NSOs Explained…
Several newsletter readers informed me that I don’t have a technical piece on NSOs. Thank you for pointing that out. Be careful what you ask for!
Non qualified stock options (NSOs) are a common type of employee stock option. They have many similarities and some differences with other types of options. Here is an NSO overview.
Grant Date
First, the grant date is the day the company gives you the NSOs. The NSOs at grant date include a value that is known as the strike price.
The grant date sets the timeline for the remaining key dates for the lifetime of the NSOs. Usually, you cannot take action on NSOs at the grant date because there is typically a vesting schedule.
Vesting Schedule
Another item on this timeline is the vesting schedule. Once the vesting period is met, you gain ownership of the NSOs, and you can exercise the options. After exercise, it’s your decision to hold the shares or sell them.
As time passes, the price of the employer stock will move up and down. If the price of the stock exceeds the strike price, then the options are “in-the-money” and have value. On the contrary, if the stock price is below the strike price then the options have no value (“out-of-the-money”).
Expiration Date
NSOs have an expiration date when issued. The options expire on this date if the employee does not take action to use them.
If the options are worthless (“out-of-the-money”) at expiration, let them expire. If the options have value (“in-the-money”), the final day to realize the value is the expiration date.
Strike Price
The strike price is the price at which you, the employee, can purchase the shares.
Exercising NSOs
Hopefully the stock price appreciates above the exercise price, so they are in-the-money and have value. You now have several decisions to make: do nothing or exercise the options. If you exercise, you need to decide whether to keep the stock or sell it.
No matter what you decide, the stock price will continue to fluctuate. As the price increases, your options become more valuable. However, if the price goes down, you could lose a large amount of money. During 2022, I’ve had conversations with many people who wish they would have exercised options and sold their shares in 2021.
If you do choose to exercise your options, how will you do it? You can choose a cash exercise or a cashless exercise. A cash exercise requires you to pay cash to buy the shares, which could be a large sum of money. A cashless exercise will utilize the sale of some shares or all shares to purchase the option shares. In this case, you don’t have to spend any cash. The cashless exercise is complicated and will be explained in greater detail in another article.
After exercising the options, do you plan on holding onto the stock or selling it? All of these choices will impact your taxes, cash flow, and investment allocation. Emotions tend to run high around large sums of money and so it’s best to formulate a plan ahead of time that best suits your specific needs.
Tax Considerations
No taxes are due prior to exercising NSOs. However, upon exercise of the NSOs, taxes are due. The gain is taxed as ordinary income, just like RSUs. The difference is that you can control the timing of the NSO exercise, whereas with RSUs, the taxable event usually occurs upon vesting and this is beyond your control.
For instance, let’s assume 1,000 options are granted at $10 and exercised at $50. At exercise, the employee would report $40,000 of ordinary income.
Taxable income = 1,000 shares x ($50 exercise price – $10 grant price) = $40,000
If the shares are held after exercise, the cost basis is $50 (the stock price on the date of exercise). When the shares are sold, any gain/loss will be taxed as capital gains/losses. If the shares are held longer than one year from the exercise date, long capital gains rates apply.
What’s Your Best NSO Approach
NSOs are tricky and confusing because there are so many variables. There are some strategies that you can implement for NSOs that depend on your goals and needs.
- Exercise and sell NSOs immediately, and the NSOs become another form of cash compensation.
- Exercise and sell NSOs near or at expiration. Many employees default to this choice.
- Exercise NSOs early and hold the shares. This is for individuals who believe that the company stock will appreciate.
What strategy is right for you? I will work with you to develop a plan to help you achieve your goals.
If you’d like some more clarity on NSOs fee free to set up a chat.