4 Ways to Exercise Employee Stock Options – Which One Is Right For You?

By: Kevin O’Brien, CFP®, AIF®, CAP®

With the stock market setting historical highs lately, perhaps it’s time to revisit your Employee Stock Options Plan, and determine if you should exercise some, or all, of your vested options. The key word here is “vested”. You see, until your options are vested, you cannot exercise them.

Upon vesting, you have two choices, either exercise the options or continue to hold them, and exercise them before their expiration date. Stock options usually vest in tranches, and expire after 10 years from the date they were granted to you. As an example, you were granted options to purchase 1,000 shares of employer’s stock at $20 per share on 3/1/2016. Generally speak, you might vest in 25% of the 1,000 shares every year for the next four years. Then by 3/1/2026, if you haven’t exercised any of the options, they will expire worthless. So, as you might have guessed, it’s wise to have a plan for how you will exercise these options before their expiration date.

Several factors should be taken into account before you exercise your options:

  1. Your personal financial goals and their time constraints.
  2. The company’s stock price compared to your exercise price.
  3. Whether or not the stock is considered undervalued, overvalued, or fairly valued.
  4. The tax implications of exercising your options.

By having your short, intermediate and long-term goals established, and knowing what amount of money and what minimum rate of return you need to accomplish them, you can determine whether regular savings and/or proceeds from your stock options will be needed.

The company’s stock price in relation to the price per share that you can exercise your options at, the “strike price” is important. If the stock price is less than your “strike price”, then there’s no reason to exercise the options, as they would be considered “under water” or “out of the money”. If the stock price equals or is only slightly higher than the exercise price, it may not be worth exercising them. However, if the stock price is significantly higher than the strike price, you should consider exercising some or all of your vested options.

Now, when we consider exercising some or all of the vested options we want to determine if the stock is considered to be undervalued, overvalued or fairly valued. This can be determined by looking at price to earnings ratios, price to sales ratios, book value, and other valuation methods in relation to the company’s historical numbers. For instance, if a company’s P/E ratio is 24 and historically it has been averaging 19, then the company could be considered to be slightly overvalued, or trading on the higher end of its valuation scale. Our philosophy suggests that if the stock is undervalued, only exercise what you need or don’t exercise any at all. However, if the stock is fairly valued or overvalued, a more significant amount of options should be exercised.

Finally, what are the tax implications of exercising your options? We’ve all heard the expression, “don’t let the tax tail wag the dog”. However, tax consequences should be considered prior to exercising your options, especially if it’s a significant amount of money. Tax consequences could be different for non-qualified stock options (NQOs) versus incentive stock options (ISOs), so you need to know which ones you’re dealing with. Once these areas have been addressed you can now decide how you want to exercise your options. The choices are Cash Exercise, Cashless Exercise, Sell-To-Cover, or Stock Swap.

Cash Exercise: you pay cash to cover the strike price and hold onto the purchased shares. Example, you can exercise an option for 100 shares at $10/share and the stock is trading at $20/share. You exercise the option by buying the shares for $1,000, meanwhile they are worth $2,000 and you continue to hold the 100 shares to sell at a later date.

Cashless Exercise: your broker will lend you the money to cover the strike price to purchase the shares, and then immediately sell all of the shares. The proceeds from the sale pays back the broker for covering the strike price, any commissions, and tax withholdings if required. The remaining cash is sent to you or placed in a cash account at the brokerage house under your name. In the example above, you would receive $1,000 cash less any tax withholdings and costs for the following example. ($2,000 value – $1,000 strike price = $1,000 profit).

Sell-To-Cover: is similar to a Cashless Exercise, only the broker only sells enough shares, after exercise, to “cover” the strike price, and you keep the remaining shares. Going back to our example, the broker would sell about 50 shares (50 shares x $20/share = $1,000) to pay back the costs to exercise the options. You would continue to own the other 50 shares.

Stock Swap: you would need to own existing shares of the same company stock as that of the options. You can then “swap” enough shares of the company stock to cover the strike price to exercise the option. So if you had 50 shares of the company stock in our example above, you could pledge them to cover the costs to exercise the options.

So, depending upon your goals, the time constraints on the money, the underlying company’s valuation and outlook, and the ultimate tax liability, you can make a well-informed, educated decision as to what approach is best for you. However, if you are still unsure of the best approach for you, you should consult a professional such as a Certified Financial Planner, or CPA, who is experienced with and well-versed in this area of expertise.

Kevin M. O’Brien, CFP, AIF, CAP is Founder and President of Peak Financial Services, Inc.  Advisory Services offered  through Peak Financial Services, Inc., a Registered Investment Advisor.  Securities offered through Triad Advisors, member FINRA/SIPC.  Triad Advisors and Peak Financial Services, Inc. are not affiliated.