- October 13, 2021
- Chris Wall, CPA, CFP
We are often asked the best time or the most efficient way to exercise the options that our clients are granted. Here is a quick rundown of a couple different strategies used when exercising your Nonqualified Stock Options (NSOs):
The Price is Right
This course of action typically involves establishing a baseline figure of the value you want out of your options and exercising your NSOs when that baseline is hit. It is fairly common to hear, “I will exercise my stock options when our company shares hit $15 per share.” When a company is publicly traded, shareholders will sometimes consider the worst-case scenario and set a minimum before they exercise their NSOs. You may hear someone say, “I want to see if our shares are going to keep going up in value, but if our company stock drops below $50 a share, I am exercising and taking the money.” Or you might see a blend of the two: The company stock is currently worth $25 and the option-holder decides they are going to exercise if the price rises to $30 a share or drops below $20. This price approach is most popular when the person has a target income goal or they have an expected larger expense that they need a fixed amount of value from their shares.
Timing is Everything
Another way for planning around your NSOs is to treat it like a 401k and profit-sharing plan and create your own vesting rules. The most common expiration of NSOs is 10 years, but this does vary from company to company. Since time is often your friend when it comes to stock options, you can simply sit out the first couple of years to allow for growth and start to exercise your NSOs in a systematic way when you are nearing expiration. You can plan on exercising 25% of your options per year, in years 5-9. This still permits early year appreciation, creates the potential of a more efficient exercise from a tax perspective because you are spreading out the income, and creates a form of dollar cost averaging which could mitigate some of the risk. This strategy assumes that you continue working at the company as you will often need to make the decision on vested shares when you leave your employer.
Bonus Plan Mentality
This strategy is best if you receive multiple tranches of options and your company stock has seen a large runup in value in a short period of time. This likely would not work for an employee of a start-up even if the company stock has had a large increase in value because the amount of the cash payout is far less beneficial then the long-term benefit of the option. With this approach, the option holder would exercise and sell their shares as soon as it vests, treating the difference between the exercise price and the fair market value almost like a cash bonus. While this does remove market risk, you are giving up the time value of the option for this level of security.
Wait It Out
This route is the easiest to understand. If you are granted options that expire in ten years, wait to exercise them until the very last minute. This allows you to see how “your hand plays out.” You get to take full advantage of the time value of your options. Like any other method, this one does not come without its limitations. There is no guarantee that the end of the option’s life is when your shares are the highest value. It may also not be practical as the average employee switches companies long before typical NSO expiration. Lastly, exercising all of your options in one year could lead to a very high tax bill as it does not allow you to recognize the ordinary income over multiple tax years.
A lot of people set out with the goal of paying as little tax as possible. This course of action looks to shift as much of your income from ordinary income rates into the capital gains bucket. This is accomplished by exercising your shares with as little of a spread between the strike price and the fair market value as possible. For startup employees, this may be much easier as your 409a valuation may have had little to no movement since your shares vested. For option holders at publicly traded companies, picking the ideal time may be a little more challenging. If done successfully, the shareholder will hold the shares for over one year with the hope that more of their income gets taxed at the more favorable long term capital gains rate. You would assume that an article that is authored by a CPA would suggest that the tax efficient approach is the best course of action, but this does come with limitations. The large downside to recognizing income earlier is forgoing the time value of the option. This opens up the possibility that the shares could go down in price or in the worst-case scenario, you paid to exercise shares that are worthless because the company goes out of business.
The Right Answer
This by no means was intended to be an exhaustive list of all of the strategies available when exercising your options. The reality is that all of these strategies and none of these approaches could be right for your individual situation. A blend of these approaches may be appropriate, but your options cannot be looked at in a vacuum. Instead exercising your options has to be part of your overall financial and goal planning.
Tags: #NSO, #Stockoptions, Uncategorized | Comments Off on Popular Strategies for Exercising Nonqualified Stock Options
Chris Wall is a Certified Public Accountant and Certified Financial Planner. He best serves those with complex stock compensation needs, including Incentive Stock Options(ISO), Nonqualified Stock Options(NSO), Restricted Stock(RSU/RSA), and Employee Stock Purchase Plans(ESPP). His specialties include tax planning, cash flow analysis, distribution modeling, retirement planning, and withdrawal strategies.
As a seasoned expert in financial planning and stock compensation, let me break down the key concepts discussed in the article authored by Chris Wall, CPA, CFP on October 13, 2021.
Strategies for Exercising Nonqualified Stock Options (NSOs):
1. The Price is Right:
- Concept: Establishing a baseline stock price for exercising NSOs.
- Evidence: Shareholders set a minimum threshold before exercising options, based on personal financial goals or worst-case scenarios.
2. Timing is Everything:
- Concept: Creating vesting rules similar to a 401k plan, spreading out the exercise of NSOs over time.
- Evidence: Utilizing the 10-year expiration period, planning to exercise 25% of options per year from years 5-9, considering potential tax advantages and risk mitigation.
3. Bonus Plan Mentality:
- Concept: Exercising and selling NSO shares immediately after vesting, treating the difference as a cash bonus.
- Evidence: Suitable for those receiving multiple tranches of options with a rapid increase in stock value, but not ideal for startup employees due to the lower cash payout compared to long-term benefits.
4. Wait It Out:
- Concept: Delaying NSO exercise until the last minute (10-year expiration) to capitalize on time value.
- Evidence: Acknowledging limitations, such as uncertain market conditions at the end of the option's life and practicality concerns for employees who may switch companies before expiration.
5. Tax Efficiency:
- Concept: Minimizing tax impact by exercising shares with a narrow spread between strike price and fair market value.
- Evidence: Different challenges for startup vs. publicly traded company employees; aims to shift income from ordinary income rates to the capital gains bucket, considering the 409a valuation for startup employees.
6. The Right Answer:
- Concept: Emphasizing that there is no one-size-fits-all strategy.
- Evidence: The article concludes that the presented strategies may or may not be suitable for an individual's unique situation, emphasizing the need to integrate options exercise into overall financial and goal planning.
Chris Wall, CPA, CFP:
- Credentials: Certified Public Accountant and Certified Financial Planner.
- Expertise: Specializes in complex stock compensation needs, including ISOs, NSOs, RSUs, and ESPPs.
- Services: Offers services such as tax planning, cash flow analysis, distribution modeling, retirement planning, and withdrawal strategies.
In summary, Chris Wall's article provides a comprehensive overview of various strategies for exercising NSOs, highlighting the importance of aligning these decisions with broader financial goals.