How to Exercise Your Employee Stock Options Strategically

Highly-skilled managers and workers are increasingly in demand, so offering attractive incentives to entice them to stay – as well as to attract new talent – is an approach many firms are using to keep people engaged and motivated.

Providing employee stock options has worked well for fresh, young startups that are short on revenue but big on possibilities. By providing equity options, startup founders can keep top talent on board by using the possibility of a hefty future payday as a lure.

It also enables larger, more established firms to build long-term relationships with critical employees while ramping up commitment levels. After all, employees with an equity holding have a lot more to gain if the company share price soars and revenues grow.

While stock options can be extremely beneficial and lucrative for those who take them up and utilize them well, many people choose not to exercise these options.

This has a lot to do with the tax implications and the costs associated with making the purchase. While these concerns are valid, it is certainly possible to leverage this opportunity through effective wealth management planning in order to maximize your wealth.

The Ins, Outs and Tax Implications of Employee Stock Options

When receiving an employee stock option plan, the first place to start is by considering the nature of the offer and how it is structured.

Let’s start with the basics: Employee stock options give you the right to purchase a number of shares in the company with which you are employed. The price and the timeframe you have to exercise (or take up) these options will be specified by the company. The company will also set a ‘vesting date’, which is the date from which you can exercise your stock options.

So, essentially, you are bookended between the vesting date and the expiration date to make your purchase – which ideally should be when the specified price is below the current market value.

If an employee does decide to take up the stock options offer, they should carefully consider which type of stock option they are dealing with since each comes with specific tax implications.

  • Non-Qualified Stock Options (NSOs): An option which companies can use to issue options to employees, company partners, vendors or other stakeholders. With NSOs, the purchaser will pay income tax on the difference between the specified price and the price of the stock when exercising the option. When the stocks are sold, capital gains tax comes into effect.
  • Incentive Stock Options (ISOs): These are only used for employees of a company. Under this option, the employee will have to pay taxes when the shares are sold. But should you exercise and hold, you can be subject to Alternative Minimum Tax (AMT). ISOs can also be subject to capital gains tax.

When they start drilling down into the tax implications, many people back off from taking up the option. However, with astute planning and professional guidance, it is possible to minimize the tax impact and help you get the most out of this opportunity.

How to Exercise Your Employee Stock Options

There are a number of avenues at your disposal when it comes time to exercise – or purchase – the company stock you are being offered.

Let’s run through just a few:

  • Buy-and-Hold: You could buy stock options in cash and then elect to hold them in the hope that the price will go up. There are fees and commissions to be paid when you opt for this choice.
  • Buy-and-Sell: This approach involves exercising your options and then immediately selling. Under this option, the brokerage dealing with the sale can front you the money and use the proceeds from the sale to cover their costs. This way, you don’t have to outlay any cash.
  • Sell-to-Cover: Another strategy is to buy and then immediately sell a sufficient number of shares to cover the purchase. This way, you don’t have to outlay cash, and you can hold the remainder of the shares in the hope that the price goes up.
  • Stock Swap: If you are looking to take advantage of the stock options plan but prefer not to outlay cash, you could consider a stock swap. This enables you to use the fair market value of a stock you already own to pay the exercise cost of the employee stock shares.

Approach Stock Options with Strategic Intent

Investing and wealth management is all about balance, weighing up the pros and the cons, and looking at an opportunity from various angles. Practically, this means being aware of over-exposure to any single stock.

If you consider that a healthy portfolio shouldn’t comprise more than 5% to 10% in a single company, then how you manage employee stock options has added implications beyond tax and timing.

It also requires a keen focus on maintaining a diverse and healthy investment portfolio to lower risk. So yes, it’s appealing to go all-in if you receive a large stock option plan. But sometimes, you need an expert hand and a steady head to talk through all the implications, including your personal financial situation, and then guide you towards your best choice.

Fortunately, the Felton & Peel Wealth Management team is on hand to help you determine your best course of action and how best to take advantage of your employee stock options. Call us today to unlock your options.

Malik S. Lee, CFP®, CAP®, APMA®
Malik Lee is the Managing Principal of Felton & Peel Wealth Management. A CERTIFIED FINANCIAL PLANNER™ with more than 15 years of financial services experience, he is a Guest Lecturer at Morehouse College, serves on the CFP Board Council of Examinations, and is a Board Member for the FPA of GA.
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