer.

Whether due to a planned retirement after a long career, a new opportunity at another company, or an intentional sabbatical from the workforce, there are plenty of good reasons why you won’t be at your company forever.

There are also less-desirable circumstances under which you might leave. While no one hopes or plans to be let go, fired, or forced to stop working for a negative reason, these things do happen.

Either way, for better or worse, it’s important to know what happens to your employee stock options upon terminating your relationship with your employer.

The answer to what happens can get complicated. Depending on why your employment status changes from employee to a former employee and what type(s) of employee stock option(s) you have, the rules surrounding what you can and can’t do with your equity compensation will vary.

The best strategy is to check your plan document for the specific rules regarding your plan. But in the meantime, here is a primer of things to know now.

The Basics of Employee Stock Options When You Terminate Your Employment

Employee stock options are issued with an expiration date. The expiration date is important because it lets you know the last day you can capture the value of employee stock options via an exercise.

The expiration date is usually ten years from the grant date. However, every plan is subject to its own rules; again, you should check your plan document to determine specific details like this.

Regardless of when the date is, if you do not exercise and the expiration date comes and goes, your option will terminate, and you will lose the ability to exercise. Subsequently, you forfeit any embedded value. This happens even if you’re still employed with the company.

Your right to exercise your employee stock options may change, however, as your employment status changes. Generally speaking, if you are terminating your employment from your company, you will need to exercise your employee stock options at the earlier of the expiration date or the new expiration period set in the plan document for a terminated employee.

Change in employment status can be segmented into several categories:

  • Termination by choice
  • Termination by disability
  • Termination by death

Your plan document should help you determine what your post-termination expiration provisions are once you know the circumstances around your departure.

Vesting of Employee Stock Options Stop When You Leave Your Company

Prior to getting into your post-termination exercise periods, you should know that when you leave the company for any reason, unvested shares remain unvested in almost all cases.

Practically speaking, this means that the in-the-money value of unvested employee stock options is forfeited. The negative impact to your net-worth statement of forfeiting potentially valuable unvested options may be material if you are considering termination employment.

Let’s assume that you have the following employee stock options

Grant Shares Vested Exercise Price FMV Total Value Vested Value
1 10,000 10,000 $1.00 $25.00 $240,000 $240,000
2 15,000 15,000 $2.00 $25.00 $345,000 $345,000
3 10,000 0 $3.00 $25.00 $220,000 $0.00
Totals 35,000 25,000 $805,000 $585,000

In this scenario, you have a total employee stock option value of $805,000 if we consider vested and unvested stock options.

Only 25,000 of the 35,000 options are vested here, meaning your current exercisable value is $585,000. That’s considerably lower than the total value of $805,000.

In order to obtain the full value, you have to stay employed with the company until the 10,000 options in Grant 3 vest. Assuming you do work until Grant 3 vests, you will have access to those shares as well. But if you terminate your employment prior to Grant 3 vesting, the value of Grant 3 goes away.

The decision to leave your employer when you know that it means forfeiting unvested options may be critically important in the financial planning process.

If I had a client who wanted to leave because they wanted to retire, for example, we might model out retirement income projections. As part of the projection, we need to know whether to include the $805,000 of total stock option value — or $585,000 of stock option value that could actually be realized and not forfeited before some of the shares vest.

That’s a $220,000 difference, which can make a big impact on how much you can spend in retirement.

If we assume a 3-5% withdrawal rate in retirement, it’s reasonable to assume that a retirement with only vested shares in this example may be between $6,600 and $11,000 less per year than what this client could spend in retirement per year if all the shares vested.

The timeline until your unvested shares vest is also important. If we assume that Grant 3 is scheduled to vest in the near term, it may make sense to work a little longer, allowing the shares to vest and you to capture the value.

Alternatively, if the shares do not vest for several years, the value of the unvested options is not an important part of your retirement plan, or both, then pulling the trigger to retire and forfeiting the option shares may be a better choice for you.

Exercise Timeline if You Leave to Take Another Job or Retire

If you leave your company voluntarily, either to retire, to take another job, or to take a break from work, you generally have up to 3 months or 90 days from your termination date to exercise your vested options. (As always, check your plan document as this period can be shorter or longer.)

Even if the expiration date of your employee stock options is further out in time than the 90-day exercise window, you must exercise within this new post-termination period.

However, if your original expiration date is after you terminate your employment but prior to the end of the 90-day post-termination exercise window, you will need to exercise by that original expiration date to capture the value.

If you have incentive stock options, your post-termination exercise considerations may become even more complicated.

For an incentive stock option to retain its status as such, you must exercise the option within 90 days of termination of your company. This probably won’t be a problem if the 90-day period coincides with the requirement of the plan document.

But if your company gives you one year from termination to exercise your incentive stock options, you will need to exercise them within the 90-day post-termination period even though you have up to one year per the plan document in order to retain their status as incentive stock options.

Both an approaching expiration date and a change of employment status signify a point where you need to make decisions around your options—choosing not to exercise means that you run the risk of losing the ability to capture in the money stock option value.

What Happens If You Become Disabled (or Worse, Die)?

Generally speaking, the timeline you have to exercise your employee stock options is longer if you become disabled than it is if you terminate for another reason. Often, you will have one year from the date you terminate employment to exercise your employee stock options.

If you have incentive stock options and become disabled, the 3-month post-termination exercise period is extended to 12 months. This allows for additional time to strategize the best way to exercise your options and plan for the future.

Like the post-termination period, if you become disabled, the post-termination exercise period for employee stock options, if you die, is longer than if you leave for another reason. Commonly, one year is used. But as always, you want to check your plan document to determine if your period is shorter or longer.

If you have incentive stock options, the rule that requires incentive stock options to be exercised within 3-months of job termination (or in this case, death) to retain status as an ISO is waived, so long as you were employed as of your date of death or within the three months preceding death.

Many plans will allow you to name a beneficiary of your employee stock options. This person may be able to act on your stock options upon death. They will have the right to exercise the options, sell the options, and/or received the stock shares themselves.

