How Leverage May Impact the Value of Your Employee Stock Options

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Key Points:

  • If the percentage change in the value of your employee stock options is greater than the percentage change of the stock price, you have leverage.
  • As the stock price goes up, the value of your stock options goes up by even more (as determined by a percentage increase).
  • Leverage means you may have a greater loss when the stock price goes down.
  • If you find that you are nearing expiration, leverage is low, and that you are ready to face the tax man, it may be time to consider exercising your options.

If you are on the receiving end of employee stock options, you might want to understand the concept of leverage, as it may have a meaningful impact on the future value of your stock. As it relates to employee stock options, leverage is illustrated by the percentage change you see in the total value of your employee stock options as a result of a change in the value of the underlying stock price itself.

If the percentage change in the value of your employee stock options is greater than the percentage change of the stock price, you have leverage.

With employee stock options, you likely can’t eliminate the issue of leverage altogether as it is inherent. You can however, begin to understand leverage by knowing how, when, and by how much it may impact the value of your employee stock options.  This can arm you with the information you need to make appropriate decisions on what to do next.

Let’s take a deeper dive to see the impact of leverage under different scenarios.

The Impact of Leverage on Employee Stock Options

To illustrate leverage, let’s assume that you have 10,000 employee stock options with an exercise price of $10 per share and a current market price of $20 per share. The current value of your employee stock options is $100,000.

Value = Number of Options * (Current Price – Exercise Price)

COMPARISON GUIDE

Not All Stock Offers are the Same! Here's a helpful comparison between two of the most common employee stock options.

Comparing Employee Stock Options vs RSUs cover

= 10,000 * (20 – 10)

=$100,000

Over time, the share price of your company stock will move as subject to the prevailing market price. It can go up or down over the short- and long-term.

What’s interesting, however, is that a percentage move in the price of the company stock may not equal the percentage move in the value of your employee stock options.

To illustrate, lets calculate the percentage change to the value of your employee stock options when the market price of the stock changes in 20% increments.

Stock Price % Change of Stock Value of Employee Stock Option Change in Employee Stock Option Value Change in Value
$16.00 -20% $60,000 $40,000 -40.00%
$20.00 0% $100,000 $0 0.00%
$24.00 20% $140,000 $40,000 40.00%
$28.80 20% $188,000 $48,000 34.28%
$34.56 20% $245,600 $57,600 30.64%

As the price of the stock moves by 20%, you can see the value of the employee stock options increases (or decreases) by more than 20%. When the stock price increases from $20 to $24 per share, a 20% increase, the value of the employee stock options increases from $100,000 to $140,000, or 40%.

A 20% increase in the stock price means a 40% increase in the value of your options. This is leverage at work in your favor.

An Example of Owning Stock Outright

For comparison, let’s assume that in lieu of owning employee stock options, you own the company stock outright. Specifically, you own the following:

  • Shares of Stock: 10,000
  • Current Market Price: $20/share

Stock owned outright may be the result of stock purchased through an online brokerage account, shares you obtained through an ESPP, or via vesting restricted stock units. Regardless of how it was acquired, it will act the same, as in there will be no leverage.  Lets illustrate:

Assume the same market movement of 20% in the value of the stock price, as illustrated in the chart below.

Stock Price % Change of Stock Total Shares Current Value Change in Value of Shares Increase in Value
$16.00 -20% 10,000 $160,000 $40,000 -20.00%
$20.00 0% 10,000 $200,000 $0 0.00%
$24.00 20% 10,000 $240,000 $40,000 20.00%

A 20% change in the stock price means a corresponding 20% change in the value of your stock. Considering the percentage change of the stock price equals the percentage change in your total value, we can see that no leverage is present:

The chart further illustrates the math (and the point) that a percentage change in the price of the stock equals the percentage change in the value.

This tells us that stock you purchased outright, ESPP shares, and vested restricted stock units do not have leverage. The percentage change you see in the stock price will equal the change you see in the value of your account.

Is Leverage on Employee Stock Options a Good Thing or Bad Thing?

When viewed through the lens of an increasing stock price, leverage can be seen as a good thing. As the stock price goes up, the value of your employee stock options goes up even more (as determined by a percentage increase).

