When the time comes to exercise your non-qualified stock options, you may find yourself asking about the process, the cost, and how it actually happens. This may lead you to ask whether to do a cash exercise or a cashless exercise.
Many people default to a cashless exercise for a few reasons. For one, a cashless exercise is an easy option with no out-of-pocket cost. You pay for the costs of exercising your non-qualified stock options with some or all of the exercised shares themselves.
The end result of a cashless transaction is that you end up owning fewer shares of stock than would you had you done a cash exercise — which might be favorable because it gives you an opportunity to be more diversified with how you hold your assets.
Cashless exercises are easy — but are they always the best option? Let’s look at the math to decide.
Why Do a Cashless Exercise of Non-Qualified Stock Options?
The are several reasons to choose a cashless exercise over a cash exercise. One big reason may be cashflow.
NQSOs vs. ISOs
This summary will break down the differences in how they work and what you should consider.
Exercising your non-qualified stock options can be expensive. If you don’t have cash (or other assets) to liquid to cover the cost, you may not have a choice but to do a cashless exercise. With a cashless exercise of non-qualified stock options, you use a portion of your exercised shares to offset the cost. The cost may include buying the shares at the exercise price, the income tax due, or both.
A cashless exercise may mean that you sell-to-cover, which means you sell enough shares to cover the cost of the exercise and the cost of the income tax due (or any combination of this), or it may mean a same-day sale that means you sell all the shares you exercise at the same time.
You may also want to sell some of your options immediately to limit your stock exposure, decrease your concentration risk, and diversify. This makes a cashless exercise a potentially good choice, even if you have the money available to cover the cost of a cash exercise.
That explains what a cashless exercise is and why you might do one. But how does it actually work?
What Happens When You Do a Cashless Exercise of Non-Qualified Stock Options?
Let’s assume that you are granted the following non-qualified stock options that you wish to exercise.
Fair Market Value at Exercise
In this example, you have the right to buy 1,000 shares of stock at $20.00 per share, for a total purchase cost of $20,000.
These same options that you can exercise and pay $20,000 to buy are currently worth $80,000 on the open market. This provides you with a gain of $60,000.
This grant of non-qualified stock options is “in the money,” meaning they have real value. Unfortunately, these in-the-money stock options are not free to exercise.
When you exercise your option, you buy shares of stock at the strike price of the option, and you create a taxable event. The cost of the shares and the taxable event will need to be covered at exercise. A cashless exercise of non-qualified stock options covers that cost by selling off some of your shares. In this example, this is often referred to as a sell to cover.
The specific costs are as follows:
- The cost of buying the original shares at the strike price of $20 per share, multiplied by the number of options you exercise
- The income/wage and any taxes associated with exercising the non-qualified stock options
The Math Behind a Cashless Exercise of Non-Qualified Stock Options
To determine how many shares you must immediately exercise and sell, you can follow the steps and the math below:
- Calculate the cost of buying the shares: In our example above, the number of options exercised times the strike price equals the cost of buying the shares.
1,000 X $20.00 = $20,000
- Calculate the income tax due upon exercise: This calculation starts by determining the taxable amount of the exercise. The taxable amount is equal to the number of options exercised multiplied by the difference between the fair market at exercise and the strike price.
1,000 X ($80.00 − $20.00) = $60,000
- Use the taxable amount calculated in step 2 to determine the income tax owed: The following tax rates are hypothetical as part of this example. Your tax rate may vary.
Federal tax = $60,000 x 22% = $13,200
Social Security tax = $60,000 x 6.2% = $3,720
Medicare tax = $60,000 x 1.45% = $870
Add these three for a total of $17,790.
- Calculate the number of shares required to perform a cashless (sell-to-cover) exercise: Divide the associated costs by the current share price.
Cost of buying the shares = $20,000 / $80 = 250 shares
Cost of paying the taxes = $17,790 / 80 = 223 shares (rounded up)
Add these two to obtain the total number of shares required, which is 473 shares.
- Calculate the number of shares remaining after the cashless sell-to-cover exercise: This equals the total shares less the figure calculated in step 4.