In lieu of a beneficiary, your personal representative in charge of handling your estate affairs will likely be able to assist in the exercise of the shares.

Before You Leave Your Company, Understand What Might Happen with Your Stock Options

When you leave your company, you likely have a short-term period during which you can exercise your remaining stock options. During this time, it’s a now-or-never proposition.

Exercise and capture the proceeds, or let them expire and lose what you have.

With that said, some advanced planning may be available to you. The first step is to check the document to know what timeframes you are dealing with. Know how long you have to exercise and how different circumstances for leaving might impact that timeline.

Next, plan and strategize for your incentive stock options. You might want to consider exercising within the 90-day period in order to retain the ISO status.

And finally, consider how your available exercise periods “wrap” around one calendar year or two. For example, if your 90-day exercise window is between November 1 of one year and January 31 of the next, you may be able to spread income over two years, which is helpful for tax purposes.

A good strategy will know the allowable timeframes and plan accordingly. This planning may include executing an early exercise of some (or all) of your options in an effort to avoid a significant singular tax bill due to a change of jobs.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  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.

How Do You Pay the Exercise Cost When You Exercise Your Employee Stock Options?

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If you have employee stock options, you’ve likely spent time considering how and when to turn the value of those options into cash proceeds you can actually use.

To turn stock employee stock options into cash, you have to exercise and sell them.  When you exercise, you are buying shares of company stock at the exercise price of the employee stock option.

Buying shares of stock means that you still need to pay for them when you exercise — but you’re getting a bargain because the price you pay will likely be lower than the current market price of the stock itself.

The exact cost to exercise equals the number of shares you exercise multiplied by the exercise price of the stock option.

Understanding the Potential Costs of Exercising

Let’s assume you have the following:

Grant Shares Exercise Price FMV Exercise Cost Value
1 10,000 5.00 25.00 $50,000 $200,000

In this example, the exercise cost of 10,000 shares is $50,000.

However, you don’t have to exercise all your options at one time. If you only exercise 5,000 options (leaving you with 5,000 that can be exercised later), the exercise cost is $25,000, or 5,000 multiplied by $5 per share.

The same logic carries forward when you have multiple grants of stock options. For example, assume that you have the two employee stock option grants:

Grant Shares Exercise Price FMV Exercise Cost Value
1 10,000 5.00 25.00 $50,000 $200,000
2 5,000 8.00 25.00 $40,000 $85,000

The total exercise cost of both grants, or 15,000 shares, is $90,000. Again, you can choose to exercise a portion; you don’t have to exercise everything all at once. You can exercise only grant 1, for example, or only grant 2 — or some or all of each.

The kind of employee stock options you have may impact the cost of exercising, as well. This is because the exercise of an employee stock option is a taxable event.

In addition to the cost you pay to buy the shares, you may also need to pay tax. The type of tax you pay, when you pay it, and how much you pay will all depend on whether you have incentive stock options or non-qualified stock options.

Because of this it’s important to check your document and be sure of what kind of options you have before you take any actions with them. Checking in with a professional who can help you choose the right strategy might be a prudent move, as well.

Exercise Strategy 1 – Pay with Cash

A simple and clean way to pay the exercise cost is to pay with cash. With a cash exercise, you must deliver the cash required to pay the exercise cost when you exercise your options.

Doing a cash exercise may be a good strategy if you’re bullish on the future stock price of your company stock and if you want to maximize the number of shares you own.

If we assume that you exercise Grant 1 above, you will pay $50,000 to exercise the employee stock option. This $50,000 needs to come from assets you own already (like cash in a bank account).

Post-exercise, you will own 10,000 shares outright — but you’ll have less money in the bank since you needed to use some cash on hand to buy the shares.

A cash exercise is effectively the opposite of diversification. This can be a good thing or a bad thing based on your goals, risk tolerance, and how the stock performs in the future.

Exercise Strategy 2 – Buy Using Shares Acquired via the Exercise Itself

A second strategy to exercise your employee stock options is cashless exercise (or a sell-to-cover). With a cashless exercise, you use newly acquired shares via the exercise itself to cover the exercise cost.

This is accomplished by giving instructions that requests the immediate exercise and sell enough shares to cover the cost of the exercise. You can retain whatever shares you didn’t need to sell to cover the cost of exercising.

If we looked at Grant 1 above, we can see the exercise cost is $50,000. In order to cover this exercise cost via cashless exercise, we need to calculate how many of the 10,000 shares must be sold immediately post-exercise to pay for the exercise cost of the employee stock option.

The math to calculate the shares required is as follows:

“Cashless Shares Required” = “Exercise Cost” / “FMV at Exercise”

= $50,000 / $25

= 2,000

If you immediately exercise and sell 2,000 of your 10,000 shares, exercised at the current share price of $25/share, you will generate $50,000 of proceeds. You can use this $50,000 to cover the exercise cost.

That means you are left with 8,000 exercised shares that you hold outright. The post-exercise result of a cashless exercise is that you will own fewer shares than you would with a cash exercise — but it also saves you from having to shell out $50,000 in cash.

A cashless exercise may be good for someone seeking to limit or diversify their company stock position. It may also be appropriate for someone who doesn’t have the requisite cash on hand to cover the exercise cost.

Exercise Strategy 3 – Use Previously Owned Shares of Stock via a Stock Swap

In addition to using cash or a cashless exercise to exercise your employee stock options, you can also use shares you already own to cover the exercise cost. You do this via a stock swap.

A stock swap allows you to exchange a sufficient number of shares you already own to cover the exercise cost of newly acquired shares from the stock option. You can use long-only shares, vested RSUs, exercised NQSOs, employee stock purchase plan shares, and exercised incentive stock options in stock swaps.

Each type of owned stock may have different rules that should be understood if being used for a swap, and you should consider the impact of each when before choosing a  strategy to implement.

When you do a stock swap, the original holding period and tax cost basis will transition to the swapped shares in a non-taxable event.  However, the exercise itself is a taxable event.

