Access to employee stock options represents an agreement between you and your employer that allows you to purchase a specified number of shares of the company’s stock at a fixed grant price for a specified period.
If the future stock price appreciates above the stated grant price (the price at which you can purchase the stock via your option), the stock options are “in the money.” This is where the agreement can offer a significant benefit: you can exercise your employee stock option, which means you buy shares of stock at a grant price that is lower than the current market price.
But if the current price of the stock falls below the grant price, the options are “out of money.” In this situation, you wouldn’t want to exercise your right to buy shares at your specific grant price. Why pay more for something than you need to?
A key feature of employee stock options is that they give you the right to exercise (or the right not to exercise) your option. There is no obligation to do so.
Should you decide to exercise your option, you know what you’ll pay to buy your shares versus what the current market value of the shares is, and therefore, what your profit will be.
In one way, an employee stock option offers you a “free” opportunity to participate in the growth of company stock without investing any of your own money.
The Key Stock Option Terms You Should Know
Before we continue, let’s first define some commonly used terms and concepts that are associated with stock options.
- Grant Date – This is the day that you receive your stock options.
- Grant Price – Also known as the strike price, the grant price is the price at which you can buy the shares of stock. Regardless of the future value of that particular stock, the option holder will have the right to buy the shares at the grant price rather than the current, actual price.
- Vest Date – This is the day that you can exercise your right to buy the shares at the grant price. Before this day, you may not have the right to exercise your option to buy your shares.
- Vesting Schedule – Incentive stock options are issued with a schedule that details when the options become vested. Working from the grant date, the vesting schedule will detail when some or all of your options vest.
- Expiration Date – This is the last day that you can exercise your options. If you do not exercise them, the options expire regardless of whether there was value in them or not.
- Bargain Element – This is the difference between the grant price and the exercise price. For incentive stock options, the bargain element may be an adjustment item for calculating AMT.
- In the Money – A term used when the current market price of the stock exceeds the exercise price, this means that the holder of the option can buy something at a lower price than what they can sell it for.
- Out of the Money – This is a term used when the current market price is below the exercise price. If it’s “out of the money,” the option has no current value.
Employee Stock Options a Chance to Participate
Again, you’re not required to exercise any of your employer stock options to buy shares. Also, you don’t have any out-of-pocket cost when your employer offers the stock option grant.
Because of this no-up-front-cost benefit, you could say employee stock options are a risk-free investment, one that may allow you the free upside of an appreciating stock price.
Let’s assume that your employer offered you 10,000 shares of XYZ stock with a grant price of $1.00 per share. In most cases, no cash exchanges hands, and no tax consequences are triggered when your employer provides these options.
Over time, the prevailing stock price will move with the markets. Should the market price of the stock fall below $1.00 per share, you wouldn’t exercise the option to buy your shares. Why pay $1.00 for a share of stock when you can go buy it somewhere else for less?
If your options remained “out of the money,” then you’d probably do nothing and let your stock options expire on the expiration date since they have no value.
But what if the market value appreciates to $50 per share? You could then exercise the option to buy shares of stock at $1.00 per share and sell them immediately for $50 at a gain of $49 per share.
Multiply $49 by 10,000 shares, and you could enjoy a gain of $490,000.
That’s what we mean when saying options can work like a risk-free investment. Even if the share price drops, you’re not obligated to buy – so you don’t lose money in this situation. And because there’s no cost to you to hold your options, it’s a bit like unlimited upside if the share price rises.
Know What You Hold: Incentive Stock Option and Non-Qualified Stock Option?
Both types of stock options offer a chance to participate in the company stock price. Each also affords you the control over when to exercise (or whether you exercise at all).
Despite those similarities, many people feel incentive stock options (ISOs) are the better of the two options thanks to their potentially preferential tax treatment.
Here are two major, distinct tax features of ISOs and NQSOs:
- When you exercise non-qualified options (or NQSOs), the difference between the fair market value at exercise and the grant price is included as ordinary income (and therefore taxed at your marginal tax rate) in the year of exercise, regardless of whether or not you exercise and sell or exercise and hold. When you exercise your ISOs, the tax reporting depends on what you do next. If you hold the shares past the end of the calendar year (as opposed to exercising your options and selling the shares right away), you don’t report earned income in the year of exercise. If you exercise and sell, you do need to report the ordinary income, similar to what you do with NQSOs.
- When you exercise and sell incentive stock options as a qualifying disposition (more on this below), the entire realized gain—from the grant price to the final sales price—may be taxed at preferential long-term capital gains rates. With a non-qualified stock option, the only additional gain from the exercise price to the final sales price is subject to potentially preferential capital gains treatment.
These tax rules of ISOs are typically advantageous because you may pay a lower tax rate on the realized gain of incentive stock options than you will the realized gain of non-qualified stock options, all else being equal.
However, incentive stock options come with the added complexity of the tentative minimum tax and the alternative minimum tax (AMT). In addition to your regular tax calculation, the tentative minimum tax is a tax calculation that takes place each year you file a tax return. As a taxpayer, you owe the IRS the higher of either your regular tax or the tentative minimum tax.
Generally speaking, if the tentative minimum tax is the higher of the two, you will need to pay the tentative minimum tax. Specifically, the difference between the regular tax and the tentative minimum tax is known as the AMT.
