If you have stock options, you came to the right place. Stock options can be a lucrative way to build wealth over time. But they can be complicated and hard to understand. Here I provide a quick overview of employee stock options and some things to consider from my 25 years of experience in advising executives. I hope you enjoy, Michael Aloi CFP
Employee Stock Options
Congratulations you have been granted stock options! Okay now what? First things first, take a deep breath and exhale. I will guide you through what you need to know. It's important to know employee stock options are designed to incentive employees to help build the company and share in its stock growth over time, that can be a good thing. I have had many clients build wealth over time with their employee stock options, so should you!
How do employee stock options work?
Typically, an employee is granted stock options as a part of their annual compensation. The option is the right to buy the company stock in the future at a predetermined price. The hope is the future stock price is higher than the predetermined stock price, that is the spread or your potential profit. See below for an example.
Step 1: Get your hands on the option agreement - Waste no time on this one, make sure you call HR immediately and ask for the option agreement. The option agreement outlines all the key terms. I suggest saving a copy to your desktop for future reference. I also suggest sending a copy to your accountant and financial advisor for their input.
Step 2: Read the agreement and look for these key terms - I know option agreements are long and boring, but it's important to know what you have so you can maximize these plans. First understand the key terms:
Grant Date: The day you receive your option and the date your options begin to vest, it's like the option birthday, the day it was born, congratulations!
Grant Price: This is the stock price that you can buy the stock at in the future if you decide to exercise the option. Also known as "strike price" or "exercise price".
Vesting Date: If your options have a "vesting schedule" this is the waiting period. The excitement of a newborn option wears off quickly when you realize you must wait to do anything with it, but the company is trying to incentivize you to stay with the company, hence the waiting period. If you leave prior to the vesting date you may forfeit the stock option. I say "may" because it varies by company, some companies have a magic age and years of service where everything vests while others may be performance based.
Exercise Date: The date you decide to "exercise" your option is the date you buy the company stock at the grant price.
Expiration Date: Options can expire, usually after 10 years. Make sure you know when your options expire.
Doug is a hard charging executive with the Widget Insurance Company. The company values Doug and wants him to stay another four years so they grant him 1,000 stock options with a four-year cliff vesting schedule - they vest 100% after four years - with strike price of $25. The stock price after four years is now $55, and Doug wishes to exercise 250 of his 1,000 options. The price Doug pays to exercise his options is $6,250 (250 x $25 original strike price).
The market value of the shares, however, is $13,750 (250 x $55 the current share price). The spread or profit to Doug is $13,750 minus the $6,250 or $7,500 - nice job Doug! But Doug shouldn't get too excited because that spread is taxable.
With stock options the spread is taxed as ordinary income in the year Doug exercises even if he doesn't sell the shares (this may not be the case with Incentive Stock Options, see below). The good news is Doug made a profit, which isn't always the case, the stock price can go down. That is a downside to stock options.
Important Planning Considerations
Beyond these basics there is much more to know about employee stock options. Here are some things to consider:
1. Taxes - While there is no taxation at the time of grant, there are potentially two times you may be taxed - at the time of exercise and at the time of selling the stock. (Depending on the type of option you own - see below.) There are tax planning techniques, but an easy one is exercising only enough options in any given year so as not to get bumped up into the next tax bracket.
2. Two types - There are generally two types of options - non-qualified stock options and incentive stock options, it is important to know the difference as the tax consequences are different.
3. Exposure to company stock - If you decide to exercise and hold the stock be aware of your overall exposure to the company stock over time. It's not uncommon for executives to get more and more company stock over time. However, too much of any one stock can be risky. At some point you may want to diversify away from the company stock.
4. Timing of other income - All else being equal, you want to exercise your options in a low tax year. In the beginning of the year, I review with my clients their upcoming bonus, stock awards, and other income. If they are in a high tax year - other stock awards vesting or receiving deferred compensation payments - then that might be a year to hold off on exercising options. However, you must weigh this with other factors like the current stock price, your overall concentration in the company stock, and your need for liquidity.
5. When to exercise? Some think holding their options to expiration increases their chances of the company stock going up and therefore increases their spread or profit. Others may be more conservative and want to exercise their options and sell the company stock as soon as possible. Each approach has advantages and disadvantages and there is no right answer since we don't know the future stock price. However, some planning can help, consider:
- What is your outlook for the stock? Executives know their company stock and may see it over- or undervalued. Having said that, executives may be too optimistic about the future stock price, they may be "drinking the Kool-Aid" as we say.
- What is your overall concentration risk? How much do you already own of the company stock? If you plan on staying at the company till your options vest, odds are you will receive more company stock over the years in one form or another. Be careful about owning too much of any one stock. A general rule of thumb is having no more than 10% of your overall net worth in one stock.
- What is your current vs future tax rate? If you expect to be in a lower tax bracket the following year than that may be a good time to exercise. However, you must weigh that with the risk of holding and owning the company stock for one more year. Also, are future tax rates set to increase? That may be hard to know, but worth considering.
6. Cashless sale vs Not - The difference between a cash exercise and a cashless exercise involves the funding for the transaction. A cash exercise means you front the money to buy the stock when you want to exercise the option. A cashless exercise means you instruct the company or custodian to use option shares to front the exercise cost of purchasing the shares, in other words, you use no cash up front. As you might expect, there are pros and cons to each approach.
A cashless sale is good for those who do not want to use up their liquidity or want to own less company stock. While a cash exercise is good for those who have the liquidity or those who see opportunity in owning more of their company stock.
The Bottom Line
As you might have guessed, there is much to know about employee stock options. My advice? Get to know your options and how they fit into your overall financial plan. Get the option agreement, confirm the type - ISO vs NSO, and know the vesting and expiration dates. And have a financial plan for when to exercise, how to exercise (cashless vs cash), and what to do with the company stock when you exercise (hold or sell). A financial plan is a great way to look at your options holistically, as part of the overall picture, and can help answer many of the questions you might be thinking.
For more information, email me at firstname.lastname@example.org.