Let’s assume the following:

Grant/Share Shares Exercise Price FMV Exercise Cost Value
Long-Only 10,000 – 25.00 – $250,000
NQSO 5,000 8.00 25.00 $40,000 $85,000

If the goal is to exercise 5,000 NQSOs, the cost to exercise will be $40,000. In lieu of paying cash or doing a cashless exercise, you can use some of your long-only shares to cover the cost.

To cover the $40,000 exercise cost, you will need to swap 1,600 long-only shares (1,600 x $25 per share equals $40,000).

Post-exercise, you will retain 8,400 long-only shares and 5,000 NQSO shares, now owned outright. That gives you a total of 13,400 shares.

Like a cashless exercise, a stock swap means that you will typically own fewer shares post-exercise than you will with a cash exercise. A stock swap may be a good option for someone who is seeking to limit exposure to company stock.

Exercise Strategy 4 – Use a Combination of Strategies 1, 2, and 3

For any number of reasons, a singular strategy to implement only options 1, 2, or 3 may not be appropriate. The best exercise strategy for you might actually be a combination of strategies 1, 2, and 3 above.

This might be true even if you used one strategy over another in the past. Every time you exercise gives you an opportunity to implement a different strategy.

For example, you may choose to exercise lot 1 in our example via a cash exercise. A year later when you go to exercise lot 2, you may choose a stock swap.

Regardless of what you decide to do, you need to be aware of the tax implications of any exercise. Those implications alone can generate a separate, additional cash call when you exercise or when you file your tax return.

The Bottom Line on Exercising Your Employee Stock Options

If you are seeking to exercise your employee stock options, it means they are in the money and you capture real value. That the good news. To capture that value, however, you need to pay the exercise cost.

You can do that in a number of ways, using any (or a combination of) the strategies outlined above. Bear in mind, however, that any kind of exercise can lead to other complications.

Personal financial planning goals, your available assets, your short- and long-term opinions of the company stock, and the pending income tax implications may make exercising your ESO a daunting responsibility.

If you find yourself with unanswered questions about how to pay for your exercise, when to exercise, and how this all fits together, you may want to reach out to a professional who can help.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  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.

How to Use a Stock Swap to Exercise Your Employee Stock Options

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A stock swap can be a great strategy to use if you have employee stock options you’d like to exercise and hold. It allows you to use the fair market value (FMV) of company stock you already own to pay for the exercise cost of newly acquired employee stock option shares.

Shares you own that can be used for a stock swap can include those you’ve purchased on the open market, shares acquired from vested restricted stock units, shares you own from an exercise and hold of previous employee stock options, and/or shares acquired from and employee stock purchase plan.

But be aware that each type of share you use in a swap can generate some very different tax implications. It’s a good idea to work with a professional to ensure you choose a specific strategy that makes sense in the context of your overall financial situation.

The First Step to a Stock Swap: Check Your Plan Document

If you are considering a stock swap, the first step may be to check your plan document. While many plans allow for a stock swap, you’ll want to be sure yours is one of them.

If your plan document allows, a stock swap may make sense if you don’t have the cash available to do a cash exercise. It may also make sense if you are not seeking to maximize the number of shares you own.

In fact, a stock swap will result in you having less value in company stock then you did prior to the exercise.

How a Stock Swap Works in the Real World

Let’s assume you own the following shares of company stock that you previously purchased on the open market. We will define these as long-only shares:

Long-Only Share Price Cost Basis / Share Total Value
10,000 $50.00 $20.00 $500,000

Let’s also assume that you want to exercise the following employee stock options or ESOs. For the sake of this immediate example, we will not distinguish between non-qualified stock options and incentive stock options (but we will cover each later in the article).

ESO Exercise Price Exercise Cost Current Share Price Total Value
5,000 $10.00 $50,000 $50.00 $250,000

The exercise cost of the ESO is $50,000. This cost can be paid for in a number of ways. You could do a cash exercise, a cashless exercise, or a stock swap.

If you are doing a stock swap, you pay the exercise cost of $50,000 by swapping the fair market value (FMV) of long-only shares equal to the exercise cost of the ESO.

If you held 10,000 long-only shares and wanted to exercise 5,000 ESOs, you will use fewer than 5,000 long-only shares to exercise and hold 5,000 employee stock options.

This is because you are using the FMV of long-only shares to buy ESO shares at the exercise price, which is lower than the FMV.

How many shares you need to swap is based on the spread between the FMV of the stock and the exercise price of the options:

Number of Shares Swapped = “Exercise Cost” / “Current Share Price”

=$50,000 / $50

= 1,000

You can swap 1,000 of your long-only shares to exercise the 5,000 employee stock options.

A swap is simply an additional way to exercise your options. More specifically, a stock swap may limit how many shares of stock you own and/or manage tax.

Stock Swaps and the Impact on Concentrated Equity

The end result of a stock swap is that you control fewer shares post-swap then you did pre-swap.

Prior to the stock swap, you had owned 10,000 long-only shares and the option to purchase 5,000 shares from the ESO. You “controlled” 15,000 shares.

After the stock swap, you have 9,000 long-only shares and 5,000 newly acquired shares from the exercise and hold of the ESO. You now “control” 14,000.

Because of this reduction in total shares controlled, a stock swap is one way to limit or decrease your concentrated equity position.  If may then make sense for someone who isn’t bullish on the stock or someone who wants to diversify their assets.

Comparing a Stock Swap to Other Exercise Methods

To evaluate whether a stock swap is a good idea or a bad idea, it makes sense to compare it to other exercise strategies. Two common strategies are a cash exercise and a cashless exercise.

A cash exercise may be a preferable strategy to stock swap if you are bullish on your company stock and want to retain as many shares as possible. With a cash exercise, you retain more shares post-exercise than you do with a stock swap.

In our example, you will pay $50,000 to exercise and hold the ESO. Since you paid cash, you will retain the 10,000 long-only shares you own and pick up an additional 5,000 shares from the ESO, for a total of 15,000 shares. This is 1,000 shares more than the swap stock in our example.

The second option is a cashless exercise. If you are not bullish on your company stock or want to diversify your concentrated position, a cashless exercise may be a better strategy for you.

