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If you're thinking about exercising your employee stock options, it's important to have a strategy in place and to know the best time to pull the trigger. While it's best to consult with a financial advisor and tax professional before you exercise options, here are some basics to help you understand the process.
What Are Employee Stock Options?
An employee stock option is a form of compensation that some employers provide to their workers. As the term suggests, having stock options doesn't mean you own shares in the company. Rather, you have the option or right to purchase shares of the company at a specified price. When you exercise your stock options, you purchase the stock at that price.
Stock options allow employers to provide incentives that they don't have to pay for right away. Ideally, they also create an employee incentive to help the company succeed. If the employee exercises their options and eventually sells the shares at a higher price, they stand to make a tidy profit.
Here are some common terms related to employee stock options:
- Grant date: The date on which your employer initially granted you the options.
- Strike price: Also known as the exercise price or grant price, this is the price at which you purchase your options. Your employer sets this price when it grants you the options.
- Vesting schedule: Many employers don't grant all of an employee's stock options at once. Instead, an employee may gain rights to their options—meaning that the options are vested—incrementally over several years or all at once after a set period. The vesting schedule may also be based on performance.
- Exercise window: You typically have a window of time during which you're able to exercise stock options granted to you. This is generally between seven and 10 years if you remain with your employer; the window may be shortened considerably if you leave the company.
- Expiration date: This is the date on which your options expire, and you can no longer exercise them.
There are two types of employee stock options you may receive: incentive stock options (ISOs) or nonqualified stock options (NSOs). The biggest difference between the two is how they're treated for tax purposes.
- Incentive stock options: ISOs aren't taxed when you exercise your options. If you hold the purchased shares for more than two years from the grant date and one year from the exercise date, they're eligible for the lower long-term capital gains tax rate, which maxes out at 20% (compared with the 37% marginal rate for ordinary income tax).
- Nonqualified stock options: NSOs are taxed at the ordinary income tax rate when you exercise them. For example, if you have a strike price of $5 per share and you exercise your options when the actual price of the stock is $15, you'll pay taxes on the $10 difference per share. If you then sell your shares after one year, you'll pay the more favorable long-term capital gains tax rate. But if you sell within a year, you'll pay the ordinary income tax rate because it will be considered a short-term capital gain.
How to Exercise Stock Options
Your company should provide information on how you can exercise your stock options. But in general, there are a few different ways you can do it:
- Exercise and hold: With this option, you'll typically exercise your options at the strike price by paying cash, and you'll hold on to them instead of selling them right away.
- Exercise and sell to cover: Depending on the situation, companies may allow employees to exercise their options and sell enough shares simultaneously to cover the cost of the purchase, taxes and added fees. You can do what you want with the remaining shares you exercised. This option may arise if the company is public or is making a tender offer to buy some of your shares.
- Exercise and sell: If your company is public or is making a tender offer, you may be able to exercise your options and sell the shares all in one transaction. In this scenario, a portion of the proceeds will go toward the purchase, taxes and fees, and you'll get to keep the rest.
Companies typically use a third party to manage their stock options, so you'll need to have access to your account to make it happen. Speak with your company's human resources manager or finance department to get more information about your different choices and the steps you'll need to take.
When Should You Exercise Options?
There are several things to keep in mind when deciding when to exercise stock options. For starters, you'll want to make sure you even can exercise your options. If they're not vested yet, you'll need to wait until that occurs before you can do anything.
If your options are vested and your company isn't publicly traded yet, you'll need to have the required cash to make it happen.
Even if you can exercise your options, you'll want to make sure the stock price is higher than the exercise price. For example, if your exercise price is $50 per share, but the stock is currently trading at $45, you'll lose money by paying to exercise your options.
Other questions to ask yourself include:
- Have you left your company? If you're no longer employed with the company, you may have a short deadline to make your decision whether or not to exercise your options.
- How's the company doing? How likely is it that the value of the company's shares will increase over time? If you're not bullish on the business, it may be best to hold off on exercising your options for now. If you believe the share price will increase, it could be worth it to exercise your options sooner rather than later.
- How long until you can sell? If your company is privately held and has no current plans to make a tender offer or initial public offer (IPO), you may never get your investment back if the company fails. But if your company is public or is making a tender offer, you could exercise your options and sell immediately to enjoy the gain.
- Can you afford the taxes? Depending on the type of options you have, it's important to understand how you'll be taxed and whether you have enough money to pay the bill.
Work With a Professional to Develop Your Strategy
If you're trying to determine how and when to exercise your stock options, it's critical that you consult with a financial advisor and a tax professional to get expert advice. While some approaches are riskier than others, professional advisors can help you determine how and when you'll get the best reward. Getting objective advice from a professional who likely doesn't have familiarity bias with your company can help you determine the best course of action.