Exercising a Stock Option - Explained
What are the Considerations when Exercising a Stock Option?
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Table of ContentsWhat is Exercising a Stock Option?Strategies for Exercising OptionsPositive of Exercising Stock OptionNegatives of Exercising a Stock Option
What is Exercising a Stock Option?
It is very common for companies to award stock options to employees as a form of compensation and method of creating loyalty and dedication to the company. It is natural that the question arises, “should I purchase my stock options?” This question is particularly relevant when an employee leaves the company.
A stock option is the option to purchase common stock. An option will have a price at which the employee can purchase common stock by exercising the option. The price to purchase the stock is known as the “strike price”. Options are almost always issued at present value, so that the grant is not taxable to the employee. If the stock rises in value, the ability to purchase the stock at a lower value is valuable.
Employee stock options are generally subject to a vesting period. After a certain period of time at the company after a stock option grant, the employee becomes owner of the option without a risk of forfeiture. At this point the employee is free to “exercise the option”. This means purchasing the stock at the price indicated in the option agreement. Most stock options have an expiration date. This is final date on which the employee may exercise her option. The option also become relevant when an employee leaves a company. At that point, the employee can generally either exercise the option and purchase the common stock or sell the option back to the company. In this article, we discuss the positives and negatives of purchasing the options. Finally, you can explore the opportunity to sell the option back to the company at the value of the shares minus the strike price.
Strategies for Exercising Options
When making the decision of whether to exercise your stock options, you should begin by examining your immediate and long-term objectives. There are several strategies that the option holder can employ when making this decision. First, she can exercise the option and hold it long-term as part of her portfolio. Second, she could exercise the option and immediately sell the stock. This can generate immediate cash. A mixture of these approaches would be to exercise the options with the purpose of holding the stock. But, upon exercise, you sell just enough of the stock to cover the expenses associated with the exercise (commissions, fees, and taxes). Lastly, if you already own company stock, you may be able to swap that stock to pay the exercise price. This will result in holding more stock and generally avoids immediate taxation.
Positive of Exercising Stock Option
Future Potential - If you believe that the stock will rise in value beyond the purchase price, then it may be a good decision to purchase the stock. That is, if the stock rises in value at a rate that exceeds the interest that the money could earn through other investment, then it would be a good decision. Of course, the future of stock is uncertain. Startup companies generally generate significant losses throughout the growth phases. If you believe the company’s valuation is growing or the company is a target for acquisition, then this could provide the liquidity you need to later sell your stock at a profit.
Diversified Holdings - Having the option to purchase a non-public firm’s stock can be a way of diversifying your asset holdings. Diversifying your asset holding can reduce the risk of loss associated with a single or limited assets. Of course, you have to make certain that the number of stock options exercised meets the needs and is reasonable in your portfolio.
Tax Benefits - Holding common stock in a company allows for growth in value that will ultimately be subject to a capital gains rate of taxation. If the stock is held more than 12 months before sale, the capital gains rate will generally be significantly lower than a normal income tax rate. This is true for Incentive Stock Options (ISOs) but not Non-Statutory Stock Options (NSOs).
Negatives of Exercising a Stock Option
Expense - If you don’t have the money to purchase the options at the stated price, then purchasing the stock may not be an option. Of course, you could compare the benefits of incurring debt to exercise the options, but this could be a risky move if the stock does not perform well. Remember, if the company fails, shareholders have the lowest priority of payment. You could end up losing all of the funds you invested in the options.
Lack of Liquidity - Owning a startup company’s stock generally entails having to hold the stock until a future investor seeks to purchase it or the company goes public. If the company reaches a maturity stage, it is also possible to sell the stock back to the company. In any event, stock associated with a startup company is traditionally illiquid (cannot be ready sold or turned into cash).