In a cashless exercise, you use shares acquired via the exercise itself to cover the cost of the exercise. Continuing with numbers from our examples above, with a cashless exercise, you’d exercise and immediately sell 1,000 ESO shares.

Number of Shares to Cover = “Cost of Exercise” / “Current Share Price”

= $50,000 / $50

= 1,000

Since you sold 1,000 of your ESO to cover the cost, you retain the remaining 4,000. Post cashless exercise, you own 10,000 previously owned shares and 4,000 shares from the exercise and hold, for a total of 14,000 shares

Both the stock swap scenario and the cashless exercise scenario, you retain 14,000 shares. The post-exercise share control is identical.

However, by digging further, you will see that the shares come from different sources.

Long-Only ESO Shares Total Shares Cash Required
Cash Exercise 10,000 5,000 15,000 $50,000
Stock Swap 9,000 5,000 14,000 $0
Cashless Exercise 10,000 4,000 14,000 $0

This difference is important as we evaluate the tax impact if the employee stock options are non-qualified or incentive stock options.

Stock Swap and the Tax Impact for Non-Qualified Stock Options

When you use long-only stock to exercise non-qualified stock options (NQSO) via a stock swap, the swapped shares retain their original cost basis and acquisition date through the exercise.  Swapping shares is a non-taxable event.

However, the exercise itself is a taxable event subject to normal NQSO tax rules. This means that the bargain element of your exercised non-qualified stock options is subject to ordinary income, Medicare, and Social Security tax.

Let’s assume that you have the following NQSOs:

NQSO Exercise Price Exercise Cost Current Share Price Total Value
5,000 $10.00 $50,000 $50.00 $250,000

When you exercise your 5,000 non-qualified stock options, you will pay income tax on the bargain element of $200,000. You pay income tax regardless of how you pay for the exercise cost of your NQSO.

Assuming you do a stock swap of 1,000 long-only shares that have a cost basis of $20 per share, the cost basis of your retained shares will look like this:

Long-Only NQSO Shares Total
Shares 9,000 5,000 14,000
Cost Basis 9,000 at $20.00/share 1,000 at $20/share

4,000 at $50/share

 14,000
Total Cost Basis $180,000 $220,000 $400,000

After the swap, you retain 9,000 long-only shares. The cost basis of these 9,000 shares remains unchanged at $20/share. You have also acquired 5,000 newly owned shares from the exercise of the NQSO.

Of these shares, 1,000 will have a carryover basis (and holding period for calculating long term capital gains) of $20/share. The remaining 4,000 shares will have a cost basis of $50/share, which is the FMV at the time of exercise.

Stock Swaps and the Tax Impact for Incentive Stock Options

You can use long-only stock to exercise incentive stock options, too. Like NQSOs, the tax rules regarding an exercise of incentive stock options, or ISOs, are the same whether you exercise via a stock swap or via another method.

This means that when you exercise and hold ISOs, the bargain element will be a tax preference item for calculating the alternative minimum tax. It also means that exercised ISOs equal to the number of shares swapped will retain the cost basis of the original shares. However, the newly acquired shares via the exercise will likely have a basis equal to zero.

Continuing our example from above, but now assuming that you have ISOs, we can illustrate a stock swap for ISOs:

ISO Exercise Price Exercise Cost Current Share Price Total Value
5,000 $10.00 $50,000 $50.00 $250,000

If you exercise and hold ISOs in an attempt to achieve a qualifying disposition (hold the shares past year-end), you do not claim ordinary income in the year of exercise. Instead, the bargain element is a tax preference item for calculating the AMT.

Since the bargain element not claimed as ordinary income, it has no adjustment to that cost basis of the new shares. If we assume you do a stock swap of 1,000 long-only shares that have a cost basis of $20 per share, the cost basis of your retained ISO shares will look like this:

Long-Only ISO Shares Total
Total Shares 9,000 5,000 14,000
Regular Cost Basis 9,000 at $20.00/share 1,000 at $20/share

4,000 at $0/share

 14,000
AMT Cost Basis $180,000 5,000 at $50/share

After the swap, you retain 9,000 long-only shares with a cost basis of $20/share. You also have 1,000 shares from the exercise of the ISO with a carry-over cost basis of $20 per share. These two are the same as what we saw in the example with NQSOs.

The remaining 4,000 shares here, however, have a cost basis of $0/share (which is different than in the NQSO example above).

It’s equally important to track the AMT basis. While the cost basis for calculating the regular tax is $0/share, the cost basis for calculating AMT is $50/share. This is because the entire bargain element is taxed when calculating the AMT.

Having two basis figures when exercising and holding ISOs is commonly known as a dual basis.

Stock Swaps for Other Share Types

The above illustrations cover what a stock swap may look like if you own long-only shares and use those shares for the swap. Typically, long-only shares are shares you purchased on the open market, acquired when your restricted stock units vested or obtained when you exercised non-qualified stock options.

The shares types above typically have a single cost basis that makes them look similar in terms of how they can be used to exercise your employee stock options and what the tax implications may be.

You can also use shares acquired from an employee stock purchase plan or from an exercise and hold of other incentive stock options grants to do a stock swap. However, the rules and taxability of which may become significantly more complicated.

This is because these shares often have different tax rules subject to holding period requirements. These requirements and subsequent tax rules can make using shares received through an ESPP and ISOs in a stock swap more complicated than other methods.

Stock Swap as an Exercise Strategy

A stock swap can be a useful strategy that allows you to do a tax-free swap of shares you own for employee stock option shares. That being said, remember that while the swap is tax-free, the exercise itself is not.

When doing a stock swap, you use the FMV of the existing shares to acquire ESO shares at their exercise cost. This typically results in you using some existing shares to acquire more — although your total control of company shares actually goes down.

If you want to limit your position in a stock, a stock swap may be a zero-cash-required way to exercise your ESOs and reduce your overall exposure to a single stock. If you want to maximize your concentrated position, you may want to pass on a stock swap and use cash to exercise your ESOs.

