When is the best time to exercise stock options?

Employee stock options are valuable because they are options, and you have a choice to exercise. It is useful that you have a long period of time to choose whether and when to purchase your employer’s shares at a set price. Because you no longer have discretion over whether or not to exercise, your stock option loses that “option” value the instant you exercise. Consequently, many individuals worry when exercising stock options is a good idea. Finding the best time to exercise stock options and get a return on your investment may be difficult when there are so many factors to consider. Hence, this article discusses the right time to exercise stock options and the benefits of exercising stock option early.

Employee stock options

A company may offer equity compensation programs as a benefit to certain or all employees. Employees who participate in these schemes often get stock ownership as part of their remuneration. Employee stock options are simply one of the many possibilities for a corporation to provide stock equity compensation. Let’s understand it in detail.

What are employee stock options? 

Issuing stock options aligns with your employees and your company’s interests and is a great tool to motivate and incentivize good performance. Employee stock options are a kind of equity compensation that, once vested, offer you the opportunity to purchase a specific number of shares in the company at a predetermined price. Vesting means when you own the options and therefore exercise them, entitles you to buy company stock. Employee options will be valued more when the firm’s share price rises. This is the motivation factor for the employees to contribute to the success of your business.

Types of employee stock options

The day when the employer grants employees stock options are known as the grant date. A stock option contract specifies the number of company shares a person is permitted to buy at the strike price or exercise price after waiting until the vesting date. Additionally, it will establish the expiry date, determining how long an employee has to exercise their options. You can exercise your stock options whenever you choose, but you’re never compelled to. You can choose to keep or sell your firm shares if you decide to exercise the options.

There are two main types of stock options given by the employer. Your choice of when to exercise your stock options may be influenced by your knowledge of the various types of options you have and their associated tax consequences. These are:

• Incentive stock options (ISOs) – Incentive stock options, often referred to as statutory or qualified stock options, may be eligible for advantageous tax treatment. Whenever exercised shares are kept for a specific time, they are classified as a “qualifying disposition” and can be subjected to capital gains tax once sold. Employees are the only ones who get ISOs.
• Nonstatutory options (NSOs) – Nonstatutory options, also known as nonqualified stock options, are taxed when exercised as general income and once again when shares are sold, with any profits being taxed at capital gains tax rates. Outside service providers, consultants, and advisers may be awarded NSOs.

Right time to exercise stock options 

If you continue to work for the business, you may exercise your options anytime after they vest up to the expiration date. There are several factors to contemplate when deciding the best time to exercise stock options. If you’re leaving your employment, examine the conditions in the contract to determine when you have to exercise; this is often known as the “post-termination exercise period”. Here are seven occasions when one should consider exercising their options:

• After vesting – Vesting refers to the procedure of acquiring the right to exercise. Typically, only vested stock options may be exercised. You can exercise your vested options anytime as long as you stay employed once you reach the vesting cliff and the waiting period.
• When leaving the company – Most businesses allow you to buy your shares for 90 days after your employment ends in the post-termination exercise period, or PTE/PTEP. Your options will then revert to the employee option pool of your employer, and you will no longer be able to exercise them. Some businesses provide you with a longer PTE term, sometimes for the duration of your employment.
• Exercise early – Some businesses may let you exercise your options before they are fully vested. You may exercise your options as quickly as you get your option grant if your employer permits it, but they will still vest following the original timeline.
• When options have value – Only if your options are valuable should you choose to exercise them. If so, they are said to be “in the money”. This occurs when your stock options’ strike price is less than the current market value of the firm shares traded on the exchange. In this situation, you might buy business shares at a lower strike price by exercising your option. The difference, or “bargain factor” might be pocketed by selling these shares on the stock market. You might hang onto your stock options if you believe in your company’s future potential. Your options’ value will increase if your company’s share price increases, delaying any tax penalties. Your stock options are much more valuable since they are discretionary or flexible for longer. There is also the possibility that the options’ strike price will always be the same as the market price. Your stock options might become useless if this happens. Remember to watch the expiry date while you hang on to them.  Unfortunately, if stock options are not used promptly, they may be worthless.
• When the company is public or private – Whether your business is privately held or publicly traded also matters. Since private company shares aren’t listed on the stock market, you’ll have to pay for the acquisition and exercise yourself instead of selling other shares to cover the cost. Additionally, you risk waiting a long period for your shares to go through an IPO or another liquidity event before you can sell them and get your money back. It may be a smart idea to consider exercising your ISO if your private firm files for an IPO. To be eligible for preferential tax treatment, ISOs must be held for one year after being exercised and two years after being granted. It often takes firm many months to be ready before the actual listing once they register for an IPO. Employees of the firm going public are often subjected to an immediate lock-up period after listing, during which they are prohibited from selling shares for approximately six months. If you use your stock options during the filing period, you may meet the conditions for receiving preferential tax treatment for the combined time between filing and the post-lock-up period.
• Fits your financial situation – The ideal moment to act in many financial situations is when it benefits you and your particular objectives. You might not require extra revenue from exercising your stock options and trading shares if your income meets all your costs. Alternatively, if you have deferred pay coming in over the next several years, you may be able to postpone exercising your options. These conditions imply that you may postpone exercising, allowing your firm shares’ market price more time to increase. However, you could want a financial boost for another reason, such as to launch a company, pay for your child’s education, or buy a house. You could finance a different, more appealing objective or investment opportunity by exercising your stock options and selling shares based on the other elements of your financial condition. Your whole financial portfolio and its asset allocation are other factors to consider. You could wish to exercise your stock options, sell your firm shares, and then use the money to diversify your portfolio if you have too much exposure to those shares.
• Tax rates – Based on your stock options, you will need to consider several tax treatments, including ordinary income tax, capital gains tax, and alternative minimum tax (AMT). Before selling, you should consider the tax repercussions of exercising your options and hanging onto business shares. The bargain portion of your stock options is typically taxed at income tax rates for ISOs during the year of exercise or NSOs sold without suitable disposal. You might postpone exercising your stock options or stretch the time to exercise over a few — possibly lower tax — periods if your earnings for the current year already puts you in a high-income tax band or extra earnings from stock options may push you there. There is no tax upon exercise for ISOs with a qualified disposition; the tax is only assessed when you sell your company’s stock. The bargain aspect may result in AMT if you hold business shares to achieve preferential tax treatment.

