Exercising Employee Stock Options: When to Do It

Employee stocks can mean life changing money, but knowing when to exercise employee stock options is easier said than done. This is why we will explore the crucial aspects of exercising your stock options, empowering you to make informed decisions about your financial future.  Remember – Employee stocks options can be life changing money, but knowing when to exercise is easier said than done.

 

What’s the difference between exercising stock options and selling them?

Let’s start by clarifying the difference, since the definitions can be confusing.

Exercising stock options

You exercise your options when you purchase shares of company stock at a specified price. The price is called the strike price, exercise price, or grant price and is the price you pay to own the shares. This is usually the fair market value at the time the options were granted to you. When you are ready to exercise an option, you notify the company that you want to purchase stock and provide payment according to the terms of the option.

Selling shares

After you exercise your options, you can sell them. This generally takes place in the stock market but can also occur at private companies through share buybacks or purchase offers – often referred to as “liquidity events”.

Timeline for exercising stock

If you stay employed at the company, you can exercise your options at any point between the “Vesting Date” and “Expiration Date”, as illustrated by the photo below.

 

Are there any limitations when you can and should exercise?

There are several aspects you should be familiar with when you want to exercise stock options for employees:

• Vesting schedules: You can’t exercise your options until they’re vested. You must wait until the time specified in the options agreement.
• Expiration dates: You can’t exercise your options after they expire. There are time limits and other factors at play, such as termination of employment.
• Under water: You may be able to exercise if you’re not in the money, but you shouldn’t exercise if you can purchase the shares at a cheaper price in the stock market.

When to exercise stock options? 

The time to exercise is one of the most important decisions you’ll make about your stock options, and one of the hardest. Before you go running off to exercise, there are some important things to consider.

Should you continue to hold your option, or should you exercise it now and own the stock? 

In most cases, it’s better to hold off on exercising employee stock options if you plan on staying invested in your shares. Meaning you should only consider exercising the option when you’re ready to cash out by selling the stock. For ISOs this could be after a one-year holding period following the “grant date” to maintain its qualified status or when the option is about to expire.

Reasons to hold off

• Downside protection: A stock option provides a form of downside protection you don’t have when you own the shares of stock outright. If the stock price falls below the exercise price of the option, you don’t lose any money because you’re not obligated to exercise the option. As soon as you own the shares, you’re fully exposed if the stock tanks.
• Exercise costs & taxes: You give up the opportunity to delay paying the exercise price, and in many cases, you also give up the opportunity to delay paying taxes. If your income is already high for the year, and you exercise NSOs or ISOs that are disqualified (both trigger ordinary income tax), then the bargain element of your stock options could put you into a higher income tax bracket. (Note: For ISOs with a qualifying disposition, you don’t pay tax at exercise. You’re only taxed when you sell. If you end up holding shares for favorable cap gains treatment, then the bargain element could trigger AMT). 

Reasons not to hold off

• Stock performance: If your company’s stock price is a lot higher than the exercise price of your stock options, then there’s a high probability that the built-in profit is much greater than the remaining time value. The option is prime for harvesting profits, even if it won’t expire for several years.
• Tax treatment: If you work at a privately owned company (pre-IPO) and you want to lock in your bargain element before the 409A valuation reprices your shares higher, then you should consider doing it early to ensure good exercise price of employee stock options. If your company allows you to purchase shares prior to vesting, you can file an 83(b) election. This means you would pay up front for the shares, including the tax, but would still be subject to the original vesting schedule before the shares could be sold.
  Purchase offers may also be available to lock in an early exercise. Because the strike price is close or will be closer to the fair market value, then you’ll pay less tax now than if taxes are paid after the shares increase in value (Note: 83(b) elections must be filed within 30 days of exercise). 

Are there any other reasons for an early exercise? Early exercise starts the clock on the holding requirements for ISOs to qualify for favorable long-term capital gains tax treatment (i.e., holding requirement is one year from the date of exercise and two years from grant date).

Individual considerations

However, there’s no one size fits all solution to a best exercising stock options strategy. A lot will depend on your unique situation. 

What if you are a SINK (“single income no kids”) or DINK (“double income no kids”)? Then there may be a chance you have a higher tolerance for risk and less financial constraints. However, if you have kids and are prioritizing several financial commitments, then your approach to exercising your stock options will most likely differ. 

As a best practice, you should consider exercising in the context of your overall situation by looking at the bigger picture. 

Your cash flow, available capital, and other competing financial goals will play a major role in deciding when to exercise employee stock options. If you have other income sources to cover your committed, discretionary, and other major planning expenses, then you might hold off on exercising or you may even consider exercising more of your options if you work at a privately owned company because you’ll have the liquidity to cover the taxes and costs associated with exercising. 

On the other hand, if you need an influx of money to help supplement your expenses or cover the costs of a new home purchase or college education, then exercising your options and selling them now will help you.

Who can help me exercise my employee stock options?

Employees tend to think the only way to pay for their options is with money out of their pocket or they end up leaving money on the table because they didn’t have the resources to pay. Don’t walk away just yet. Your options are complex. It may be time to consult with a tax professional or financial planner. Making informed decisions about your stock options can be a struggle if you lack time, knowledge, or resources. 

This is where Augustus Wealth can help you. We’re a team of professional investment planners with many years of industry experience and a long list of satisfied clients from companies such as Amazon, SpaceX, Tesla, Netflix, Mattel, and many others. We’ll assess your current situation and give you advice on how and when to exercise your options for maximum gains. Get in touch today!