Either way, the experience, objectivity, and accountability a professional can offer may be a worthwhile cost if you need help determining whether a stock swap is right for you.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  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.

 

How Leverage May Impact the Value of Your Employee Stock Options

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If you are on the receiving end of employee stock options, you might want to understand the concept of leverage, as it may have a meaningful impact on the future value of your stock. As it relates to employee stock options, leverage is illustrated by the percentage change you see in the total value of your employee stock options as a result of a change in the value of the underlying stock price itself.

If the percentage change in the value of your employee stock options is greater than the percentage change of the stock price, you have leverage.

With employee stock options, you likely can’t eliminate the issue of leverage altogether as it is inherent. You can however, begin to understand leverage by knowing how, when, and by how much it may impact the value of your employee stock options.  This can arm you with the information you need to make appropriate decisions on what to do next.

Let’s take a deeper dive to see the impact of leverage under different scenarios.

The Impact of Leverage on Employee Stock Options

To illustrate leverage, let’s assume that you have 10,000 employee stock options with an exercise price of $10 per share and a current market price of $20 per share. The current value of your employee stock options is $100,000.

Value = Number of Shares * (Current Price – Exercise Price)

= 10,000 * (20 – 10)

=$100,000

Over time, the share price of your company stock will move as subject to the prevailing market price. It can go up or down over the short- and long-term.

What’s interesting, however, is that a percentage move in the price of the company stock may not equal the percentage move in the value of your employee stock options.

To illustrate, lets calculate the percentage change to the value of your employee stock options when the market price of the stock changes in 20% increments.

Stock Price % Change of Stock Value of Employee Stock Option Change in Employee Stock Option Value Change in Value
$16.00 -20% $60,000 $40,000 -40.00%
$20.00 0% $100,000 $0 0.00%
$24.00 20% $140.000 $40,000 40.00%
$28.80 20% $188,000 $48,000 34.28%
$34.56 20% $245,600 $57,600 30.64%

As the price of the stock moves by 20%, you can see the value of the employee stock options increases (or decreases) by more than 20%. When the stock price increases from $20 to $24 per share, a 20% increase, the value of the employee stock options increases from $100,000 to $140,000, or 40%.

A 20% increase in the stock price means a 40% increase in the value of your options. This is leverage at work in your favor.

An Example of Non-Employee Stock Option Stock

For comparison, let’s assume that in lieu of owning employee stock options, you own the company stock outright. Specifically, you own the following:

  • Shares of Stock: 10,000
  • Current Market Price: $20/share

Stock owned outright may be the result of stock purchased through an online brokerage account, shares you obtained through an ESPP, or via vesting restricted stock units. Regardless of how it was acquired, it will act the same, as in there will be no leverage.  Lets illustrate:

Assume the same market movement of 20% in the value of the stock price, as illustrated in the chart below.

Stock Price % Change of Stock Total Shares Current Value Change in Value of Shares Increase in Value
$16.00 -20% 10,000 $160,000 $40,000 -20.00%
$20.00 0% 10,000 $200,000 $0 0.00%
$24.00 20% 10,000 $240,000 $40,000 20.00%

A 20% change in the stock price means a corresponding 20% change in the value of your stock. Considering the percentage change of the stock price equals the percentage change in your total value, we can see that no leverage is present:

The chart further illustrates the math (and the point) that a percentage change in the price of the stock equals the percentage change in the value.

This tells us that stock you purchased outright, ESPP shares, and vested restricted stock units do not have leverage. The percentage change you see in the stock price will equal the change you see in the value of your account.

Is Leverage on Employee Stock Options a Good Thing or Bad Thing?

When viewed through the lens of an increasing stock price, leverage can be seen as a good thing. As the stock price goes up, the value of your stock options goes up by even more (as determined by a percentage increase).

However, there’s a flipside. The same leverage means a greater loss when the stock price goes down. As illustrated in the chart above, a 20% price drop means a 40% loss in value.

This shared risk-reward tradeoff is typical of owning a single stock, and it’s only heightened when you introduce employee stock option leverage.

Whether this is good or bad is often a personal decision about your appetite for risk and acceptance (or avoidance) or volatility.

How the Spread Between the Exercise Price and Current Price Impacts Leverage

If we continue the chart above and illustrate the impact of leverage as the difference between the exercise price and the current market price increases, we can see that the percentage change in value of the employee stock options gets closer to the percentage change in stock price as the spread gets bigger.

For example, when the stock price moves from $103.20 per share to $123.83 per share, a 20% increase, the change in the value of the employee stock options is 22%. Leverage, as the difference between the exercise price and the current fair market value gets bigger, has less of an impact on the total value of the employee stock options.

Stock Price % Change of Stock Value of Employee Stock Option Change in Employee Stock Option Value Change in Value
$16.00 -20% $60,000 $40,000 -40.00%
$20.00 0% $100,000 $0 0.00%
$24.00 20% $140.000 $40,000 40.00%
$28.80 20% $188,000 $48,000 34.28%
$34.56 20% $245,600 $57,600 30.64%
$41.47 20%  $314,720  $69,120 28.14%
$49.77 20%  $397,664  $82,944 26.35%
$59.72 20%  $497,197  $99,533 25.03%
$71.66 20%  $616,636  $119,439 24.02%
$86.00 20%  $759,963  $143,327 23.24%
$103.20 20%  $931,956  $171,993 22.63%
$123.83 20%  $1,138,347  $206,391 22.15%

As leverage decreases, your employee stock options look more and more like stock you own outright. This may be an indication that employee stock options with low leverage are ripe for exercise.

 What Leverage on Employee Stock Options Means for Reaching Your Financial Planning Goals

 Leverage can have a material impact on when and how you reach your goals.  For example, assume that you $1,000,000 of value in your employee stock options and that’s made up of the following:

Exercise Price Current Stock Price Total Shares Current Value
$10.00 $20.00 100,000 $1,000,000

If your goal is to reach $2,000,000 of value, you might think you need the stock price to double, going from $20.00 per share to $40.00 per share.  Leverage, however, illustrates a different story:

Exercise Price Current Stock Price Total Shares Current Value
$10.00 $40.00 100,000 $3,000,000

In fact, when the current stock price doubles, the value of your options increases by 3 times.

