Exercising stock options, taxes, and when to exercise is very important for you to know before you even agree to sign the agreement letter. Stock options are a form of equity derivative that gives an investor the right (not obligation) to buy or sell the stock of the company in the future at an agreed-upon price and date. The holder of the option can eventually choose to buy/sell the stock or leave the option to expire. Purchasing the company stock at the agreed-upon price means exercising stock options.
In this article, we will discuss what exercising stock options means, when, and how to exercise stock options; taxes associated with exercising options, and the advantages and disadvantages.
Related: Types and classes of stocks
What does exercising stock options mean?
Exercising a stock option means the holder of the option is purchasing the shares of the company at the exercise price defined in the option grant. This means the option holder can now own shares in the company. Therefore, the process of buying the shares of the company at the price and time specified by the stock option is known as exercising the stock options. Hence, it is important to note that owning stock options doesn’t mean owning shares outright. The holder only owns shares of the company after exercising stock options.
In an option contract, the price of the stock that is agreed upon is known as the grant price, strike price, or exercise price. The stock option exercise price is usually equivalent to the fair market value (FMV) of the shares at the time the options are granted. The option contract, however, comes with a fixed date known as the expiration date. This means that a stock option can only be exercised prior to or on the expiration date.
For American-style options, the stock option can be exercised at any time up to and including the expiration date of the option. But for the European style options, the option can only be exercised on the date of expiration. The expiration dates are usually identified by a month and a specific date is identified within the expiration month as an exact deadline. This deadline is usually the third Friday of the expiration month for both American- and European- style options. Therefore, on the third Friday of the expiration month, an investor usually has until 4:30 p.m CT to instruct his broker to exercise an option.
Furthermore, stock options can expire either in-the-money (ITM), at-the-money, or out-of-the-money (OTM). The stock options that are in the money can be exercised. This is when the fair market value of the stock is greater than the stock option exercise price. Hence, the investor stands to make some profit. Whereas, the options that are out-of-the-money end up becoming worthless. An option is said to be out of the money or underwater when the fair market value of the stock is less than the exercise price. More so, options are said to be at the money when the fair market value of stocks is the same as the exercise price.
What happens when you exercise stock options?
By buying the shares of the company’s stock, you exercise the stock option which you can choose to sell for profit or hold on to. Stock options are usually profitable if the company’s stock price rises above the stock option exercise price.
In such instances, the stock options are exercised because the price of the stock is above the stock option exercise price. This means that the holder of the stock options will buy the company’s stock at a discount and can choose to hold onto the stock over time or sell the stock immediately in the open market to make a profit.
An example of exercising stock options
Let’s look at an example to explain how exercising stock options work. We will be using a type of stock option known as the employee stock option (ESO) for this example.
For ESOs, there is a timeframe during which an employee can earn the options known as the vesting period. The options may be granted all at once known as cliff vesting or can be granted over a period of time known as graded vesting. The company usually set the timelines called the vesting schedule which tells the dates and number of years it will take an employee to work with the company to be able to earn the option.
Assuming Miss Mary is hired at a new startup and the company offers her employee stock options. Say, she is offered 10,000 option shares at an exercise price of $1 per share. If Miss Mary’s vesting schedule is for 4 years with a one-year cliff, where after one year the remaining shares vest monthly at 1/36. This means that Miss Mary has to continue working with the company for one year to be able to earn any shares at all. Therefore, if she leaves before this, she will have no option shares.
Based on the company’s vesting schedule for Mary’s ESO, it is calculated that after:
- One year- 2,500 shares are vested
- Two years- 5,000 shares are vested
- Three years- 7,500 shares are vested
- Four years- 10,000 shares will be vested
Now, let’s assume Miss Mary stayed at the company all through the four years and has earned the right to exercise the 10,000 shares if she wants to. She then chooses to purchase 10,000 shares of the company at the exercise price of $1 per share. This means Miss Mary has exercised her stock option.
Assuming the company shares are trading at a price of $10 per share at the time Miss Mary exercised her stock option. This can be a big win for her. This means that she bought the 10,000 shares that are currently worth $100,000 at a total of $10,000. By simple arithmetics, Miss Mary will earn a $90,000 profit ($100,000 – $90,000) if she decides to sell her shares. In this instance, the option was exercised because it was in the money (i.e the fair market value of the stock is greater than the stock option exercise price).
See also: Restricted shares
When to exercise stock options
- Early exercise of stock options
- Exercising stock options after vesting
- Exercising stock options after termination (leaving the company)
Wondering when to exercise stock options? There are several things to keep in mind when making plans to exercise your stock options. First of all, one has to be sure the option can even be exercised. For instance, if the options are not vested yet, one would need to wait until they are before exercising stock options.
