Many companies — from internationally known, huge corporations to budding start-ups — offer their employees stock options, along with their salary and benefits packages. These financial instruments give employees the chance to profit from their company’s success, sometimes even more than non-working investors in the company may realize.
Stock options function a little bit differently than traditional market transactions. And for many employees, the nature of stock options can be very confusing. Here’s a brief explanation of everything you need to know about stock options exercising, how it works, and how to take advantage of it.
How to Exercise Stock Options
First Things First
Let’s start by explaining what it means to buy stock. You purchase shares in a company, which means you actually own a percentage of that company. You buy a stock in hopes that its price will increase over time. When it gets to a certain price point, you may choose to sell all or some of your shares. Alternatively, you may decide to hold onto the stock if you think it will go even higher in the future.
When you work for a company, they may offer you stock options as a part of your compensation package. Stock options aren’t shares. Instead, they’re contracts that give you the option to transact on shares when they reach a certain price before a certain date.
For example, say that you work at Fizz Corp, a fictional soft drink company. You’ve been there for almost a year. Fizz Corp is a publicly owned company, which means that they sell shares to anyone who wants them.
As you’re coming up on your first work anniversary, Fizz Corp grants you the right to buy shares in the company for $25 per share (the “strike price”) within six months.
This is your stock option — more specifically, it’s an “incentive stock option.” You now have the right to purchase Fizz Corp stock at the fair market value of $25 within the next six months. But you’re not obligated to do so. That’s why it’s an option.
Here’s the thing, though: If, within the next six months, Fizz Corp’s share price goes up to $30, or $35, or $50, or whatever, you still have the option to buy it at the original strike price of $25. No matter how much the share price goes up, you’ll only have to pay the lower strike price if you buy in before the expiration date. And you could see an immediate profit if you sell your Fizz Corp stock immediately after you exercise your option.
Of course, the Fizz Corp price may well go down in those six months. If you buy at the strike price, you may lose money in the short term. But you can hold onto your shares until Fizz Corp starts to turn a profit. And again, you don’t have to buy the stock — you just have the option to do so. You may decide to wait until the next round of stock options comes your way after six months.
The option to buy a stock when it hits a certain price point is called a “call” option. There’s another stock option for selling your shares when it hits a certain price point, known as the “put” option.
Let’s say that Fizz Corp gives you the option to sell shares you already own when they hit $20 within six months. The Fizz Corp stock price then goes down — let’s say it hits $10. If you have the put option, you can sell your stock at the agreed-upon $20 price if you do so before six months are up, no matter how low the price gets.
When Can You Do It?
Every company has a different policy for stock options exercising. Most of the time, though, you can’t exercise your options the minute you get them. Generally, you must remain employed at a company for a certain amount of time or reach some other benchmark before you can exercise them. The option contract should make it clear exactly when you can start exercising your stock options.
The process of earning the right for stock options exercising is known as “vesting.” Once you’ve hit the benchmark, your stock options are considered to be vested. You’re now free to exercise on the options as you wish.
You may act on vested options for as long as you’re employed by the company. Many companies will allow you to exercise options even after you’ve departed, as long as you do so within a pre-set “post-termination exercise period” (PTE). A PTE can be anywhere from a few months to several years.
Some companies allow employees to exercise on their stock options before vesting is complete. This is called — wait for it — “early exercise.” In this scenario, you’re allowed to exercise your stock options whenever they’re granted to you, even if you haven’t hit the benchmarks. The options will continue to vest. There are some risks in early exercising, which we’ll discuss in a bit.
The Expiration Date
Stock options are valid until the expiration date. After that, you no longer have the choice to exercise them and the options lose all value.
That’s not necessarily a bad thing. If you’re nearing the end of your option term and the stock price falls beneath your strike price, you have no reason to exercise your option. When you’re near the end of your option term, your strike price might be $25, but if the stock has fallen to $20, you should do nothing. You can buy the stock yourself at the lower price if you want.
If you leave the company, but don’t exercise your options before the PTE, the options are terminated and revert to the company’s options pool. Each company sets its own PTE. Some set it at 3 months; others are more generous and give you multiple years. Still others give you as much time as you worked for the company — if you leave after working for 4 years, you’ll have 4 years after termination to exercise the option. The terms of your PTE should be outlined in the legal language of your stock option grant.
What You Need to Know About Early Exercising
As mentioned above, early exercise on stock options is an alternative that some companies allow. Again, the legalese on your stock option grant will explain whether you can exercise options before they fully vest or not.
Early exercise may be beneficial when it comes to your taxes. If you have incentive stock options, early exercising may help you to gain favorable tax treatment. Usually, you’ll need to hang on to your shares for at least two years after they’re granted and hold onto them for at least one year after you’ve exercised the options for this benefit to apply.
If you choose to exercise stock options the minute they’re granted (and if the company allows you to), you’ll likely avoid owing additional taxes, since you’re acquiring them at fair market value. You’re not paying more than they’re worth, so there are no taxable gains.
Early exercising does come with a few risks. For one, you must use your own cash to pay for the stock you buy — you can’t just sell additional company stock to buy the option shares.
You may also trigger something called the $100K rule. That’s an IRS-imposed regulation that limits your execution of incentive stock options to $100,000 in a calendar year.
When you choose to do early exercising, you’re also leaving your share price in the hands of the stock market — an unpredictable force. You could lose a considerable amount of value. If you wait until your options are fully vested, you’ll have a better idea of whether to exercise or not.
Every company’s policy for exercising stock options is different from the next. Generally, the choices are twofold: To pay with or without cash.
Using your own money to buy optional shares is called an “exercise and hold.” It’s straightforward enough: Pay the cash and get the shares. The only real drawback to exercise and hold is that you’re not guaranteed any profits or even a break-even point. Your money is entirely tied up in the stock shares until you choose to sell them. However, if the stock price goes up, you’ve made a tidy profit.
There are two cashless strategies that some public companies offer. One is “exercise and sell cover.” In this scenario, you exercise your options and immediately sell just enough shares to cover the purchase price and associated taxes and fees. You keep the remaining shares to do with as you wish.
The other cashless transaction is known as “exercise and sell.” In this transaction, you exercise and sell all of your shares in a single transaction. After deducting some proceeds to cover the price and fees, you’ll keep the rest of the money.
Things to Consider When Making Your Choice
Before exercising stock options, it’s vital to think about a few issues and set a strategy. Some questions to consider include:
Can I Early Exercise My Options?
Some public companies don’t allow for early exercising on stock options. At some corporations and start-ups, you’ll have to use your own funds to do an early exercise.
How Healthy is the Company?
Be honest about how successful you think your employers are going to be in the near future — do you expect the share price to rise or fall? Avoid blinders and familiarity bias; be as realistic and objective as possible, no matter how much you love your company.
How Soon Can You Sell Shares After Exercising?
This is primarily a question if your company is still private and doesn’t have an initial public offering coming up. Exercising options while the company’s still under the radar may mean that you’ll buy shares that can never be cashed in, so there’s an elevated risk.
Can You Afford the Taxes?
Be aware that your capital gains profits on exercising options are all taxable. Make sure that you can afford these taxes.
What Do You Want?
If you sell stock right after you’ve exercised the option, you may reap some profits but may incur higher taxes. If you exercise and sell within one year, you’ll likely pay the most expensive tax rate. If you hold shares for at least one year, you’ll likely owe lower taxes and possibly reap bigger profits. Of course, you may also post a bigger loss.
It’s always worth talking to a tax advisor to determine how to proceed when exercising stock options.