However, there’s a flip side. The same leverage means a greater loss when the stock price goes down. As illustrated in the chart above, a 20% price drop means a 40% loss in value.

This shared risk-reward tradeoff is typical of owning a single stock, and it’s only heightened when you introduce employee stock option leverage.

Whether this is good or bad is often a personal decision about your appetite for risk and acceptance (or avoidance) or volatility.

How the Spread Between the Exercise Price and Current Price Impacts Leverage

If we continue the chart above and illustrate the impact of leverage as the difference between the exercise price and the current market price increases, we can see that the percentage change in value of the employee stock options gets closer to the percentage change in stock price as the spread gets bigger.

For example, when the stock price moves from $103.20 per share to $123.83 per share, a 20% increase, the change in the value of the employee stock options is 22%. Leverage, as the difference between the exercise price and the current fair market value gets bigger, has less of an impact on the total value of the employee stock options.

Stock Price % Change of Stock Value of Employee Stock Option Change in Employee Stock Option Value Change in Value
$16.00 -20% $60,000 $40,000 -40.00%
$20.00 0% $100,000 $0 0.00%
$24.00 20% $140.000 $40,000 40.00%
$28.80 20% $188,000 $48,000 34.28%
$34.56 20% $245,600 $57,600 30.64%
$41.47 20%  $314,720  $69,120 28.14%
$49.77 20%  $397,664  $82,944 26.35%
$59.72 20%  $497,197  $99,533 25.03%
$71.66 20%  $616,636  $119,439 24.02%
$86.00 20%  $759,963  $143,327 23.24%
$103.20 20%  $931,956  $171,993 22.63%
$123.83 20%  $1,138,347  $206,391 22.15%

As leverage decreases, your employee stock options look more and more like stock you own outright. This may be an indication that employee stock options with low leverage are ripe for exercise.

What Leverage on Employee Stock Options Means for Reaching Your Financial Planning Goals

Leverage can have a material impact on when and how you reach your goals.  For example, assume that you $1,000,000 of value in your employee stock options and that’s made up of the following:

Exercise Price Current Stock Price Total Shares Current Value
$10.00 $20.00 100,000 $1,000,000

If your goal is to reach $2,000,000 of value, you might think you need the stock price to double, going from $20.00 per share to $40.00 per share.  Leverage, however, illustrates a different story:

Exercise Price Current Stock Price Total Shares Current Value
$10.00 $40.00 100,000 $3,000,000

In fact, when the current stock price doubles, the value of your options increases by 3 times.

We can calculate that in order for you to reach your goal of $2,000,000, the stock price only needs to reach $30 per share, or an increase of 50%.

Exercise Price Current Stock Price Total Shares Current Value
$10.00 $30.00 100,000 $2,000,000

What Leverage Means for Exercising Your Employee Stock Options

If you like the idea of leverage and can stomach volatility in the value of your employee stock, it may be reasonable to retain your shares and assume the risk.

However, the potential positive impact leverage may have on the value of your employee stock options may reach a point where you can achieve a similar outcome by simply buying the stock outright.

Said another way, once leverage has maxed out, is your employee stock option providing as much value as it once did?

If you find that you are nearing expiration, leverage is low, and you are ready to address tax due, it may be time to consider exercising your options.

As always, the answer to this question should be considered in the context of which type of stock option you have (incentive stock options or non-qualified stock options) and what you are trying to achieve with your overall financial plan.

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.

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Hi, I'm Daniel Zajac, CFP®, EA

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I write about equity compensation and employee stock options in a way that is easy to understand.

2 Comments

  1. Evan Lambert

    Hi Daniel – I love the content on your site. I was interested after reading this – is there a % change in value you would consider a trigger for exercising NSOs (relative to the actual change in stock value)? In other words, how much leverage would you consider little enough to consider exercising – as a guideline?

    Reply
    • Daniel Zajac, CFP®, AIF®, CLU®

      Hi Evan
      Good question – I don’t have a set percentage or a rule of thumb that I can offer as it pertains to the specific question. We typically try to balance the figures you discussed and the opportunity with other equity, financial planning, tax, and investment considerations.

      Sorry I can’t be more specific

      Reply

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