If Shakespeare’s Hamlet had worked in biotech or high-tech, this might be the question he would have asked himself. Whether your company is privately held or publicly traded, this post will discuss the pros and cons of exercising employee stock options. The main considerations include the cost of exercising (buying) options, tax implications, and subsequent performance of company stock.
In a previous post, we looked at the basics of employee stock options (definition of key terms). There are two types of options: incentive stock options (ISO’s) and nonqualified stock options (NQSO’s), with different tax implications.
Here are some precepts for exercising either type of option:
- You can only exercise options that have vested.
- You will only want to exercise options that are “in the money” – i.e. the options are worth more at the date of exercise than what you pay for them (based on price at date of grant).
- Options usually expire 10 years from date of grant, so that may be a trigger for exercise of vested options which are “in the money”.
- Another impetus for exercising options is when you leave a company. Usually you will have only 90 days to decide on whether you want to exercise your vested options.
When you plan on exercising options, you will need to decide how you will pay for them. If you are working for a privately held company, the option price may be so insignificant the cost will not matter. However, for publicly traded companies, the expense may be substantial. A “cashless exercise” is one way to fund the cost. In a same-day transaction, the company will help you sell some stock to pay for exercising options.
Tax Implications of Exercising Options
For both ISO’s and NQSO’s, there are no taxes owed at the time of grant.
When you exercise options, the tax treatment is very different for ISO’s and NQSO’s. For ISO’s, no taxes are withheld. However, you may be liable for alternative minimum tax (AMT), depending on the value of your shares at exercise (vs. grant date). The more shares you exercise and the more they have increased in value, the more likely you are to trigger AMT (your income also matters). It is important that you plan ahead for taxes before exercising ISO’s.
When you exercise NQSO’s, taxes will be withheld at the supplemental income rate, which may be insufficient. You may need to sell company stock to cover supplemental taxes. It is important that you plan ahead for taxes before exercising NQSO’s.
Upside of Exercising Options
Once you exercise your options, you start the clock ticking for how much tax you will owe when you sell company stock. If you wait for more than one year to sell company stock after exercising, you have the potential to save significant taxes, because your gains will be taxed as long-term capital gains (lower rate than income tax rate). If you sell stock one year or less after exercising options, you will pay short-term capital gains (same as income tax rate).
Downside of Exercising Options
Working at a privately-held company: if your company doesn’t go public, you will have lost the money you spent on exercising options and on any taxes owed. If your company goes public, there may be a lockup period of six months where you are not allowed to sell company stock. The share price could fluctuate wildly during that time.
Working at a publicly-traded company: you will have paid for exercising options and for any taxes owed. It is up to you to decide when to sell company stock. Simply put, you have two choices – sell and pay short-term capital gains or hold company stock and wait so that you can benefit from long-term capital gains. This can be a very difficult decision with a large emotional component. Do not let tax minimization be the driver for sale of stock because there is no guarantee on the future price of your company stock. If you are not convinced of this, remember the dot-com bust of the early 2000′s. During that period, employees paid huge amounts of taxes and held onto stock that eventually was worthless.
A Financial Planning Perspective
Your stock options have the potential to provide you with significant wealth, depending on your company’s future and how you manage your options. Keep in mind your financial goals. If you want to use the proceeds of company stock to buy a home in the near-term, it may be in your best interest to exercise and sell sooner rather than later. Also, if your company stock is a significant percentage of your net worth (especially likely if you are young), it will be important to exercise, sell and reinvest in a diversified basket of funds or stocks.