We can calculate that in order for you to reach your goal of $2,000,000, the stock price only needs to reach $30 per share, or an increase of 50%.

Exercise Price Current Stock Price Total Shares Current Value
$10.00 $30.00 100,000 $2,000,000

What Leverage Means for Exercising your Employee Stock Options

If you like the idea of leverage and can stomach volatility in the value of your employee stock, it may be reasonable to retain your shares and assume the risk.

However, the potential positive impact leverage may have on the value of your employee stock options may reach a point where you can achieve a similar outcome by simply buying the stock outright.

Said another way, once leverage has maxed out, is your employee stock option providing as much value as it once did?

If you find that you are nearing expiration, leverage is low, and that you are ready to face the tax man, it may be time to consider exercising your options.

As always, the answer to this question should be considered in the context of which type of stock option you have (incentive stock options or non-qualified stock options) and what you are trying to achieve with your overall financial plan.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment. Diversification does not guarantee a profit or protect against a loss.  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.

6 Steps for Handling Employee Stock Options as a Conservative Investor

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If you done any research on equity compensation and employee stock options, you’ve likely come across terms and phrases like “concentration risk” and “too many eggs in one basket.”

You may have also read up on stories that detail how a declining stock price wiped out someone’s net worth before they could exercise, sell, and realize the value that used to be in their employee stock options.

As a result, you might feel wary about your own employee stock options — especially if you’re more conservative with your investments.

That’s understandable, because having employee stock options may come with a unique set of risks that need to be managed. Particularly, single stock risk, and the risk that the value of your employee stock options may fluctuate meaningfully.

Assuming single stock risk is real, it leads to a question – does it make sense to retain employee stock options and other equity compensation if you are a conservative investor? And if so, how does someone go about managing equity compensation and employee stock options in a way that aligns with their conservative nature?

Let’s take a look at 6 steps conservative investors might want to take when it comes to managing their employee stock options.

1 – Know What Type of Equity Compensation and Employee Stock Options You Have

When it comes to equity compensation, it’s not one size fits all.

Equity compensation comes in many forms. Various types of equity brings its own rules regarding when you can access the value and/or shares, when you pay income tax, how they are taxed, and what, if anything, you can do to control the timing of these events.

Here are some common types of equity comp that might be sitting in your portfolio right now:

  • Stock purchased on the open market – Company stock you own outright, usually purchased on the open market
  • Employee Stock Purchase Plan (ESPP) – Stock acquired through an employer-offered option to buy shares, often through a payroll deduction, often at a discounted price.
  • Restricted Stock Units (RSUs) – Shares of stock (or the value paid in cash, please see your plan document) that you acquire based on rules set by your employer, often the passage of time period.  Commonly referred to as a vesting schedule.
  • Non-Qualified Stock Options – Employee stock options provide you with the option to buy company stock at an exercise price set by the employer. Prior to exercise you do not own the stock, only the right (or option) to buy it. Post-exercise, you own the shares. The option is typically offered for a set period of time, often 10 years.
  • Incentive Stock Options – Similar to non-qualified stock options, but more complex from a tax standpoint. However, you may be able to obtain preferential tax treatment on the sale of your stock if you meet certain rules.
  • Stock in a 401(k) plan – it is possible to on company stock in a 401(k) plan, something that should be considered as part of the overall percentage in one company stock

One interesting note about the various types of equity compensation is that in some cases you own the stock and in others you own the right to buy the stock. Both types, however, are impacted by a movement in the stock price.

If you are conservative, a good first step is to evaluate what you have access to and what you may already own. Once you know what you own, you can begin to develop a plan to retain, manage, or eliminate your risk.

2 – Know When You Can Do What with Your Employee Stock And Equity Compensation

Once you know what you have, you need to know what you can do with it — and when.

Long stock, or stock that you probably purchased on the open market, is usually freely transferable at any time. If it is, you may be able to immediately sell the shares and transition the proceeds elsewhere.

For a conservative investor who is looking to remove risk, this is an easy option (keep in mind, however, that selling stock is a taxable event.  And you might want to consider how you will be impacted by a sale).

If you don’t have long stock, things may get more complicated as you’re likely more limited on when you can sell. RSUs, for example, are typically issued with a vesting schedule. Until the units vest (and assuming you receive shares, not the equivalent cash value), you cannot sell them.

In theory, you may have thousands (or hundreds of thousands) of dollars tied up those restricted stock units that you cannot do anything with.

Similarly, you have been participating in an ESPP plan that allows you to easily accumulate stock, potentially at a discount, via payroll deductions. Some ESPP plans however, may not allow you to sell those shares right away. To know for sure, you can check your plan document for more information around the rules and regulations of your specific ESPP.

Employee stock options may allow for the most planning opportunities, but you still may not be able to sell them. They often follow a vesting schedule like RSUs, but they differ in that you can control when you exercise the option to buy the shares and therefore when you are taxed.

This ability to control the exercise of employee stock options may lead to additional considerations for the conservative investor. In one sense, you didn’t pay anything for the option so you have little to lose should you do nothing. But by not exercising and selling your shares, you are putting whatever value the options currently have at risk — something a conservative investor may not be interested in doing.

3 – Consider Selling Your Restricted Stock Units (RSUs) ASAP

If you have restricted stock units, you might want to sell them immediately. As touched on above, your ability to sell your restricted stock units may or may not be totally in your control due to vesting schedules — but once you can sell, it might make sense for you to choose this option.

Remember, when your employer grants RSUs, they give you a promise of something in the future. You may be given 10,000 RSUs, for example, and those vest in 3 years. Between the time the RSUs are granted and the time they vest, you have no right to them nor are they taxed.

When you reach the 3-year time restriction, however, the RSUs vest and you take ownership of the shares (check your plan document to see if you will receive shares or cash when this happens).

