I see too many smart people with substantial gains in stock options who do dumb things. A disciplined stock option exercise strategy can prevent some big mistakes and significantly increase the value of your option grant. Here are eight guidelines for anyone who is thinking about exercising their employee stock options.
- Don't exercise too soon. But…don't wait too long.
A common reason I hear for wanting to exercise employee stock options shortly after they vest is to make a significant purchase, like a fancy boat or sports car. The most expensive boat or car I can imagine is the one bought with stock options. If left unexercised, the options could appreciate significantly (something a car or boat is not likely to do) and the gains will generally remain tax-deferred until you exercise.
Let me explain why: When you exercise an employee stock option, you have to pay for it, usually from part of the gains on the option spread in a "cashless" exercise. In doing so, you lose the potential value of the future appreciation on the options you exercise and the shares you sell. This is often referred to as "opportunity cost": it's what you lose when exercising options too early. For example, let’s say you were granted options at $18 when the company was restructuring. The stock's price ranged from $16 to $21 for the next two years. Finally, the results of the restructuring began to appear in improved earnings. The stock then rose to $31.
Along with other executives and employees you talk to about the company stock, you exercised your options, thinking that the rise to $31 was a spike in the price. But what if the price continued to rise and, today, is at about $53? The difference between $31 and $53 is the opportunity cost of the decision to exercise while the options were relatively young (And, by the way, the guys in the break room probably aren't Financial Planners, even Norman, the guy with the spreadsheet).
If you are patient and wait to exercise, you realize any benefit of this opportunity. The benefit is like an interest-free loan. Look at it this way. Your options appreciate in value as the stock price rises. Since you have no tax responsibility until you exercise, it's as if your company extended you a line of credit for the difference between your grant price and the market price of your stock. But if you wait too long to exercise, there may not be enough time for the stock to recover from a temporary decline before you are forced to exercise at expiration, which leads to other points discussed below.
- Your risk rises with your profit.
As the profit in your employee stock options increases relative to the value of your interest-free loan, you have more to lose than gain because more of your own money (your potential profit) is at risk. Don't be greedy. Short-term rallies in the price of your stock are probably selling opportunities. Something that may mitigate the eagerness to exercise in number 1, above is the age and price of the other grants you have been given and if you expect to continue to receive future option grants. Exercise your oldest (not necessarily the lowest-priced) options when these price increases occur. This requires you to spend some time in watching and understanding the price behavior of your company's stock. An experienced equity compensation advisor can be a big help.
- Consider "alternative investment cost."
Your alternative investment cost is determined by how much an alternative investment must appreciate to justify exercising your options and putting net profits into another investment.
Here is a simplified way to think about it. Let's say you have an option that was granted to you nine years ago at $3. Today the stock is trading at $62. (This would be an appreciation rate of about 40% a year, which is not unheard of for fast-growth companies.) Let's also assume that earlier in the year your stock traded as high as $64 and as low as $50. Finally, assume that if you make an investment in the market you can expect a return roughly equivalent to the return of the S&P 500 stock index over the prior 10 years. Should you exercise or continue to wait?
I'd suggest you exercise. Here's why. The stock has appreciated at 40% a year but is trading only 3% away from its high. More importantly, it's trading 22% above its recent low. Since the stock has recently traded at both of those prices, it's reasonable to assume that it could go back to either of them again. Said another way, your opportunity cost is 3% (upside potential) and your risk of loss is 22% (downside risk).
The alternative investment cost in this example is the 3% return you must beat to exceed the expected return from holding the option. And the grant is nine years old. There isn't much time left in it, anyway. This fact and the low alternative investment cost means that your comparative future reward from holding your option has decreased and your risk has increased. At this point, you are probably better off with exercising, taking your profit, paying the taxes, and investing the proceeds in a stock or a mutual fund whose performance will complement your other holdings.
- Use an "average out" strategy to exercise your options.
If you intend to exercise your options in a cashless same-day sale, consider having a stock option exercise strategy, perhaps exercising monthly or quarterly, beginning two years before their expiration. If your company offers one, you may want to set up a Rule 10b5-1 plan for prearranged trading in your company's stock. This strategy may reduce your chances of being forced to accept a lower price for all of your options by a temporary decline in the stock near expiration. If you plan to hold the exercised stock, wait until expiration to exercise. I encourage you to combine this strategy with an "average in" strategy: You invest your exercise proceeds in a diversified portfolio of stocks, bonds, and/or mutual funds on a periodic basis corresponding to your exercises.
- Know your company’s exercise rules and procedures.
For instance, not all companies allow cashless exercises but instead require you to put up cash or swap other company stock for the exercise cost. Although most companies have systems that allow online viewing of grants and online stock options exercises, similar in concept to some regular brokerage accounts, some companies, especially small ones, still use paper-and telephone-based systems for option exercises. Look at your plan documents and any ancillary forms and materials your company gave you that explain the procedures for exercise transactions.
