Stock Option Basics
If you received stock options as part of your compensation package, that’s great! You’re probably thinking, “What should I do?”. You are probably also wondering, “How do I maximize their value?”. “How do I protect what I have?”
Before answering those questions, let’s go over some stock options basics.
Stock Option Terms
A stock option is an agreement that allows the holder to buy a precise number of shares at a specified price (exercise price) by an explicit date (expiration date). You receive the stock option when the company makes a grant or award. First, you can purchase or “exercise” the stock according to the terms of the agreement. An exercise can only be completed if the option is vested. Furthermore, some options have vesting periods and some do not. If there is no vesting period, you can exercise the option right away.
The exercise price is the price you pay when you exercise the option. For example, if the stock is trading at $40 per share and the exercise price is $25 per share, the option is in-the-money. This means that the value of the stock is higher than the exercise price. The difference between the current stock price and the strike price is the spread, and in this example the spread is $15. On the other hand, when the stock price is below the strike price, the option is underwater, or out-of-the-money.
Stock Options Documentation
The company will typically give you an option agreement when granting stock options. This documents the key terms of your option, including the number of shares you can buy, the purchase price, the time periods during which you’re permitted to exercise the option, vesting schedule, and the type of option.
In addition, companies usually provide a prospectus when granting options. This is a summary of the terms and conditions of the option and other information that will help you decide when to exercise the option.
How to Exercise
Now that the basics are covered, here are the steps to exercise an option.
1.) Know Your Rights
You need to know if you can exercise any of your stock options, and if so, which ones. If you are unsure, let’s talk. Sometimes you can exercise some options but not the others. Also, you may only be able to exercise part of a stock option.
2.) Select A Stock Option
There may be more than one option that you can choose to exercise. If you are not planning to exercise all eligible options, you need to choose which one(s) to exercise. For example, you have an option to buy 100 shares at $35 per share and another option to buy 200 shares at $27 per share. Both options are fully exercisable and you want to exercise for 100 shares. If your plan permits a partial exercise, you can be strategic. You might want to exercise half of the $27 option instead of the $35 dollar option. This will cost $800 less because of the lower exercise price, but it will also increase your taxable income by an additional $800. Or you might want to exercise the $35 option in the current year if your taxes are usually high, for example.
3.) Select A Method Of Payment
You can pay for the option with cold, hard cash, but some companies make other payment methods available. For instance, one technique is a cashless exercise. Before anything else, the company makes an arrangement with a brokerage firm that lends the money needed to buy the stock. Then the brokerage firm sells the stock immediately, with part of the sales proceeds used to repay the loan, cover any tax withholding, and pay any fees. In the end, you receive what is leftover in cash, (if you sold all of the shares), or unsold shares, (if you sold some of the shares).
Another method is to use stock you already own to pay the exercise price. If it will cost $5,000 to exercise your option, you can hand over $5,000 worth of stock instead of $5,000 in cash.
4.) Withholding Taxes
If you’re an employee and you exercise a nonqualified option, the company withholds the taxes on the income you get from exercising the option. Sometimes, if the company withholding rate and your personal withholding rate differ, you have to come up with additional cash for the withholding taxes. Before exercising your option, you should figure out the withholding amount and determine how you will pay it. This will eliminate any unpleasant surprises on April 15th.
5.) Exercise The Option
To exercise the option read through the option agreement to get the specifics on how to proceed. You may have to fill out a form online while other companies need notification in writing. If you are confused, there is a contact person at your company that you can call for help.
What To Do With Your Shares After Exercise
There are many factors to take into consideration when exercising an option, such as the type of option, taxes, holding period, and portfolio diversification. When you exercise the option you increase your ownership in the company. I will write about these important details in future articles. If you have questions, please set up a free consultation.