You are also taxed on the value of the units that day. Specifically, you are taxed on the following:

Number of Units Vested * Share Price = Taxable Income

Typically, the amount of tax due is paid through a cashless exercise where some units are withheld to cover the tax liability and you receive the remainder (keep in mind however, that the amount withheld may or may not be enough to cover your actual tax bill, and you may want to consult with someone who can help).

Because you already paid tax on the shares of stock you receive and because shares are no longer subject to risk of loss, they very much resemble stock as if you went out and purchased it the same day. Following that logic, it makes sense that if you sell that same day, there is likely little taxable gain/loss that needs to be reported.  It also makes sense for conservative investors who want to diversify that vested restricted stock units are an easy option.

4 – Consider Selling ESPP Shares ASAP, As Well

An employee stock purchase plan allows for a convenient way to purchase company stock through payroll deductions. Some companies even offer a discount of up to 15% of the stock price to participate in an ESPP.

Typically, participation in an ESPP means that you defer a set dollar (or percentage) per pay period into the plan. For a set period of time (often 6 months) the money is collected. At the end of the set period, your dollars are used to purchase shares of company stock on your behalf.

An ESPP can provide a convenient, profitable, and low-risk way to participate in the growth company stock. But as a conservative investor, you may want to consider liquidating your plan shares immediately after they are purchased for you. If you get to buy the stock at a discount, immediately selling may mean locking in a minimum profit equal to that discount.

Much like restricted stock units, ESPP shares resemble stock purchased outright once they are purchased through the plan. Therefore, as a conservative investor, it may make sense to sell them right away.

5 – Make a Plan for Employee Stock Options

Employee stock options may present the biggest planning challenge for conservative investors, and deserve a well-thought out strategy for properly managing them according to your goals and risk tolerance.

You may have considerable wealth tied up in your employee stock options, which is an opportunity — but mismanagement can cost you, and no matter what, you may need to pay taxes on any exercise and sale that you do.

Let’s assume that you were granted 10,000 options with an exercise price of $1 per share and a current share price of $50 per share, with a value of $490,000. There are a few things to note in this scenario:

  1. Until you exercise your shares, you likely don’t have to pay anything for them.
  2. If you do exercise your shares, you may need to pay tax. The type of tax depends on the type of employee stock options that you have.
  3. If you do not exercise, your $490,000 is subject to the fluctuations of the market and the prevailing share price. This may mean positive or negative swings in the value of the option

To overly simplify, if you are a conservative investor and seek to eliminate company stock risk, an exercise and sell at all tax cost may be the best strategy.

But if you are conservative and willing to assume some level of risk, you may be able to develop a strategy the manages your conservative investment nature with your goals of being tax smart and investment conscious.  This means developing a strategy to exercise (or not) and sell (or not) your employee stock options.

6 – Determine How Much Money You Have Elsewhere

After all of this is said and done, none of it may even matter if you have only a small percentage of your overall net worth tied up in employer equity and employee stock options. One rule of thumb in the suggests no more than 10-15% of your net worth should be tied up in company stock.

If you fall below this percentage, even if you are a conservative investor, you might want to consider whether you are comfortable with that risk.  And if so, does it make sense to keep your shares in company shares (while keeping an eye on your equity comp to be sure it remains an acceptable portion of your net worth).

For example, if your total net worth was $1,000,000 and you hold $100,000 worth of company equity, then only 10% of your wealth is tied up in your company. This may be an acceptable figure even for a conservative investor.

Be mindful, however, of how the other $900,000 of your wealth is invested. If all $900,000 is invested in a US equity fund, your overall allocation may be too aggressive considering your appetite for risk and willingness to expose yourself to volatility.

Putting the rest of your net worth into something like a more conservative mix of fixed income and equity types investments might be a more appropriate way to meet your stated conservative intentions.

What You Should Consider Next as a Conservative Investor with Employee Stock Options

If you’re a conservative investor with employee stock options, you may want to keep things simple and liquidate your entire company stock position as soon as possible.

This strategy pays no regard to tax or timing. It simply turns equity into cash as soon possible, removing the risk associate with a single stock position

However, this simple strategy (while it may be appropriate for some) may sometimes be an oversimplification of the process. Even a conservative investor may benefit by holding some company stock for the short and long term, especially if the holding is well maintained in a tracked, suitable, and reasonable financial plan.

Ultimately, conservative may mean a lot of different things. Determining what is means to you and how the impacts your financial plan will be determined by a confluence of your age, income, assets, and other personal needs.

Once you determine what conservative means, you can build a plan that addresses your needs for conservative investing.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  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.

Should You Exercise and Sell All Your Employee Stock Options Right Now?

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If you have employee stock options, you’ve probably spent time considering the absolute best time to exercise those options — and from there, whether you should sell or hold your shares.

Answering the question of “when” — when to exercise, and when to sell — is wrapped in complexity. With so many liquidation strategies at your disposal and so many personal needs to consider (such as what kind of stock options you own and what the tax implications may be for taking action with them), the decision-making web can seem endless and overwhelming.

But there is one approach that can make everything much simpler: exercise all your options and sell all your shares immediately.

No tax planning, no worries about the future value of the stock or what you may be “missing,” no holding period requirements that keep you invested longer than your intentions.

Just exercise and sell everything.

The result? You transfer value in your employee stock options into cash proceeds that can be used to fund your financial planning goals and objectives immediately.

It sounds simple and straightforward enough. But is this the strategy for you? A good start to discovering the right answer is to educate yourself on the positives and negatives of this strategy. Here’s what you need to know.

Advantages of Liquidating Your Employee Stock Options Right Now

The most notable advantage to an immediate exercise and sale of all your employee stock options is that you transfer the imbedded value of your employee stock option into cash. In other words, you transform paper value into real value via cash you can use right now.

The best use of this cash might be to reinvest it in the market through a more diversified portfolio. You could also use it to fund specific savings goals. Or, depending on your financial situation and plan, it might be appropriate to use this money right away in other areas of your life.

A second benefit of the exercise-and-sell-immediately strategy is the ability to diversify your assets. We touched on this above, but it’s worth digging into more detail to understand what happens when you hold instead of sell.