Moreso, supposing the options are vested and the company isn’t publicly traded yet, one will need to have the required cash to make it happen. Even if a holder can exercise his/ her options, they will want to be sure that the stock price is higher than the exercise price.
Most importantly, knowing when to exercise stock options is key for tax implications. Exercising stock options can have a potentially huge impact on your taxes. Hence, it is best to speak to a tax advisor before exercising any stock options.
In addition, some companies usually don’t allow you to exercise your stock options right away. They may require you to stay at the company for a certain period of time (usually at least a year) or achieve a milestone, or both.
Whichever way, there are 3 main periods, that one can exercise their stock options which include an early exercise, exercising after vesting, or after leaving the company.
Early exercise of stock options
Early exercise of stock options is the process of buying or selling the shares of the company’s stock under the terms of the option contract before its expiration date. Some companies allow the holder to early exercise before the options vest. If a company allows this, the holder can exercise his options as soon as he gets his option grant, though the option grant will continue to vest according to the original vesting schedule.
Benefits of early exercising
- Favorable tax treatment for ISOs
- Lower long-term capital gains tax
- Reduces spread and additional taxes
There are some benefits associated with early exercise such as:
Favorable tax treatment for ISOs
Early exercising gives favorable tax treatment for ISOs (incentive stock options). This means that the option holder can qualify for ISO tax benefits by early exercising. However, in order to qualify for this tax benefit, the holder has to keep his shares for at least 2 years after the option grant date and one year after exercising the stock options.
Moreso, it is important to note that you must file an 83(b) election within 30 days of exercising to be able to take advantage of this potentially favorable tax treatment. There could be serious consequences if this deadline is missed. Making an 83(b) election, means you’re requesting that the IRS (Internal Revenue Service) recognize income and levy income taxes on the purchase of company shares when granted, rather than later upon vesting.
Lower long-term capital gains tax
Another benefit of early exercising is that it ensures the holder starts holding the shares earlier. Therefore, any income from the sale of the shares is taxed as a long-term capital gains tax. Early exercising may help the holder pay the lower long-term capital gains tax when he/she sells the shares.
Reduces spread and additional taxes
The option holder likely won’t owe additional taxes if he or she early exercises their options. If a holder early exercises the options as soon as they’re granted, he will be buying the shares at fair market value. This means reducing the spread and therefore reducing the amount of tax that would have been paid because there’s no spread between the current worth of the stock and the amount the option holder pays for the stock.
Disadvantages of early exercising
- Cash has to be used for early exercising of options
- No assurance that the shares will increase in value
- Early exercising may trigger the $100K rule
- Leaving the company after early exercise is unfavorable
In as much as there are benefits associated with early exercising of stock options. There can be disadvantages as well. Some of the risks associated with early exercising include:
Cash has to be used for early exercising of options
You have to use your own money when exercising early. This means you have to use cash to purchase the shares. No other methods of payment are allowed for early exercising of options. Therefore, you can’t even sell some of your stock to pay for your shares.
No assurance that the shares will increase in value
There’s no assurance that the shares will increase in value in the future. When you don’t early exercise and wait for the usual one-year vesting cliff, you can watch the value of the stock to know if it is increasing or decreasing in the market. This can help give you a better idea of whether you should exercise your options or not. But if you exercise early and the stock price doesn’t increase in the future, you may lose your money.
Additionally, it is advisable to wait as long as possible before exercising stock options in a private company. This is because no matter how good the outlook is at the moment, the company may run into trouble and the stock you purchased may become worthless. Therefore, exercising stock options before IPO can be dicey because as long as your company is private, the company shares (if exercised) as well as the options are usually worth nothing. The reason is that there’s no market for it and the only person you can sell the shares to is the company itself.
Early exercising may trigger the $100K rule
It is important to note that you may trigger the $100K rule if your option grant is early exercisable. Triggering the $100k rule means you’re prevented from treating more than $100K of the full value of your grant as incentive stock options (ISOs) in the year that you receive your grant. Therefore, the value of your option grant that is above $100K is treated as non-qualified stock options (NSOs) for tax purposes.
Leaving the company after early exercise is unfavorable
Another disadvantage of early exercise of stock options is that it can be unfavorable for the holder if he/she leaves the company after early exercising but before their stock vests. Some companies buy back their shares for various reasons. Therefore in an instance, whereby the holder leaves the company after early exercising before the option gets vested, the company has the right to buy back the early-exercised but unvested stock.