1,000 − 473 = 527 shares
Exploring the Post-Exercise Impact of a Cashless Exercise
In the above example, your cashless exercise of non-qualified stock options allowed you to exercise your non-qualified stock options with little to no cash outlay.
In doing so, you transitioned from controlling 1,000 options to controlling 527 actual shares. You went from having $60,000 of pre-tax value to owning $42,160 of post-tax value.
Moving forward, the remaining shares have a cost basis equal to the fair market value at exercise, ($42,160) and begin their holding period as a capital asset.
What’s the Right Choice: Cash or Cashless Exercise?
The question remains whether or not a cashless exercise of non-qualified stock options is the right choice. The truth is, there is no one, always-right answer. The real answer is something along the lines of, “it depends.”
A cashless exercise may be the best option for someone who is seeking to minimize cash outlay or is seeking to reallocate any existing company stock.
However, a cashless exercise of non-qualified stock options may not be right for someone seeking to maximize long-term appreciation via concentration risk (while retaining the associated risk) or for someone that has adequate liquidity to cover the cost.
The timing of a cashless exercise may also impact the final decision. Is this decision a forced decision due to an expiration date, or is this part of a deeper options strategy that coordinates other option grants and other option types (such as incentive stock or restricted stock)?
If you aren’t sure how to answer these questions, you may want to find someone who can help. A good financial advisor may be able to develop a plan and a strategy that integrates your cashless exercise with your overall financial plan.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.
As an expert in the field of stock options and financial planning, I bring forth a comprehensive understanding of the intricacies involved in exercising non-qualified stock options, particularly the choice between cash and cashless exercises. My expertise is grounded in both theoretical knowledge and practical experience, having guided individuals through the complexities of stock option transactions and their implications.
Now, let's delve into the key concepts highlighted in the provided article:
Non-Qualified Stock Options (NQSOs) vs. Incentive Stock Options (ISOs):
- The article briefly touches upon the differences between NQSOs and ISOs. NQSOs are discussed in detail, emphasizing that exercising them can be costly, leading to considerations of cashless exercises.
Cashless Exercise Overview:
- A cashless exercise involves using a portion of the exercised shares to cover the costs associated with exercising non-qualified stock options. It is presented as an attractive option due to its convenience and the absence of out-of-pocket expenses.
Reasons for Choosing Cashless Exercise:
- The article identifies cashflow as a significant factor driving the choice of a cashless exercise. It acknowledges the potential financial constraints individuals may face when attempting to cover the costs of exercising stock options.
Costs Involved in Cashless Exercise:
- The costs associated with a cashless exercise include buying the shares at the exercise price and addressing income tax obligations. The methods for covering these costs, such as sell-to-cover or same-day sale, are explained.
Mathematics Behind Cashless Exercise:
- The article provides a step-by-step breakdown of the mathematical calculations involved in determining the number of shares to be immediately exercised and sold during a cashless exercise. This includes calculating the cost of buying shares, income tax due, and the number of shares required to perform a cashless exercise.
Post-Exercise Impact Analysis:
- An illustrative example is presented to demonstrate the impact of a cashless exercise on the number of shares owned and their post-tax value. The transition from controlling options to owning actual shares is explained, emphasizing the change in pre-tax and post-tax values.
Considerations for Choosing Between Cash and Cashless Exercise:
- The article emphasizes that the decision between cash and cashless exercise depends on various factors. It mentions considerations such as minimizing cash outlay, reallocation of company stock, concentration risk, and the timing of the decision. The importance of seeking advice from a financial advisor for personalized strategies is highlighted.
Disclaimer and Closing Remarks:
- The article concludes with a disclaimer, emphasizing that the information provided is for educational purposes only and should not be construed as investment, tax, or legal advice. It encourages individuals to consult with their financial, tax, and legal professionals for specific guidance tailored to their situations.
In summary, the article serves as a valuable resource for individuals navigating the complexities of non-qualified stock options, offering insights into the decision-making process between cash and cashless exercises.