When Should You Exercise Your Stock Options?
Stock options in private companies are a type of equity compensation that gives employees the right to buy a specific number of shares in the company at a predetermined price over a period of time. Probably the most common questions asked by employees in regard to the exercise of stock options is when should they exercise their stock options? Why exercise stock options? And how does the stock option exercise work? Well, stock options typically have a vesting period, and thereby after the vesting schedule is over, exercising the stock options means purchasing the underlying shares. This article sets out to answer those questions with a more comprehensive look at the nature of stock options and how they are exercised.
Stock option exercising
When an employee exercises their stock option, they are basically choosing to purchase shares of stock at a price specified in the option agreement. Stock options generally have a vesting schedule whereby the employee is required to wait until a certain date before the option is considered vested and exercisable. The main reason behind having a vesting schedule is to ensure the employees of a company are committed and dedicated to the business.
At the time of granting stock options to employees, the stock option exercise date is assigned, and the employee must exercise their stock options before the expiration of the option period. Upon the exercise, they will be entitled to obtain the shares of stock corresponding to their shareholding percentage on the exercise date.
What are stock options?
Stock options are the right to buy a certain number of shares at a particular price at a future date. Most commonly, in private companies, stock options are granted to employees as part of a compensation package. It includes senior management, employees, advisors, and other consultants. From an employer’s point of view, these grants to employees are a great way of retaining and motivating its best and most valuable employees.
However, the stock options can only be exercised at a later date, typically at the end of the vesting period or on a specific exercise date. While it is essential to note that stock options give the right but not the obligation to purchase stock, and hence, the decision to exercise the options lies with the employee. Thus, stock options are essentially a long-term promise of employment with future performance.
Types of stock options
Now that we know the concept of stock options, it is time to look more closely at their types. Stock options are categorized into two different types: incentive stock options (ISOs) and non-statutory stock options (NSOs). Following is a brief description of the two types of stock options:
- Incentive stock options (ISOs) – ISOs are the most common type of stock options granted to employees. While ISOs are also referred to as “qualified stock options” or “statutory stock options”. ISOs are the technically more attractive type of option due to the fact that the tax benefit is more favorable than the non-statutory stock option. Basically, these options are taxed at the time of selling the stock and treated as capital gains. While no tax event is created at the time of stock option exercise or vesting. Hence, there is a substantial federal tax advantage when exercising ISOs in comparison to NSOs.
- Non-statutory stock options (NSOs) – NSOs are generally used by matured companies and are more commonly granted to high-paid employees. In fact, NSOs are also referred to as “nonqualified stock options”. While these options do not need to be reported under Internal Revenue Code Section 422. Unlike ISOs, NSOs are taxed in two instances; at the time of vesting and at additional tax when stock is sold. As a result, NSOs have a higher tax burden than ISOs, which is the primary reason why the majority of companies use ISOs instead of NSOs.
When should you exercise stock options?
Exercising stock options depends upon the vesting schedule of the stock options. Stock options generally have a vesting period of anywhere between months to years. After the vesting period is over, employees have the right to exercise their stock options. As a matter of fact, the stock options should be exercised before the expiration date; otherwise, the employee will lose their rights, and the stock option agreement will be considered terminated.
However, in certain circumstances, a company may allow the employee to exercise the stock options before the vesting period is over. In addition to this, when an employee leaves the company, thereby within 90 days after the end of the employment, they can exercise their shares, known as the 90-day post-termination exercise period (PTE or PTEP). Thus, the time to exercise the stock options essentially depends on the vesting schedule, agreement or mutual understanding between the employee and the employer.
How to exercise stock options?
Now that you have seen the options of exercising stock options, it is time to look at how it actually works. Depending on the company, employees have various options when it comes to exercising their stock options. The approach your employee choose depends on whether it is cashless or cash stock option exercise, and thus based on the company’s policy. A cashless exercise is one in which the employee exercises the options and immediately sells the underlying shares in order to cover the exercise price.
Whereas the cash stock option exercise is when the employee exercises the option and decides not to sell the underlying shares but instead holds them for a certain period of time. As such, it depends entirely on the employee and employer on how they proceed with the exercise of stock options. In the later part of this article, we will look at the various options and the manner in which the options can be exercised.
