Last week, we discussed the two different types of employee stock options (NSO’s and ISO’s), which if you missed you can read here. This week we are going to discuss some exercise strategies as well as risks and strategies after exercise. Many of the strategies discussed in this blog depend on your specific company plan. So, be sure to double check your option plan agreement before moving forward with any strategy.
Hold your options
The first strategy is just to hold onto your options for as long as possible before exercising them. However, make sure you understand and know when your options expiration date are.
This strategy works if you believe the stock price will rise over time allowing you to take advantage of the long-term nature of the option. You will also delay any tax implication until exercise
Exercise and Hold
You can also exercise the options as soon as they are vested. Keep in mind that to buy shares of your company you will need cash. After exercising, you can then hold on to the shares for as long as you’d like. If you sell more than a year later, you will be afforded long-term capital gains treatment on the gains.
Exercise and Sell to Cover
In this strategy you exercise your options to buy shares of your company and immediately sell just enough to cover the stock option cost, taxes, and commissions. You will still have shares of your company but avoid paying out of pocket to acquire them. This strategy only works if the market price is well enough above the grant price to cover costs. Also, be sure to check with your company to see if this is allowed.
Exercise and Sell (Cashless)
The final strategy is known as a cashless exercise and must be allowed by your company. You exercise your stock option to buy your company stock and sell the acquired shares at the same time without using your own cash.
The proceeds you receive from an exercise-and-sell transaction are equal to the fair market value of the stock minus the grant price and required tax withholding and brokerage commission and any fees (your gain).
This strategy is good for those who are looking for liquidity or trying to avoid “concentration risk”.
Employee Stock option Risks
Not understanding how employee stock options are taxed is one of the largest risks. If you missed part 1 where I explain how the different types are taxed, you can read that here. It is important to have a plan for your employee stock options that fit into your larger financial situation.
The other risk that comes from employee stock options is known as concentration risk. This happens when large amounts of your net worth are tied up in a single stock. It’s never smart to put too many of your eggs into one basket, and investors should always seek to have a diversified investment portfolio. That is especially true when it comes to investing in stock in your company, because when you invest in your own company, your finances are doubly exposed.
1. In the event your company falters, not only might your investments tumble, but you might also find yourself out of work at the same time.
The rule of thumb is to avoid having more than 10% of your total net worth in any one stock. So if exercising your options puts you at risk it may be wise to consider a cashless exercise and re-invest the proceeds into a diversified portfolio.
If you have employee stock options as a part of compensation and would like to discuss building a financial plan around them, you can schedule a call with me here. I would be happy to learn more about your situation and offer guidance.
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