It is highly recommended, therefore, that you consult with an attorney, accountant, or other experienced tax professional before exercising any stock option. Note that a stock option is a right, not an obligation, to purchase the stock, meaning that the option holder may choose to not exercise the option. As mentioned above, employee stock options have become a popular benefit given to new and valuable employees as an incentive to join a company and work hard to make the company a success. Exercising a stock option means purchasing the shares of stock per the stock option agreement.
The benefit of the option to the option holder comes when the grant price is lower than the market value of the stock at the time the option is exercised. You receive a stock option as part of your compensation package as a new employee at your company. Your option vests see below. You decide to exercise your option.
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As the owner of the shares, you now have the choice of selling them or holding them. A vesting date is a common feature of stock options granted as part of an employee compensation package. All stock options come with an expiration date, that is, the last date by which the option holder must exercise her option or lose it. Many people believe that it is wise to wait until just before the expiration date to exercise their stock options and purchase the option shares. And they may be right, under most circumstances. There are times, however, when exercising your options early is a good idea.
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Here are four reasons to consider exercising your options before the expiration date:. You currently own, or hold options on, too many shares of company stock than is healthy for your overall investment portfolio. You believe the stock is a good investment for the long term and you want to buy as many shares as you can afford.
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Your financial gain from exercising your options all at once would push you into a higher tax bracket, so you are spreading out your stock purchases under the option agreement. ESOs are just one type of equity compensation a company may offer. Other types of equity compensation may include:.
In broad terms, the commonality between all these equity compensation plans is that they give employees and stakeholders an equity incentive to build the company and share in its growth and success. For employees, the key benefits of any type of equity compensation plan are:. The benefits of an equity compensation plan to employers are:.
Proceeds From the Exercise of Stock Options
In terms of stock options, there are two main types:. There are two key parties in the ESO, the grantee employee and grantor employer. The grantee—also known as the optionee—can be an executive or an employee, while the grantor is the company that employs the grantee. The grantee is given equity compensation in the form of ESOs, usually with certain restrictions, one of the most important of which is the vesting period.
The vesting period is the length of time that an employee must wait in order to be able to exercise their ESOs. Why does the employee need to wait? Because it gives the employee an incentive to perform well and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant.
Note that the stock may not be fully vested when purchased with an option in certain cases, despite exercise of the stock options, as the company may not want to run the risk of employees making a quick gain by exercising their options and immediately selling their shares and subsequently leaving the company.
If you have received an options grant, you must carefully go through your company's stock options plan, as well as the options agreement, to determine the rights available and restrictions applied to employees. The options agreement will provide the key details of your option grant such as the vesting schedule, how the ESOs will vest, shares represented by the grant, and the strike price.
If you are a key employee or executive, it may be possible to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, or a lower exercise price. It may also be worthwhile to discuss the options agreement with your financial planner or wealth manager before you sign on the dotted line. ESOs typically vest in chunks over time at predetermined dates, as set out in the vesting schedule. As mentioned earlier, we had assumed that the ESOs have a term of 10 years.
This means that after 10 years, you would no longer have the right to buy shares. Therefore, the ESOs must be exercised before the year period counting from the date of the option grant is up. It should be emphasized that the record price for the shares is the exercise price or strike price specified in the options agreement, regardless of the actual market price of the stock. In some ESO agreements, a company may offer a reload option. A reload option is a nice provision to take advantage of.
We now arrive at the ESO spread. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread. The following points need to be borne in mind with regard to ESO taxation:. This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares. This aspect can give rise to the risk of a huge tax liability, if you continue to hold the stock and it plummets in value.
The ability to buy shares at a significant discount to the current market price a bargain price, in other words is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate. Thus, even if you do not sell the shares acquired pursuant to your ESO exercise, you trigger a tax liability at the time of exercise.
The value of an option consists of intrinsic value and time value. Time value depends on the amount of time remaining until expiration the date when the ESOs expire and several other variables. Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, their time value can be quite significant. While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them.
To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model to compute the fair value of your ESOs.
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You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO. From there, it is a simple exercise to calculate time value, as can be seen below. The exercise of an ESO will capture intrinsic value but usually gives up time value assuming there is any left , resulting in a potentially large hidden opportunity cost.
The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and above all, volatility. Consider a situation where your ESOs are out of the money i. It would be illogical to exercise your ESOs in this scenario for two reasons. The biggest and most obvious difference between ESOs and listed options is that ESOs are not traded on an exchange, and hence do not have the many benefits of exchange-traded options.
Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an option portfolio.
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Not so with your ESOs, whose value is not as easy to ascertain, because there is no market price reference point. Many ESOs are granted with a term of 10 years, but there are virtually no options that trade for that length of time. LEAPs long-term equity anticipation securities are among the longest-dated options available, but even they only go two years out, which would only help if your ESOs have two years or less to expiration.
Option pricing models are therefore crucial for you to know the value of your ESOs. Your employer is required—on the options grant date—to specify a theoretical price of your ESOs in your options agreement. Be sure to request this information from your company, and also find out how the value of your ESOs has been determined. Option prices can vary widely, depending on the assumptions made in the input variables. For example, your employer may make certain assumptions about expected length of employment and estimated holding period before exercise, which could shorten the time to expiration.
With listed options, on the other hand, the time to expiration is specified and cannot be arbitrarily changed.