A large position in a single company stock exposes you to concentration risk. With concentration risk, you retain the possibility that the value of your stock options can swing drastically in a short period of time.

If you exercise and sell, you remove the inherent volatility associated with concentration risk. And again, you can then use the proceeds to invest through a better diversified, more strategic investment portfolio.

While diversification does not guarantee protection from market volatility or investment loss, it’s generally accepted that a diversified portfolio will lessen the volatility of your investment portfolio.

A final advantage of the exercise-and-sell-it-all strategy? Certainty. A bird in the hand is better than two in the bush, after all.

If you exercise and sell, you know what you the final outcome of your transaction will be. No more guessing, projecting, or hoping for a future value of your stock options. No more seeing the value of your employee stock option statement change.

When you exercise and sell, you know the exercise price, you know the market price when you exercise (or hopefully very close to it), and you know the final sale price (or very close to it). Therefore, you know what will you get once that transaction is complete.

Certainty is intangible, but that doesn’t mean it can’t be of great value when it comes to building wealth.

Disadvantages of an Immediate Exercise and Sale Strategy for Employee Stock Options

When you exercise and sell your employee stock options, the transaction is taxable and reportable on the calendar year’s tax return in which the transition occurred. Any profit you realize will be taxed as ordinary income.

Ordinary income receives no preferential tax treatment and is taxed at the highest marginal tax rate — which could be a potential downside when it comes to exercising and selling all of your options and subsequent shares.

If you have a lot of profit potential in your employee stock options, receiving that profit after implementing this strategy could push you into a higher tax bracket. All else being equal, a higher tax bracket means more tax owed and less money in your pocket.

Essentially, you lose some tax efficiency when you exercise and sell everything all at once. In some cases, you could pay less in taxes if you use a different approach and exercise and sell your stock options over a period of time.

But the most tax efficient strategy isn’t necessarily the best one, depending on your specific circumstances.

You should talk to an advisor with experience in both leveraging stock options and understanding tax planning to run the numbers. Then, compare various strategies available to you. You’ll want to evaluate what leaves the most money in your pocket, of course — but you also need to consider pros, cons, and trade-offs.

Another disadvantage of exercising and selling immediately is one that specifically pertains to incentive stock options: you will not get to perform a qualifying disposition. Again, this is a tax-related issue.

It means you won’t be able to take advantage of the lower tax rates you may get if you exercised, then held shares and sold them later. This isn’t a reason to automatically rule out the exercise-and-sell-immediately strategy — but it is something to keep in mind and weigh alongside all the other factors that will impact your decision.

Thinking Through the Unknowns: What About the Future Value of Your Options?

If you exercise and sell your employee stock options, you also forego the upside potential of your company stock. Holding employee stock options affords you the opportunity to participate in potential price appreciation of the shares.

An appreciating stock price is certainly not guaranteed — and the volatile path the stock might take on its way to higher value might not be an experience you can emotionally handle — but it is possible that you can make a lot of money by staying invested.

And it’s also possible you lose a lot of money, too. While it’s worth considering the potential future value of company stock before you decide what strategy you want to use, you can’t base your entire decision around what to do on this alone because you simply don’t know what will happen.

There’s Leverage to Think About, Too

In addition to giving up on maybe getting a bigger gain in the future, selling everything now also means you give up leverage. Leveraging your stock options may allow for your growth to be more than the actual growth in a stock price, as a percentage basis.

Here’s what that means: If you have 10,000 stock options with a grant price of $10 per share and a current market price of $20 per share. then the value of your employee stock options is $100,000.

Value = Number of Shares * (Current Price – Exercise Price)
= 10,000 * (20 – 10)
=$100,000

To illustrate leverage, we can adjust market price of the stock in 20% increments and calculate the value of the employee stock options

Stock Price % Change of Stock Change in ESO Value Increase in Value
$16.00 -20% $40,000 -40.00%
$20.00 0% $0 0.00%
$24.00 20% $40,000 40.00%
$28.80 20% $48,000 34.28%
$34.56 20% $57,600 30.64%

As the price of the stock moves by 20%, you can see the value of the stock options increases by significantly more. When the stock price increase from $20 to $24 per share, a 20% increase, the value of the stock options increase by 40,000, or 40%.

Again, you can’t base your decision on whether to exercise and sell everything immediately solely on something like this. But it’s worth considering and making a part of the conversation around what you should do with your options.

A Few Good Reasons to Exercise and Sell

It’s easy to write about the advantages and disadvantages of an immediate exercise and sell, but how do you incorporate this into practical decision making?

One compelling reason to exercise and sell everything right now is if the after-tax proceeds of the transaction will give you enough money to meet all your financial planning goals and objectives.

Once you have “enough,” isn’t that good enough?

A second reason to exercise and sell immediately is if you are risk averse and cannot handle the volatility of a single stock position.

A single stock position can move severely in a short period of time. As it does, the value of your employee stock options can more even more as illustrated above with leverage.

If you are not comfortable with the big swings, exercising and selling everything right now might be right for you so you can take advantage of a big benefit of that strategy: certainty.

A third reason to exercise and sell would be if you consider the stock to be fairly valued, and you believe it will go down in the future.

While predicting where a stock price will go is difficult and no one can be sure, a strong conviction and the subsequent desire to act upon this may warrant an exercise and sell. This would allow you to capture the current value of the options before it is wiped away by a falling stock price.

What’s Next?

A single exercise and sell strategy is one that strips away the complexity that can potentially inhibit your ability to make a decision. By simplifying the decision-making tree, you may feel more confident about taking action — and you know you’re choosing the strategy that will immediately put real money in your pocket.

This strategy is simple, straightforward, and you know what you are going to get as a result.

For this reason, it’s worth considering starting your decision-making process by comparing your other options to the sell and exercise immediately strategy. Using this as the base case, you can more adequately weight both the benefits and drawbacks of other advanced planning techniques.

What you may find upon careful inspection and comparison is that the bird in the bush isn’t quite as attractive as it might seem.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment. Diversification does not guarantee a profit or protect against a loss. 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.

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