Exercising stock options: What it is & when to do it

Exercising stock options refers to an employee purchasing shares in the company for which they work. These options are granted to them as part of their compensation package and are particularly common at tech companies. Stock options typically come with a predetermined price, known as the "strike price," and a specified period, or "exercise period," during which the employee can exercise them.

These options are part of your compensation package, and their popularity has grown significantly; one study found the value of the options granted by S&P 500 firms rose from an average of $22 million per company in 1992 to $141 million in 2002.

Stock options come with a "strike price" and an "exercise period" during which you can buy the shares. This article will walk you through how to exercise your options, when to do it, and what to expect along the way.

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What does it mean to exercise stock options?

Exercising stock options means buying company shares at your predetermined strike price, regardless of the current market value. You pay the strike price and receive actual shares in return.

If the market price is higher than your strike price, you can profit by selling immediately or hold the shares for potential future gains.

Stock options serve a dual purpose:

• A form of incentive for the employee, potentially leading to financial gain contingent on the company's success; by 2002, research showed that over 90% of stock options were being granted to managers and employees, not just top executives.

• The promotion of employee retention, as stock options often come with vesting schedules that require a certain length of employment. Research has shown three and four years are among the most frequent vesting times for both uniform and cliff vesting plans.

For employees, exercising stock options carries some risks. The market price may fall below the strike price, resulting in a loss if the shares are sold. The cost of purchasing shares and potential tax implications must also be considered.

Types of stock option exercises

When you're ready to exercise your stock options, you have a few different ways to go about it. The right method depends on your financial situation and goals.

Here are the most common approaches:

• Cash exercise: Pay the full strike price upfront using your own money. You own the shares outright and decide whether to hold or sell.

• Cashless exercise: A brokerage provides a short-term loan to cover costs. They sell enough shares to repay the loan and taxes, giving you the remaining profit.

• Sell-to-cover: Similar to cashless, but you only sell enough shares to cover costs and taxes. You keep the remaining shares.

In short, a cash exercise of stock options directly turns options into ownership, demanding upfront cash payment from the option holder.

How to exercise stock options with cash

A cash exercise of stock options refers to the traditional method by which an employee exercises their stock options. With this approach, the employee pays the necessary cash to buy shares at the strike price, which is predetermined and typically below the current market price (see above).

For example, if an employee has the option to buy 1,000 shares at a strike price of $10, they will need $10,000 to carry out a cash transaction. After this transaction, the employee owns these shares outright and can choose to sell them or retain them.

A cash exercise requires the employee to have enough liquidity to pay the strike price upfront for all the shares they wish to purchase. It's also essential for the employee to consider potential tax implications, which can be significant and are often levied on the difference between the market value of the shares at the time of exercise and the strike price.

When to exercise stock options

There's no universal answer, and research shows that many workers tend to exercise ESOs soon after vesting, which can sacrifice significant potential value. Ultimately, the right time depends on your finances, company outlook, and risk tolerance.

Key factors to consider:

• Vesting schedule: You can only exercise vested options. Track your vesting dates closely.

• Company performance: Exercise and hold if you believe the stock will keep rising.

• Personal financial goals: Need cash for a major purchase? Your timeline affects the decision.

• Expiration date: Options expire, especially if you leave the company. Don't let them become worthless.

What is an early exercise of stock options?

The early exercise of stock options refers to the opportunity to exercise these options before expiration. In most cases, this refers to American-style options, which can often be exercised at any point during the agreed-upon term. Conversely, European-style options almost always require the employee to wait until the end of the period.

Tax implications of exercising stock options

Exercising stock options isn't just a financial transaction-it's a taxable event. In fact, the IRS states that after exercising an Incentive Stock Option (ISO), you should receive from your employer a Form 3921 to document the transaction.

This bargain element is typically taxed as ordinary income. The rules vary between ISO and NSO options, and you might trigger Alternative Minimum Tax (AMT).

Tax laws are complex and location-dependent, so consult a qualified tax professional for your specific situation.

Stock option exercise examples

Let's walk through a simple example to see how this works in practice. Imagine you have options to buy 100 shares of your company's stock at a strike price of $5 per share.

The stock is now trading at a fair market value of $25 per share. You decide to exercise all 100 of your options using cash.

• Cost to exercise: 100 shares x $5 (strike price) = $500

• Value of shares: 100 shares x $25 (market value) = $2,500

• Paper gain: $2,500 (value) - $500 (cost) = $2,000

In this scenario, you pay $500 out of pocket to acquire shares worth $2,500. The $2,000 difference is your immediate gain on paper and is typically the amount subject to taxes.

Making the right choice for your situation

Exercising stock options is a big financial decision that combines your personal goals with market realities. Understanding your options, timing, and tax implications helps you make the right choice for your situation.

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FAQs

Should I exercise stock options immediately?

Exercising immediately after vesting can help you qualify for better tax rates later, but it means taking on risk sooner. It depends on your confidence in the company and financial situation.

Should I exercise my stock options before an IPO?

Exercising before an IPO can be profitable since strike prices are usually lower than IPO prices. However, there's no guarantee the IPO will succeed or happen at all.

What happens if I can't afford to exercise my options?

Use a cashless exercise where a broker loans you money to buy shares, then immediately sells some to cover costs and taxes. You keep the remaining profit or shares.