Non-qualified stock options (NSOs) are commonly issued to allow employees to participate in the upside potential of a company. They may also be used as the proverbial “golden handcuffs.” Golden handcuffs may offer you a substantial value in the future, should you continue to work for your company.
Non-qualified stock options are issued at a grant price. When the price appreciates, the stock option has value.
However, employers may not allow you to tap this value for years via a vesting schedule. You can’t cash them in until the stock options vest.
If the stock options have value and aren’t yet vested, combined with the risk that if you leave the company, they are forfeited, you may be more inclined not to leave your company. Who would walk away from potential substantial value (i.e., golden handcuffs)?
Eventually, after the stock options have vested, an employee will want to take action on these options. Upon taking action, the employee will opt for either a cash or cashless exercise.
Below, we take a look at 3 broad options for exercising non-qualified stock options, as well as the final value.
Exercise and Sell When They Vest
When stock options are granted, they are given a vest date. The vest date is a date in the future when the employee (stock option holder) has the right to exercise the options. Prior to this point, the employee cannot take action. Employers protect themselves and keep employees engaged in the on-going success of the company by setting vesting schedules well into the future.
One strategy that may be implemented is to exercise and sell the options as soon as they vest.
With this strategy, the goal is often to capture the stock option value immediately. Often, the captured value is then allocated to a diversified investment portfolio*. The thought for someone implementing this strategy, commonly, is to treat stock options as compensation.
As compensation, the employee is not interested in waiting for the stock to appreciate or extending their holding period. By treating stock options as compensation, the singular goal is to often sell and diversify as soon as possible.
For example, let’s assume that 1,000 stock options are issued with a grant price of $20 per share and are valued at $50 per share upon becoming vested.
Using this strategy, the employee will elect to exercise and sell the shares immediately. On this transaction, they will generate a gain of $30,000 (the difference between $50 (the current value) and $20 (what they can buy it for), or $30 per share multiplied by 1,000 shares)
If the stock price appreciates later, the employee who has chosen to sell and diversify has effectively lost out on the opportunity.
However, should the stock price depreciate, the employee who diversified will take solace in the fact that they may have made a prudent decision to diversify.
The $30,000 is often then invested into a diversified portfolio*.
(It’s important to note that this $30,000 will be taxed as compensation and needs to be claimed on one’s tax return in the year of exercise).
Exercise and Sell at Expiration
Similar to a vesting date that is given upon the grant of NSOs, an expiration date is also provided.
An expiration date is the date at which the shares and any subsequent value disappear, assuming that no other action is taken.
If the current market value of the stock is lower than the grant price, then the stock options will expire as worthless.
If the current market price is in excess of the grant price, then the stock options have value. Should you let options expire that have value, you are effectively throwing money out the door (so I would not recommend this!).
Often, employees will wait until (or near) the expiration date to make a decision because they think that not making a decision to act is the far easier decision. At this point, this is often the default decision.
In addition, delaying the exercise of your option is also a decision to delay the tax impact. Taxes may be due upon the exercise of options. Because of this tax impact, many employees will wait as long as possible to exercise options. As the expiration date nears, the pending tax hit becomes secondary to the risk of throwing money out the window!
If we extend the example above, we can assume that the expiration date is several years after the vesting date. Let’s assume that the stock price has further appreciated to $100 per share.
In this scenario, the employer will need to claim $80,000 as ordinary income (the difference between the grant price ($20) and the current price ($100) multiplied by the outstanding shares). If we assume a 33% tax bracket, the tax due on this exercise will be $26,400.
Exercise at Vest and Hold
In lieu of exercising and selling immediately or exercising upon expiration when there is no better option, a potentially better strategy exists that may be beneficial for a highly appreciating stock.
The strategy may be to exercise the options at the vest date, and then hold the shares to take advantage of long-term capital gains tax rates.
Using the scenario above, an employee who exercises the shares at vest date will claim $30,000 of income that will be taxed at ordinary income rates (the difference between a grant price of $20 and an exercise price of $50, times 1,000 shares). Assuming a 33% bracket, the tax due on this exercise will be $9,900.
Upon exercise, the employee will begin their stock holding period, and the stock will have a basis of $50,000. After a 1-year holding period, any gain on a future stock sale will be taxed as a long-term capital gain.
Using the same example above, the stock will grow to $100,000 and be sold. In this scenario, the $50,000 gain will be taxed at long-term capital gains rates. Assuming a 15% tax bracket, the tax due will be $7,500.
In total, this transaction will cost $17,400 in taxes. Alternatively, by exercising at expiration, the tax owed was $26,400. Essentially, this employee was able to save $9,000 in tax.
However, we must note the additional risk assumed by the employee. By exercising early, the employee was electing to pay tax sooner, rather than later. Should the stock depreciate in value after exercise, the employee will lose. They will have paid tax on a higher amount than had they simply held the stock and not exercised.
Which Option Is Best
No one option is best for everyone. Some employees choose to diversify immediately, while others wait until expiration.
Other things to consider should be your expected receipt of future options. For example, if you expect to receive options annually, you may be more inclined to sell your shares immediately and diversify. Why is that? Because you may be able to participate in the upside of the company through future options, as opposed to the ones you can exercise now.
Most importantly, as the value of your stock options becomes a substantial portion of your net worth, it requires an honest discussion and evaluation of your goals to decide which exercise strategy is best for you.
Sometimes, when you have enough, you have enough!
* 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.
The above figures and examples are hypothetical and are for illustrative purposes only and do not attempt to predict actual results of any particular investment.