In this lesson, you will learn how to exercise your options and how to pay for the stock.
Exercising your employee stock options is not a complicated process. Your option agreement should spell out exactly what you need to do.
It is important to understand exactly what the process is and how long it takes. This can be especially important if the underlying stock is volatile. Many high-tech stocks can have big swings in the price in one day of trading. It is not uncommon for the stock price to fluctuate 10 points or more in a single day and that could mean trouble if you were counting on a specific price.
Tip
Exercising stock options is usually fairly simple; however, be sure you understand how the process works to avoid unpleasant surprises.
For example, say you have vested options for 100 shares of XYZ at $80 per share. The current market price as of the close of business on Monday is $110 per share. You notify the appropriate department that you want to exercise your options. Your plan is to sell the stock immediately.
Unfortunately, by the time, you exercise the options and the stock is yours to sell, the market price has dropped to $100 per share. Instead of a $3,000 profit ($110 - $80 = $30 × 100 = $3,000), you have a $2,000 profit ($100 - $80 = $20 × 100 = $2,000).
Later in this lesson, I show you how some companies help employees avoid this circumstance.
For now, let's review the three alternative actions I outlined in Lesson 7, "When to Exercise Your Options":
This chapter focuses on the first two alternatives, which require you to exercise the options.
Most likely your company will require you to fill out a form or notify it in some written manner that you want to exercise your options. If you plan to exercise your options and hold the stock, it doesn't matter what the exact market price is when you officially own the stock. However, as with our preceding example, if your plan is to immediately sell the stock, the market price of the stock when it officially becomes yours is important.
The option agreement should detail when the company considers the stock yours. It might be as of the close of business the day you submit your exercise notice or some other date. This is an important date for several reasons. If you want to hold the stock, this date establishes the "basis" for the stock when computing future tax liabilities. (More about basis in Lesson 9, "Taxes and Options.")
Your company may grant employee stock options on a regular schedule, such as every year or every six months. It is possible that you will have more than one grant available for exercise.
It is almost certain that the options will have different grant prices and may have different vesting schedules. It is also possible you have a combination of nonstatutory stock options (NSOs) and incentive stock options (ISOs).
This is why it is so important to keep good records of the grants. This way you will have a clear picture of which options are "in the money" and which aren't.
It is not necessary to exercise options in the order you received them. You can skip over grants in favor of others that meet your needs.
This can become a tax issue, which I discuss in Lesson 9.
Tip
If your company does not provide you with detailed statements on the status of your options, develop your own method of keeping track of them. A little work now can pay big dividends in the future.
For now, let's look at a simple example to illustrate how important it is to keep careful records. We'll assume that all of these are vested options with no other restrictions. The current fair market price of the stock is $35 per share.
Grant | Exercise Price | Type of Option | |
|---|---|---|---|
1 | Jan. 1998 | $22 | ISO |
2 | July 1998 | $32 | NSO |
3 | Jan. 1999 | $38 | NSO |
4 | July 1999 | $29 | NSO |
5 | Jan. 2000 | $40 | ISO |
First, grants three and five are out of the money, so you can eliminate them from consideration.
Grant one is an incentive stock option, which means you have to hold the stock more than one year to qualify for a favorable tax rate. It would be a good choice since you will pay no taxes until you sell the stock, assuming you meet the holding requirements.
Grant two is barely in the money. You may want to wait on this one and see if the stock price rises far enough to make this a good exercise.
Grant four is $6 in the money and may be a good candidate if you want to sell the stock immediately. To recap:
Your personal financial situation and goals may cause you to arrive at a different strategy. The point is, careful record keeping gives you the information you need to make the right decisions.
Once you have exercised your options, you need to pay for the stock. Your options agreement or company policy should detail the conditions and terms of payment.
In Lesson 7 I mention that this is one of the drawbacks of exercising options. For some option plans, that means cash. A check with the exercise notice is frequently standard procedure. (See the following section on withholding.)
However, some companies offer alternatives that make exercising options much more convenient for the employee, although usually at a price.
It's not that the government doesn't trust you, but if you are an employee, your employer is required to withhold taxes from the proceeds of the sale.
Plain English
Withholding taxes are the same taxes withheld from every paycheck: Social Security, Medicare, federal and local income taxes.
If you are paying for the stock with cash, you also must include enough to cover the withholding taxes. Remember, you create a tax liability when you exercise an NSO. You owe ordinary income taxes on the spread between the exercise price and the fair market price on the day you exercise.
Your employer should tell you what the withholding tax would be so you can include it in the check.
The cashless exercise is a very convenient alternative offered by some employers for employees that want to exercise the options and immediately sell the stock. Your employer will work a deal with a stockbroker to handle the transaction. The broker will take care of the trade and handle most of the paperwork.
Here is how the cashless exercise works:
You need to open an account with the broker. Your employer will have the necessary forms or tell you where to get them.
When you are ready to do a cashless exercise, you let the broker know in whatever manner it wants.
The broker "loans" you the money to buy the stock and immediately sells it. The broker uses the proceeds to repay the loan, cover any withholding, and pay brokerage fees and commissions. You receive what is left.
If this alternative is available to you, it is well worth the fees involved in most cases. This form of exercise prevents wild fluctuations in the stock price that may occur from the time you exercise until you can sell by conventional means.
Not all companies make this alternative available. Check your option agreement for details and availability.
This alternative only works with vested nonstatutory stock options. Frequently, nonemployees who hold NSOs have the same access to the cashless exercise as employees.
Fortunately, there are no additional taxes associated with the cashless exercise. While it appears to you as one motion, it is actually two transactions:
First, the options are exercised and the stock is bought.
Then the stock is sold.
The tax liability is the same as if you had paid cash for the stock and sold it. You will pay ordinary income tax on the spread between the exercise price and the fair market price.
There is another way to accomplish an almost cashless exercise by using stock you already own to pay for the new stock. The idea is to "trade in" stock you own for more shares under the exercised option.
Caution
You must own stock in the company already to use it to exercise options. You can acquire the stock in the open market or through previously exercised options. See Lesson 9 for more details.
For example, you own 1,500 shares of stock. The current market value is $25 per share. You own options to buy 1,000 shares of the same stock at an exercise price of $10 per share. Normally you would need $10,000 (1,000 × $10 = $10,000) cash to exercise the option.
Instead, you "turn in" 400 shares of your existing stock (400 × $25 = $10,000) to pay for the new stock. The result is you now own 2,100 shares of stock (1,500 - 400 = 1,100 + 1,000 = 2,100).
I said earlier that this was almost a cashless transaction. You will still need to cover the withholding and any fees if you are an employee. Still, it is a convenient way to accomplish an exercise without a large outlay of cash.
Taxes get a little tricky with these types of transactions. In general, they are easier for nonqualified stock options than incentive stock options.
The tax code treats NSOs the same way as a regular exercise with one little twist. The government considers the shares you "turn in" a tax-free exchange. You must report income on the balance of the stock.
For example, let's continue with the preceding example. You have options on 1,000 shares. You use 400 existing shares to buy the stock. The government considers those 400 shares a tax-free exchange and no income needs to be reported.
The 600 shares in the balance generate an ordinary tax liability of the spread between the fair market price and what you paid (600 shares × $15 per share spread = $9,000).
Incentive stock options present a more complicated picture and one best explained in Lesson 9 when we look at taxes in more detail.
Exercising your options is usually a straightforward process outlined in your stock option agreement.
You can exercise vested options in any order you choose.
There are several alternatives that may be available to you for paying for the options: cash, cashless transaction, or using stock.
You may be required to pay withholding taxes when you exercise nonqualified stock options if you are an employee.