In an effort to attract and retain top talent, more companies are providing stock options as part of their benefits package. Employees don’t receive stock outright but will have the option to purchase shares at a specific price. This guide will show you how to exercise stock options so you can take full advantage of your benefits.
What Are Stock Options?
Stock options grant investors the right to buy or sell shares of a stock at a specific price and a specific date. You’re never required to exercise stock options, but investors may want to take advantage of a lower price and secure an asset at a discount.
There are two types of stock options: stock puts and stock calls. Stock puts are basically a bet that a stock’s price will fall, while a call is a bet that the price will rise.
Employee Stock Options (ESOs) are technically a type of call option. Employers offer ESOs as part of a larger benefits package, allowing employees to receive a discount on the company’s corporate stock, which can be a way to help newcomers enter the market.
How Do Stock Options Work?
When it comes to stock options, exercising your rights can take a different process depending on your company. Generally, you’ll be allowed to purchase stocks after an initial vesting period, and you’ll have access to these options for as long as the company allows.
What Is the Option Grant?
The option grant serves as the contract between you and the issuing party. The option grant will outline things like:
- The predefined stock price
- The duration of the vesting period
- The deadline for stock options exercising
- Any additional terms and conditions
Again, the terms vary by company, but the options grant will help you understand your exact rights and responsibilities relative to your stock options.
What Is the “Strike Price?”
The “strike price” refers to the predetermined price of the stock. For stock options exercising to be a good value, investors will exercise their options when the strike price is less than the current value of the stock shares.
For example, if corporate stock is trading at $150 per share, but the employee has stock options with a strike price of $100 per share, this would be a good time to exercise these options.
What Is the Vesting Period?
In most cases, you won’t be able to exercise your stock options until after an initial “vesting period.” This period can vary between companies, but many employers expect their employees to remain with the company for at least a year or hit certain professional benchmarks before exercising stock options.
The “vesting cliff” refers to the end of this initial waiting period. Once you reach this point, you’ll be able to exercise your stock options for as long as the company allows.
What Is Early Exercising?
In some cases, investors can exercise their stock options before the vesting period. This will be spelled out in your option grant.
On the one hand, this allows you certain tax benefits. For example, starting your holding period earlier can better ensure that you pay the lower long-term capital gains tax if you sell these assets.
On the other hand, exercising your stock options earlier can be risky. After all, you don’t necessarily know if your corporate stock will increase in the near future or by how much.
Can I Exercise Stock Options After I Leave My Company?
Your option grant will specify a deadline for exercising stock options. In some cases, you’ll only be able to exercise these options for a specified period. In other cases, you can exercise your stock options as long as you’re with the company.
Other companies offer a generous post-term exercise (PTE) period. This means that even if you leave the company, you can exercise stock options at any point before this PTE period ends.
How to Exercise Stock Options
As an investor, you can exercise stock options in one of three ways:
1. Pay Cash (Exercise and Hold)
This is the most direct approach. To exercise your stock options, you’ll use your own funds to buy shares and keep all of them.
As with any investment, this practice carries some risk. And there are some isolated reports of startups pressuring employees to exercise their options, which is unethical, to say the least. Still, this can be a great way to pad your nest egg or simply take advantage of a potentially profitable approach to investing.
2. Cashless (Exercise and Sell to Cover)
Some companies allow you to exercise your options but sell enough of your shares to cover the purchase price and any applicable fees or taxes.
The advantage is obvious: it allows you to recoup the administrative costs of investing and keep the remaining shares or sell them entirely. However, not every options grant allows you to do this, so check your contract before exercising stock options.
3. Cashless (Exercise and Sell)
In other cases, you might exercise your options and sell them all in the same transaction. The money you make will cover the purchase costs, and the rest of the money is yours to keep.
This might be a good strategy if you’re not interested in your company’s stock but want to use these options to invest in another individual stock.
When to Exercise Stock Options
Knowing how to exercise stock options isn’t always as important as knowing when to exercise these options. Here are some guidelines that you can use to guide your decision.
When You’re Allowed
Remember: you can only exercise stock options within a specified time frame. Unless you have early options specified in your options grant, you’ll have to wait for your vesting cliff to exercise your options.
You’ll also need to exercise your options before the end of your post-term exercise (PTE) period, shortly after you leave your company.
When Your Options Have Value
Stock options only have value when the strike price falls below the stock’s market price. But savvy investors might also want to keep an eye on the value of corporate stock to ensure that the investment is even worth it. After all, it’s possible for the stock to be a good value but offer limited potential for meaningful future growth.
When Your Company Is Public
Your company doesn’t have to be public to exercise stock options, but since private companies aren’t traded on public exchanges, you’ll have to pay the fees to fund the purchase. And once you purchase these shares, they have very low liquidity, making it significantly harder to cash out.
You might consider waiting to see if your company goes public before exercising your stock options.
When It Makes Sense for Your Taxes
Typically, the “bargain” element of your stock options is taxed at income tax rates in the year that you exercise your stock options. This could potentially push you into a higher income tax bracket than if you were just claiming your annual salary.
For some, it may make sense to exercise your stock options early in your tenure with a company when your salary is low enough that you won’t get bumped into a higher bracket. But for others, it might make sense to wait until your salary increases since the stock options won’t affect your bracket significantly.
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