Understanding Employee Stock Options

February 14, 2020, by Mac Frasier

What are my options? 

Employee stock options can be a great way to build long term wealth and participate in the growth of a company.  However, when it comes time to utilize those options there can often be confusion on what is the best strategy to implement.  While everyone’s approach will be unique to their specific circumstances, hopefully this blog can help you begin thinking more about your options strategy.

Stock Options Terminology

Before we dive into the different choices for exercising your stock options, let’s first review some of the key elements of a stock option.  These terms will be important as we look at different strategies for exercising your options.

Grant Date   The date on which you receive the stock options.  This date is important because it effects vesting and when the options expire.

Vesting – The period of time an employee must wait from the grant date before exercising the options.  It may be a cliff vesting in which all shares become eligible at a single time or graded vesting in which a certain number of shares vest each year until all shares are vested.

Expiration Date – This is the date by which you must choose to exercise your options.  It is common to see the expiration date set at 10 years, but it can vary.

Exercise Price – The predetermined price at which you can buy shares.  For example, an exercise price of $60 means that you can buy shares at $60 even if the current price is $100 / share

Bargain Element (Spread) – The difference between the exercise price and the market value of the stock when the option is exercised or the stock is sold.  This amount is taxable to the employee and the type of taxation will differ between Non-Qualified Stock Options and Incentive Stock Options.

Non-Qualified Stock Options (NSO or NQSO) – These options give employees the right to buy a set number of shares at a predetermined price during a designated timeframe.  Employees will be taxed on the Bargain Element (Spread) in the year the options are exercised.  Companies may withhold some of the proceeds in order to help pay applicable taxes however these withholdings are often too low.

Incentive Stock Options (ISO) – These main difference between ISO’s and NSO’s is how the Bargain Element (Spread) is taxed.  ISO’s are taxed when you sell your shares versus when you exercise them. Because of this ISO’s are eligible for what is called a “Qualifying Disposition” which means you can be taxed at long-term capital gains rates versus ordinary income tax rates.   A Qualifying Disposition is when shares of a stock are held for at least one year from the date of exercise and two years from the grant date.  It should also be noted that the Bargain Element on an ISO is a preference item for Alternative Minimum Tax (AMT).

Three Different Strategies

Now that you are familiar with that stock option terminology let’s review some option strategies and when they make the most sense to utilize.  Before making any decision regarding the exercise or your stock options you should first refer to your options agreement to determine any specific rules in place concerning your options.

  Number of Shares to Exercise Exercise Price Number of Shares sold Current Market Price Out of Pocket Costs to Exercise Realized / Unrealized Profit*
Exercise and Hold 1,000 $60 0 $100 $60,000 $40,000
Exercise and Sell 1,000 $60 1,000 $100 $0 $40,000
Sell to Cover 1,000 $60 600 $100 $0 $40,000

*This chart is intended to be hypothetical in nature and is provided for illustrative purposes only. It does not reflect any fees or taxes associated with the exercise of stock options. 

  1. Exercise and Hold – This would be the preferred method for exercising ISOs since it may allow you to use the “Qualifying Disposition” rule in order to receive a more favorable tax treatment. The downside to this strategy is that you must first come up with the cash needed in order to exercise the shares.
  2. Exercise and Sell (Cashless Exercise) – As the name implies this approach involves purchasing the stock and then immediately selling all of it leaving you with cash. Since this method would not be eligible for a “Qualifying Disposition” it is best suited for NSOs.
  3. Sell to Cover (Net Exercise) – A hybrid strategy that involves selling enough shares to cover the cost of exercising the shares and then holding on to the remaining shares. This method works for both ISOs and NSOs.  It can be used when a person would like to hold on to the stock but does not have the cash needed to utilize the Exercised and Hold method.

 

If you would like to have further discussions regarding options strategies please contact your tax and financial advisors.

Oakworth Capital Bank does not provide tax or legal advice.   All decisions regarding the tax and / or legal implications of these strategies should be discussed with your tax and / or legal advisors before being implemented.