You remember Mikaela from a few weeks ago? She is the fun-loving tech executive with incredible energy who recently joined a startup. We chatted again about the mechanics of exercising her options and about how they really work.
Options Mechanics
When you own a stock option, you have the choice to “exercise” it. Or as I like to call it “put it into play” or “make it useful.”
Making an option useful means that you own shares in the business. There are several ways to put the options into play, and how you choose to do so has a big impact on your financial picture – today and well into the future. This is not a one-time, set it and forget it decision.
The Difference between Cash and Cashless Exercise
There are two ways to make your options useful. Some more finance jargon – cash or cashless exercise. Ugh!
A cash exercise is when you pay “cash out of pocket” to own the shares.
On the other hand, a cashless exercise does not involve using your cash. Instead the cost is company shares. This is known as the “cash in pocket” strategy. There is no cash coming out of your pocket but these options are not free.
The decision comes down to – do you believe in the company?
Cash Exercise
If you believe in the company it’s better to own more shares. You can do this with the “cash out of pocket” strategy.
However, this is an expensive choice. The amount of cash required is the number of options you put into play multiplied by the exercise price of the stock option.
This may require you to sell other assets or spend cash that you have on hand.
And the new shares that you own will be a large portion of your assets.
If the stock price increases, you do very well, but if it does not, you will lose money.
Cashless Exercise
If you are not so hot on the company and its prospects, use the “cash in pocket” strategy.
Instead of paying for the shares with your own cash, you pay for the shares with the shares. Confused? Here’s what usually happens.
You put your options into play and then sell some of the shares to cover the cost of using the shares for the purchase and the associated tax liability.
Essentially, you use the stock to pay for the stock. The amount depends on the terms – option price, current fair market value of shares, and how many shares you want to own, and how they fit in with your finances.
You will still own company shares, but the amount won’t be as high as the “cash out of pocket” method.
Moving Forward
If you really believe in the company, its outlook, and its vision, then owning more shares – “cash out of pocket” is appropriate for you. Alternatively, if you are lukewarm on the business, “cash in pocket” is more suitable for you.
The number of options you can use are a function of vesting schedules, the fair market value of the stock, and your financial situation. As all of these factors continue to change, it’s best to pay yourself if you play the game well.