Benefits of exercising stock options early

If your employer permits, you can exercise your stock options before they are vested. This implies that even if you paid for business shares, you would still have to wait until the end of the original vesting period for the shares to become yours legally and be capable of being sold. Here are some advantages of exercising early:

• Preferential tax treatment for ISOs – To be eligible, you must hold onto your shares for a minimum of two years from the date the option was granted and a minimum of one year after it was exercised.
• The reduced holding period for NSOs – Early option exercise allows you to begin your holding period earlier and sell your NSO at a reduced long-term capital gains tax rate.
• Not being charged additional tax – If you exercise your options early when they are issued, you will likely not pay any extra taxes since you are purchasing them at fair market value. This supposes no difference between what you invested and the stock’s current value.

When to exercise stock options early? 

Here are three situations when early exercise of your stock options makes sense, given the benefits and the risks – 

• Employee scenario – Normally, stock options with an exercise price of only a few cents per share are given to early workers. Suppose you are lucky enough to be in this circumstance, even if you are given 100,000 shares. In that case, the total cost to execute your options may be $1,000 to $2,000 if you can afford to give up this money because it makes a lot of sense to exercise all of your shares before your company does its first 409A assessment. It’s advisable for early employees who promptly exercise their shares to prepare for losing all of their investments because your tax savings will be great if your business is successful.
• Success – Consider the following scenario – You are one of the mid-early employees between the 80th and 100th, and you exercise all of the 10,000 options you were granted at an exercise price of $2 per share, and your firm collapses. Both monetarily and mentally, it will be quite difficult to bounce back from that $40,000 loss (plus the AMT you must have paid). Because of this, it is advisable to exercise stock options with an exercise price over $0.10 per share unless you are 100% convinced that your company will succeed. In many circumstances, you may think your business is ready to go public after then.
• When a company file for an IPO – Employee stock options are normally prohibited for six months after a company’s IPO. Following the announcement of the lock-up, a company’s shares normally decline for two – weeks to two months. Typically, it takes three to four months for a company’s stock to begin trading publicly after it files its first registration document with the SEC. As a result, you probably won’t be able to sell your stock for at least a year after your firm files a registration to become publicly traded. Therefore, if you wait to exercise until your firm notifies you that it has filed for an IPO, you will assume the least liquidity risk. Early workers who exercise their shares promptly are advised to prepare for total financial loss. However, if your business is successful, it will save a tremendous amount of taxes.

How to exercise stock options 

You could exercise stock options in several ways, depending on your firm. Here’s a list of ways – 

• Pay cash (exercise and hold) – You purchase your shares with your own money and retain every one of them, given that you can’t count on making money or may even lose them all. Hence, this strategy is the most dangerous. Additionally, until you sell, your money is restricted to your shares. However, if your shares are really valuable, they could be worthwhile.
• Cashless (exercise and sell to cover) – You may be able to exercise your options and concurrently sell enough shares to pay the total cost, fees, and taxes if your firm is public or making a tender offer. The remaining shares are yours to do as you like; you may sell any or all of them.
• Cashless (exercise and sell) – You may be able to exercise and sell your stock options at once if your firm is public or making a tender offer. You keep the remainder of the selling proceeds after paying the purchase price and any associated fees and taxes.

Manage your employee stock options on Eqvista! 

Want to handle and keep track of your stock options? Eqvista’s cutting-edge cap table application may assist in keeping track of and staying ahead of all the essential data collection. Use the free Eqvista program to manage the specifics of your company stock options, make new plans, and keep track of your ownership in the company. Get in touch with us to find out more or to get started right now!