When to exercise stock options?
When an employee makes a decision regarding a stock option exercise, there are specific financial and tax considerations that should be taken into account. Stock options are most often exercised shortly after vesting, but some companies allow the employee to exercise options before vesting. There are various ways in which options can be exercised. Below is a list of the most common and several ways of exercising stock options.
Different ways of exercising stock options
Following is a list of the various ways in which an employee can exercise their stock options;
- Exercise and hold – This method is most often chosen when the employee is confident about the company’s future and is ready to wait it out before cashing in the profits. It is basically a cash stock option exercise, wherein the employee exercises the options and then holds the shares in the investment portfolio for a certain period of time before selling. While it can be risky, however, it is worth considering when the company is expected to show substantial growth in the future.
- Exercise and sell cover – This cashless option is chosen by the employee when they want to exercise the stock options and subsequently sell the underlying shares to cover the exercise price along with the additional taxes and fees. Usually, a tender offer is initiated in private companies where the employees can sell their share to a group of investors, individual investors, or back to the same company. This is a unique way of exercising stock options, as it allows the employees to have a smooth and safe sale of the shares.
- Exercise and sell – Similar to the above approach, the employee can choose to exercise the stock options and simply sell the underlying shares to cover the purchase price. As a matter of fact, the stock of private companies is traded; hence, a tender offer is essentially one of the only ways to sell the shares. This is a cashless way of exercising stock options, as the employee benefits from the stock being sold immediately after exercising.
The right time to exercise your stock options
Well, depending upon various factors and events, employees have different opinions when it comes to the right time to exercise their stock options. Here are a few instances where you should consider exercising your stock options:
- When stock options have value, or you filed 83(b) election – The stock options can be valuable when the strike price is equal to the fair market value (FMV) of the stock at the time of exercise. Additionally, when proper filing under 83(b) is done and timely exercised, the employee will have no taxes owed. As a result, when the stock options are valuable and are properly filed, the employee can choose to exercise their stock options.
- At the time of the IPO and acquisition – When the company goes public or is acquired, employees are generally restricted from selling the stock for a certain period of time. In short, there is a lockup period where the selling of shares is prohibited during IPO or acquisition. Thus, it makes sense for the employees to exercise their stock options at or before the time of the IPO or acquisition in order to avoid a possible loss.
- Depending on your financial situation – Employees should consider their financial liquidity when exercising stock options. In fact, the ability to bear the loss should be of concern to employees. Therefore, it is necessary for employees to consider their financial position and evaluate the value of the options before exercising.
- Considering tax treatment – The way in which employees exercise their stock options will have an effect on the tax implications of their decision. Typically, there are three types of taxes considered when the stock options are exercised, i.e., alternative minimum tax (AMT), ordinary income tax, and long-term capital gains tax. Hence, employees should evaluate the tax implications and make decisions accordingly.
- Favorable employee scenarios – When an employee has confidence in the company’s future or the employee is new to the company, it might be wise for them to exercise their stock options before others. In such cases, employees should exercise their options to realize the value of their options and sell the underlying shares for profits.
Make the right decision when exercising stock options
There is no doubt that when the time comes for employees to exercise their stock options, they need to be sure of the right decision. While there are several factors and scenarios mentioned above, employees should evaluate the different options and choose the best one that suits their needs and financial situation. The best decision will be one that will maximize the value of your options, as well as minimize any loss incurred. Thus, be sure to consider the various factors in detail and consult a professional who can help you make the appropriate decision.
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In private companies, the strike price of stock options is generally determined based on the FMV of the shares. Unlike public companies, in which the FMV is established using market forces, 409A valuation is used in private companies to determine the FMV. As an employer, it can be difficult for you to carry out the entire process of 409A valuation. Don’t worry; Eqvista has got you covered. With our easy-to-use platform, you can accurately and confidently determine the FMV of shares for the purpose of pricing stock options. Simply enter the required financial data, and our software will calculate the fair market value of your stock within minutes. Contact us today!