Exercising stock options after vesting
Some companies can only allow exercising vested stock options. This means the option holder can only exercise after vesting. Vesting is a timeframe during which the holder of an option can earn the right to exercise the option. The options may be earned and granted all at once (cliff vesting) or can be granted over a period (graded vesting). Companies usually set the vesting schedule that tells the dates and number of years it will take to earn the option.
For instance, all or some of the options may require that an employee continue to work in the company for a particular number of years before earning the right to exercise an option. The essence is to lure the employee and keep him/her working for the company for as long as possible. Therefore, as the number of years increases, more option is earned.
Hence, after hitting the vesting cliff, one can be able to exercise the vested options whenever as long as the person remains employed. Furthermore, companies usually use targets to set vesting schedules such as the employee or the company meeting certain performance goals or profits. The targets used to set vesting schedules could be time-based targets, milestone achievements, or a combination of both.
Exercising stock options after termination
Stock options can also be exercised after leaving the company. The majority of companies have a 90-day post-termination exercise period (PTE or PTEP) whereby the holder can still purchase the shares even after leaving the company. Therefore, the holders of stock options must exercise their vested options with the standard 3 months PTEP after they have ceased providing services to the company.
Nevertheless, some companies offer more generous post-termination exercise periods, some for as long as you worked at the company. After this PTEP, you can no longer exercise your options. The stock options will then go back into the company’s employee option pool.
How to exercise stock options
- Pay cash (exercise and hold)
- Cashless exercise of stock options (exercise and sell to cover, exercise and sell, or stock swap)
Exercising a stock option can be done in a variety of ways depending on the company. How to exercise stock options is to pay cash; exercise and hold, or carry out a cashless exercise of stock options which entails exercise and selling to cover, exercise and sell, or stock swaps.
Pay cash (exercise and hold)
Exercising a stock option can be done with cash; you purchase the shares and hold onto them. For this exercise method, you use your own money to buy your shares and keep all the shares. You may also need to deposit cash into your brokerage account or borrow on margin to pay for your shares. Therefore, you are likely to pay brokerage commissions, fees, and taxes.
The upside of using cash to exercise is that it gives you the maximum investment in company stock. Hence, you are provided with the potential for gains from increases in stock value and payment of dividends (if any).
However, the downside to this is that this can be a risky way to exercise as you’re not guaranteed to make a profit or even get your money back. Also, until you sell the shares purchased, your money is tied up and could only pay off if your shares end up being worth a lot.
Cashless (exercise and sell to cover)
One of the ways to carry out a cashless exercise of stock options is to exercise and sell to cover. A company that is public or offering a tender offer, may allow you to simultaneously exercise your options and then immediately sell just enough of your shares to cover the purchase price, applicable commissions, fees, and taxes. After this, you can do whatever you desire with the remaining shares; either keep the remaining shares or sell some.
Cashless (exercise and sell)
Another way to carry out a cashless exercise of stock options is to exercise and sell the shares immediately. This means you purchase your option shares and immediately sell them. A company that is public or offering a tender offer, may allow you to exercise and sell all of your options in one transaction.
In several cases, your brokerage will allow this transaction without using your own cash. Therefore, the purchase price, as well as the commissions, fees, and taxes associated with the transaction are covered by the proceeds from the stock sale. This leaves you with cash in your pocket to put into other investments or do whatever you please.
Another form of a cashless exercise of stock options is a stock swap. With a stock swap, one can exchange the company shares that one already owns to pay for the shares obtained from the exercise of the stock option.
The main advantage of this choice is the avoidance of taxes. However, have it in mind that in order to avoid incurring tax costs you must hold the shares used in the exchange for a certain period of time (usually one or two years). This will avoid the transaction being treated as a sale and taxed as such.
Exercising stock options and taxes
People are usually interested in knowing when to exercise their stock options because of the tax implication. One thing is sure; exercising stock options comes with taxes.
Are stock options taxable when exercised? Yes, the fact is you become liable for taxes once your stock options are exercised. Before exercising your stock options, you do not need to pay taxes. This is because you do not own the stock yet.
However, after exercising stock options, your tax rate will depend on the type of stock option you’re holding. The tax implications depend on whether you’re holding incentive stock options (ISOs) or non-qualified stock options. ISOs come with preferential tax treatment and can be taxed at capital gains rates, whereas NSOs are taxed at ordinary tax rates.
See also: Are stock buybacks tax deductible?
What happens if you don’t exercise stock options?
Vested stock options expire and are canceled if they are not exercised before the expiration of the post-termination exercise period. Therefore, as a stock option approaches the expiration date, the contract holder must decide whether to sell, exercise, or let it expire. In many cases, when the holder waits for too long to exercise, he/she misses out on tax advantages because incentive stock options (ISOs) turn into non-qualified stock options (NSOs).