Failure to follow company procedures can result in a violation of securities laws and the possible forfeiture of your profit. Your broker (if you’re not required to use one or two firms designated by your company) should also be advised to carefully follow your company’s procedures to avoid delays in payment or delivery of your stock, both of which can cost you money.
Particularly for executives, make sure the plan administrator, company legal counsel, and broker communicate with one another before the exercise is executed or any company stock is sold. I was recently made aware of an exercise where a company mistakenly (during a blackout period where no employees could sell stock) approved an executive’s exercise. The executive then found himself in the embarrassing position of having to ask his broker to reverse a transaction that his company refused to process.
In a circumstance like this, it is crucial that you have a precise record of the company’s and the broker's actions. In this particular case, it was only because the broker was willing to unwind the transaction that the executive and his company avoided having to report an insider trading violation to the shareholders.
- Broker (margin) loans: don't let tax issues cloud your judgment.
Tax-averse employees sometimes want to use borrowed funds from the broker to exercise and hold an incentive stock option (ISO) instead of putting up their own cash. The most fashionable rationale for exercising ISOs is that, by holding the stock for one year (the sale must occur at least one year after the ISO exercise), it will qualify for long-term capital gains treatment.
For ISO stock not sold in the same tax year as exercise, the spread at exercise may be subject to the alternative minimum tax (AMT). AMT rates start at 26% and move to 28% at higher income levels. Because of the potential that you may owe AMT, examine the profit situation of any grants you exercised earlier in the year as year-end approaches to see if it makers sense to just sell the stock, pay the tax and walk away with a profit. For more about year-end planning, see my post here.
Employees who are in a higher marginal bracket may believe that the AMT, with long-term capital gains later when they sell, is preferable to the ordinary income tax now. Thus, they exercise and hold. Implicit in this strategy is the assumption that the stock will go up (something that I can all too well tell you, cannot be assured).
For employees at some companies with a consistent, long-term history of superior stock price performance, an exercise and hold can be a good strategy when viewed in perspective of all their other investments. But for others it can be a disaster, particularly if they use margin loans and the stock price plummets. If the option's total exercise cost is less than half of the current market price, your broker will only be too happy to provide you with a margin loan, using the stock you will acquire in the exercise as collateral.
Brokers are allowed by Regulation T of the Federal Reserve to lend up to 50% of a stock’s market price on the day of the loan. So, for example, if you have 1,000 ISOs with a strike price of $10 and the stock is trading above $20, there is enough margin for your broker to loan you the funds you need to exercise and hold the shares. You’ll need to sign a margin loan agreement and pay interest on the $10,000 exercise cost until the loan is repaid.
There is no requirement that you repay the loan unless the value of the stock in your account falls to a point where it can no longer adequately collateralize the loan (i.e. below the 50% point). If this happens, your broker will give you a margin call. [Be careful: The rules for when a broker will give you a call vary by firm, and brokers can elect to require more or less margin on specific stocks, at their discretion.]
This means you will either have to send a check or provide other assets to make up the shortfall, or allow the broker to sell some of your stock. Selling stock will defeat your tax avoidance strategy. Any money you pay your broker (whether it’s interest or funds to meet a call) is gone, just as if you had paid it to the IRS.
- Margin loans: Know the risks.
I am not a big fan of using borrowed money to exercise stock options. In the volatile world of technology and initial offerings, dramatic price reversals are common. Imagine watching as stock you’d acquired in an exercise-and-hold transaction, initially rises from $27 on the day its exercised at a $13 exercise price, to $55 ,120 days later...only to watch it fall to a three-year low of $11, recently. On the way down, you could be forced to liquidate, near the lows, to meet margin calls. How would you feel if the stock is now trading at $38?
You would have been better off exercising, selling, and paying the taxes (profit is $27-$13 = $14/share; tax in the 35% bracket is $4.90/share), or abandoning the tax avoidance strategy when the stock began to really climb (e.g. maybe at $50, when the profit would have been $37/share; tax in the top bracket would have been $13/share). Instead, by sticking to an AMT/long-term capital gains strategy, riding the stock down, paying interest on a loan that you are eventually forced to cover, you finish with very little profit. Decide for yourself if the risk is worth it.
- Don’t forget to exercise.
If you fail to exercise before expiration, the value of your options will be lost. Some companies do not make it a practice to keep optionees (whether or not they are current employees) informed of approaching expirations. Also, in volatile markets, it’s easy for an option to “spring back to life” when the stock rises rapidly, near the expiration of a grant. It turns into a very expensive vacation if you’re out of town or out of touch when your out-of-the-money options suddenly acquire value. You should have some way to alert yourself of approaching grant expirations. Again, this is where an experienced advisor can come in handy.
One final thought: Don’t assume that, just because your options have a 10-year term, when you leave your company you have the remaining years left to exercise them. The unvested options expire immediately, and it's likely that the vested options expire within 90 days—or even the day you leave. It might be different for retirement or disability. Check your grant agreement and plan documents for the details.