Many of our clients have large company stock option grants that they have received as compensation from local Silicon Valley firms, so we are quite experienced at guiding clients to handle them profitably.
Stock options are very complex. From their tax treatment to the many risks involved, it’s important that you both educate yourself and surround yourself with a professional team of advisors to avoid potentially devastating financial missteps.
The bottom line: Don’t exercise your company stock options without the help of a fiduciary financial advisor and tax expert.
But for the sake of better understanding what they are and how they work, here’s an overview.
Let’s take a look at the ins and outs of stock options and fill you in on the important details you need to know.
What are stock options?
Stock options are offered as compensation by pre-IPO, as well as publicly traded companies. A stock option gives you the option to purchase shares of company stock at some predetermined price. Although not all companies offer stock options, it is common with both established companies and startups.
Ideally, your option to purchase shares of the stock will be at a much lower price than the stock is actually trading for on the day you exercise and sell your option. If you purchase a share for $2 and sell it for $98 on the open market, you’ve just made $96 per option (not considering taxes). That’s just one example, and many of our clients have earned far more than that with their company options. However, what goes up can come down! And if the stock is trading for less than your exercise price, your options can be worth nothing. This is known as options that are “underwater.”
Types of Stock Options
There are two primary types of stock options. They are:
- Non-qualified stock options (NSOs)
- Incentive stock options (ISOs)
NSOs can be granted to employees and also consultants, advisors, or contractors. ISOs, on the other hand, can only be granted to employees, usually executives. The other main difference between the two is how they are taxed, which we’ll cover a bit later in this article.
There are several stipulations surrounding stock options that are important to understand. For instance, nearly all stock option contracts have a vesting period. You would receive a certain percentage of your options each year up to a certain time when you will have received all your options.
For example, you might be granted 10,000 stock options with a four-year vesting schedule. In this case, 2,000 options would become “vested” each year for four years. You can only exercise options that are vested.
Many stock option contracts also come with an expiration date. This is the date at which an employee can no longer purchase stocks and the stock options contract becomes void. In most cases, the expiration date on stock options is 10 years from the grant date, or 90 days after you leave the company. That applies whether you resign, retire, or get laid off.
What should I do with stock options?
Exercise Your Stock Options
When your stock options have vested, you can exercise your options to buy company stock at the predetermined price. However, just because your options have vested doesn’t necessarily mean you should buy the stocks right away. Suppose your stocks have vested and you have an exercise price of $5. If the stock price at the time of vesting is $4, it wouldn’t make much sense to buy stocks at that price. However, if the stock price is higher than the exercise price, say $8, then exercising your options would make more sense.
When you do exercise your options and purchase the stock, there are a few different routes you can take to cash in on those stocks. Let’s say you have 10,000 stock options at $5 a share. Here is what you could do once you exercise your options:
- Buy the stocks outright for $50,000 (10,000 X $5). Then you could either sell them right away, sell some and keep some, or hold on to the stocks hoping the price rises in the future.
- Make an exercise-and-sell transaction with the brokerage handling the sale. The brokerage will front the money for the sale and then immediately sell the stocks at market price once they’ve reimbursed themselves for the cost of the sale.
- Make an exercise-and-sell-to-cover transaction in which you immediately sell enough shares to cover the cost of buying the stocks, then hold on to the rest to sell in the future.
Remember, your stock options do have an expiration date, so you won’t be able to hold them indefinitely. Also, keep in mind that you will have to pay any fees and taxes that come with exercising your options.
Talk with an expert.
When should you exercise your options and sell your stocks? How do you know if it’s the best time to exercise your options? Who can you trust to give you the advice you need?
Trying to manage your company stock options without consulting with a fiduciary financial advisor and your tax expert isn’t recommended. There are too many complexities and variables to consider and consequences to plan for in order to get this right. People who get this wrong have very definitely wound up with 7-figure tax bills with zero stock proceeds with which to pay the bill because they went about their stock options the wrong way.
Understanding and getting the most out of your stock options requires help. Talking to a fee-only fiduciary financial advisor can offer a better understanding of the different stock option strategies available to you and which one is the best choice to make. Talk to us today to see how we can help.