AMT and the tentative minimum tax may be an extremely important part of any incentive stock option exercise, because the exercise of incentive stock options often causes the tentative minimum tax calculation to be the higher of the two.
In fact, it’s possible that the exercise of incentive stock options can lead to the tentative minimum tax being so much higher that finding the cash to pay the pending tax bill will be a significant concern.
When Should You Sell Your Employee Stock Options?
While it’s possible to argue that the $490,000 gain we looked at in our example earlier was risk-free, you could just as easily make a case for employee stock options being high risk (since you could miss the opportunity to create serious wealth).
Why? Because your newly-generated wealth is subject to change as the stock price changes. If you exercise and hold, you could wind up with shares less valuable than what you paid for them. Or, if the stock price drops back down to $1 per share before you exercise and and sell your option, the $490,000 potential value that existed before you chose to act could be wiped out.
Because of these risks, it’s important to consider what strategies you may have at your disposal to exercise your options. Once you have vested shares available to exercise, you will most likely want to choose one of the following (but keep in mind, this is only a sampling of possible ideas to handle your stock options):
- The Do-Nothing Strategy (Continue to Hold the Options) – Doing nothing means risking that the stock price may change and impact the value of the options. In effect, doing nothing is an active decision to retain investment risk and concentration risk of owning a single stock position.
- The Diversify Strategy (Exercise and Sell) – In effect, this captures the value created by the option and turns it into money you can actually use. This strategy is intended to transfer stock option wealth into cash. That cash can then be used for other consumption (i.e., buying stuff) or funding saving goals.
- The Tax Planning/Investment Planning Strategy (Exercise and Hold) – In addition to purchasing the shares and paying the AMT, both of which may require a significant outlay of cash, this strategy may have you exercise and/or sell some or all of the shares in an effort to obtain preferential tax treatment and/or with hopes that the stock will appreciate.
Holding in the money options when you can exercise and sell them is an active decision to retain single stock risk. As the value of a high-risk single stock position increases and becomes a more significant part of your overall portfolio, or as it becomes more critical to the success of your financial plan, the risk of retaining the stock options also increases.
Therefore, a plan to exercise and/or sell should be something that is considered as part of a sound financial plan because it can be lower risk and provide an instant profit for in the money options.
Evaluating the Value of Your Employee Stock Options
In its simplest terms, the value can be calculated as the fair market value of the stock less the grant price multiplied by the number of shares. Using our example above, each share has a value of $49, which is the difference between the current market value and the grant price.
A small next step might be to separate the above-calculated value into vested stock option and unvested stock options. Vested stock options would be the options that you may be able to exercise and sell now. Unvested options, even if they are in-the-money, likely cannot be sold.
Before exercising and subsequently selling your options and stock shares, the value is simply “paper value.” Paper value is value that can change either positively or negatively with the changes in the stock price.
In addition to the current “paper value,” employee stock option value can be calculated using more complex formulas that consider the price volatility of the stock and/or the amount of time until the expiration of the option.
If we assume a stock with high price volatility, it would be reasonable to consider a broader range of projected outcomes and a greater range of potential future value.
It’s also reasonable to assume that stock options with a longer time before expiration may lead to more significant price variability, all else being equal. Short time horizons (options nearing exercise) have less time for price variability and are therefore generally more accurately valued in terms of current and future value.
Eventually, an informed stock option holder will likley exercise “in the money” shares. Assuming an exercise and hold, the value remains as paper value since it was purchased through the exercise but not sold. The held shares remain subject to continuing price volatility.
In one way, the value of exercised and held stock options may decrease. Why? Because you’ll likely need cash to buy the shares and to pay AMT.
It’s not until the exercised shares are sold that paper value becomes realized value. Value, after a final sale of stock and requisite taxes are paid, is after-tax value. After-tax value is the remaining amount available that you can use for consumption or investment.
A Word About Concentration Risk and Employee Stock Options
It’s worth taking a minute to discuss concentration risk. That’s the risk of having a significant portion of assets invested in one stock.
It’s not uncommon for an employee to receive stock option grants several times throughout their employment. As the number of grants get more significant, the frequency increases.
It’s possible for you to quickly amass an employer stock position that equates to a considerable percentage of your net worth — and end up with an undiversified portfolio that takes on more risk than necessary.
If you consult many of the financial planning handbooks out there, they will suggest that no more than 10%–15% of your net worth should be tied up in a single company stock. This rule of thumb is prudent advice — but it should be part of a larger discussion that takes the specifics of your financial situation into account.
In one sense, the risk of having all your eggs in one basket is a risk that not many would want to take. That wealth can easily be wiped out by a decreasing stock price. On the other hand, owning a large position in a rapidly appreciating stock can generate considerable wealth.
The right answer depends on the facts as pertains to your unique situation.
What’s Next for You If You Have Employee Stock Options?
Rules of thumb are useful guidelines, but that doesn’t mean there aren’t exceptions to them. For example, someone with a $50 million net worth may have a different take on concentration risk than someone with a $2 million net worth.
Once you identify your specific appetite for and ability to handle concentration risk, you can make plans to either eliminate, mitigate, or retain the single stock risk based on personal financial goals, time horizons, and objectives.
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.