You have to consider potential tax implications, whether or not you have the necessary cash flow to execute a chosen strategy, and of course, deal with the fear of making a “wrong” decision.
Although the tax situations with employee stock options may get complex, the thing that may trip most people up first is fear of missing out or getting it wrong. You may fear missing out on a rising stock price, for example, so you wait too long to exercise — and instead of rising, the stock price falls.
Or you might fear exercising your options because you want to be seen as a team player, so you don’t exercise or just hang onto the shares you buy when you should have sold immediately.
Whatever your fears, hesitations, or uncertainties, the bottom line is that if your employee stock options are worth something, you’ll want to exercise at some point.
With the proper planning, you may be able to identify a plan for you to act. The right strategies can also help address how to handle potential concentration risk, determine how your timeframe to retirement impacts your decision to exercise, and more.
Here are 6 of those strategies to consider so you make the right moves when it comes to the opportunity your stock options provide you:
Case 1 – Exercise and Sell Your Stock Options As Soon As Possible
The first opportunity you have to exercise your stock option(s) is when they vest. Prior to vesting, you can’t exercise. Unvested shares are simply a future promise of hopefully valuable stock options.
In the exercise and sell ASAP strategy, you exercise and sell your shares immediately when your options vest.
This strategy may be the best for someone whose goal is to convert “in the money” stock option value (or profit) into cash as soon as possible. You can then redeploy that cash into the market via a diversified portfolio, or you can use it for personal consumption (in other words, spend it on things you want or need, or use it to fund savings goals).
This strategy could also work for someone who is not interested in retaining company stock or not optimistic about the future stock price of the company.
Strategy 1 is the quickest way to turn employee stock option value into cash.
Case 2 – Wait Until Your Stock Options Are About to Expire
The other end of the stock option spectrum from Strategy 1, where you exercise and sell ASAP, is Strategy 2: wait as long as possible to exercise. “As long as possible” means right before your options are set to expire.
Employee’s stock options are issued with an expiration date. The expiration date is the final day you can exercise your stock options. Any “in the money” value in the option will be lost if you don’t exercise before the options expire.
This exercise option is often used by someone who simply hasn’t made a decision or felt afraid to act — and now they’re forced to act if they don’t want to lose the option.
Waiting so long to exercise means putting yourself at risk of simply forgetting about the expiration date, or missing your window of opportunity if the trade doesn’t go through in time.
Although it’s usually better to be proactive than reactive, some people may want to use this strategy if they’re highly confident the price will rise with time. Others make an intentional decision to defer the pending tax liability associated with an exercise of shares. Whatever the reason, exercising at expiration is a now-or-never decision that is clear for any in the money options: exercise before you lose the opportunity to do so.
Case 3 – Exercise Your Employee Stock Options and Hold Shares
An “exercise and hold” strategy could describe anything that falls between “exercise and sell ASAP” and “wait until the bitter end.” In this strategy, you exercise your options — but you do not sell the stock.
Strategy 3 may be best for someone who is bullish on the stock price of the company (in other words, they think the stock price will continue to go up).
This strategy is often coupled with a tax strategy to hold the shares of stock after exercising the option (often for incentive stock options), a market timing decision, or a strategic financial planning decision.
Depending on the type of employee stock options you have (incentive stock options or non-qualified stock options), the tax and timing of an exercise and hold may have materially different outcomes. To know if Strategy 3 is right for you, you’ll likely need to do more comprehensive planning first to evaluate your specific circumstances.
Case 4 – Exercise and Sell As Your Concentrated Position Increases
You could be on the receiving end of additional employee stock options every year as part of a compensation package. In this situation, what started as a single stock position making up a small portion of your net worth can evolve into a position that represents a much bigger percentage of your wealth.
That may expose you to concentration risk*. Concentration risk is the risk of having too many eggs in one basket. Having one stock position take up too much of your overall investment portfolio can expose you to far more volatility than you want to deal with (or can handle).
The amount of concentration risk you assume depends on your financial situation, goals, and needs — as well as your age and time horizon to when you need to start tapping your nest egg.
For example, you may need to be more averse to concentration risk when you’re in your 50s and approaching retirement than you might need to be when your 30.
Imagine if you’re about to retire, and the value of your stock options drops by 50%. This may be the difference between being able to quit working or not. But if you’re in your 30s and still working, you may be able to handle this drop with less impact.
Concentration risk may also be influenced by your net worth. Imagine you have $5,000,000 in one company stock in addition to $10,000,000 on the side.
You may be able to handle the concentration risk of a $5,000,000 stock position greater than someone who has “only” $2,000,000 but has it all tied up in the same stock. One person has assets to fall back on. The other, not so much.
Ultimately, concentration risk should be identified and addressed. If you realize (or already know) you are averse to this risk, the best choice may be to exercise and sell your stock options — then allocate the proceeds to a more suitable, more diversified investment portfolio.
Case 5 – Rolling Exercise and Sale of Employee Stock Options
This strategy is a bit like dollar-cost averaging. Dollar-cost averaging allows you to invest a certain amount of dollars on a set schedule over a period of time.
For example, think of your 401(k) retirement plan: contributions from your paycheck are the same each time and put into your account at regular intervals.
A benefit of the dollar-cost averaging approach is the ability to buy into the market at a variety of prices, which helps you avoid consistently buying at inopportune times (like when prices are high). Your average cost basis should be lower with dollar-cost averaging than it would be if you always tried to time the market instead.
You can try this same strategy with stock options. To do so, you could exercise X% of the options over X amount of years.
For example, let’s assume you have 50,000 stock options that are vested. A rolling exercise could require exercising 25% of the shares (or 12,500 shares) per year for the next four years (assuming the shares are “in the money”).
This rolling exercise creates a systematic process that allows you to participate in the upside and downside of the stock but also removes emotional decision-making that may force a bad decision during periods of market volatility or uncertainty.
Another advantage of Strategy 5? It could spread taxes owed over a series of years (instead of owing a massive amount all in one year). But as always, you should complete a detailed tax plan to understand what your tax implications may be.
Case 6 – Exercise and Sell When You Have “Enough”
When evaluating your stock options, it’s important to consider two values: the paper value and the after-tax value.
The paper value is often the value you see on an account statement. Paper value is the pre-tax value of your stock options based on a current per-share price. Often, the paper value includes the value of both vested and non-vested shares, so it’s important to separate the two.
Paper value often does not account for income tax owed upon exercise. What is left after you exercise and pay income tax is known as after-tax value.
After-tax value is a clearer representation of the actual dollars received should you exercise and sell your stock options. This is the amount you would have available to fund your lifestyle, to spend in retirement, or to save for another day.
A good time to exercise your stock options may be when this after-tax value is “enough.” What “enough” actually is will be a personal decision.
For you, enough may be the amount required to fund a comfortable retirement, pay for college, or buy a second home. For others, enough may be the amount required to generate generational wealth or leave a large legacy behind.
But once you have enough, is it worth taking the risk of losing it? Know your “enough,” and then act when your options allow you to achieve it.
Financial Planning for Employee Stock Options
No matter what your situation or your motivations for wanting to exercise, all of these strategies should be explored within the context of a full financial plan and retirement strategy.
While there is likely no right answer for everyone, each strategy above has its own advantages and disadvantages that should be considered prior to pulling any one trigger. What makes a strategy the “right” one depends on the specifics of your unique situation.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.