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The world of equity compensation has grown over the past few decades. With employers looking for new ways to attract, retain, and incentivize employees, several equity alternatives have emerged as popular choices. However, good old-fashioned Non-Qualified Stock Options (NQSOs) are still alive and well with many employers offering these awards to mid and senior level management.
For those who receive NQSOs, most often the main stress point they face is deciding when to exercise their options. For some, it could quite literally be the million-dollar question. Your employer is often tasked with educating you regarding your option grants, which might be the equivalent of “Options 101” and cover topics such as grant dates, vesting schedules, and other basic information. However, there is something equity plan administrators are not allowed to offer, and that is tax or financial advice. The employee is left to seek advice elsewhere, often relying on feedback from co-workers who might not have a firm grasp of the tax or financial impact of exercising options.
Option Agreement
When new options are awarded, you will receive an option agreement specific to that award. My advice: read it thoroughly. This document will not only answer many of the questions you have regarding the award, but it will provide the essential information you need to properly manage your award and develop a strategy. Topics covered include:
The type of options you received
The number of shares granted and the exercise price (purchase price)
The vesting schedule
The expiration date of your options
Whether early exercise is available (83(b) elections)
What happens if you separate service
What happens if you retire
What happens if you die
What happens if you become disabled
What happens if the company is sold
The transferability of your options
If you can exercise a portion of an option or if the entire option must be exercised
And more
If after reading the document you still have questions, the equity plan administrator will help to answer general questions, but don’t ask for specific advice because they won’t provide it.
When to Exercise Your Options
Once your option vests, you have until the option expiration date to decide when to exercise. For those with substantial value attached to their NQSOs, this decision might not come lightly.
Watching values fluctuate daily and time ticking ever closer to expiration can lead to indecision and paralysis. If this is you, I’ll save you the suspense. The odds of exercising all your shares at just the right moment (an all-time high or other noteworthy moment) are small. Like trying to time the stock market, trying to time the perfect exit price for a single stock is equally difficult, if not more so.
But, the good news is that if you devise a plan ahead of time, and stick to it, you likely won’t need to sell at an all-time high to amass wealth and achieve your financial goals. I have seen clients amass great wealth with their equity compensation and they did it despite the unpredictability of stock price fluctuations and not knowing where the “top” was.
Strategies for Exercise
Volumes can be written on exercise strategies for NQSOs. However, your approach should be based on your unique financial situation, the terms of your option award, your outlook for continued employment with the company, if you receive new grants regularly, your wealth, your financial goals, and so on. Following are some of the more common strategies used to exercise options, some holding more merit than others.
Time-based – With this method, the decision to exercise is solely based on time. On one end of the spectrum, some choose to exercise their options as soon as they vest. By locking in the profit (assuming the current price is above the purchase price) you are no longer subject to fluctuations in value, but on the other hand, you can no longer take part in the potential appreciation of the stock for the remainder of the option’s term, which could span many years ahead. On the other end of the spectrum, some wait until expiration, or near expiration, to exercise their options. Option holders who utilize this strategy certainly can’t be labeled as hasty, but again, it may not be the best strategy. Although the hope is that your employer’s stock will appreciate over time, there is no guarantee that the stock price at expiration will present better opportunities than at other points over the term of the option. Basing your exercise strategy on time alone is generally not recommended.
Timing – Just as some try to time the stock market, some try to time the exercise of options based on expectations of movements in stock price. Often employees have a good pulse of the company. However, their knowledge of the company can lead them astray, giving them a false sense that they can somehow predict the future movements of their company’s stock (unless of course you’re an insider, but trading based on non-public material information is a big no-no and tightly regulated). Stocks can move up and down for any number of reasons, and often in the opposite direction than one might expect. Your attempt to time your company’s stock might prove tragic and is fraught with challenges (namely, making emotion-fueled decisions based on vacillating stock prices).
Price Targets – Setting price targets ahead of time can be an excellent way to exercise options. By setting a price target, or series of price targets, option holders can establish price levels where their options will exercise, and sell, when a predetermined price is hit. Using this approach reduces the likelihood of making emotional investment decisions, can make it easier to stick to a plan, and can minimize the possibility of missed opportunities. Price targets can be based on any number of variables, such as:
Significant past highs
All-time highs
Price targets based on historical volatility
Price targets based on the option’s value
Price targets based on the stock's fair value
If you don’t have a plan for your options, consider using price targets at various price levels to provide a systematic way to exercise your options.
Diversification – For some option holders who possess substantial holdings and equity comp, the decision to sell often has less to do with current price levels and more to do with risk management and maintaining diversification with their wealth. As company stock holdings grow and make up a larger share of an individual’s overall wealth, a time may come when the benefit of diversifying your holdings might outweigh the benefit of continuing to hold your options. There is no magic number of how much is too much, as everyone’s financial situation and risk tolerance are different, but as your equity compensation grows, reducing risk by effectively managing concentrated positions should be part of your overall investment strategy.
You Need the Money – Your options are there to provide a financial benefit. When opportunity presents itself, some take a recent push higher in price as an opportunity to cash in and enjoy the fruits of their labor, pay bills, or reach a financial milestone. I have worked with clients who have exercised options to pay off the remaining balance on a home mortgage, fund college for their children, or use the proceeds to remodel their home. As long as the pros and cons are weighed, using your options to fund goals can make financial sense given the circumstances.
Option Analysis – There are other, more complex, methods that can aid in determining when to exercise options. Some of these methods involve calculations to determine an option's Value at Risk (VaR), intrinsic value versus time value, and leverage analysis. These methods require a more in-depth discussion and will be discussed in greater detail in a future post.
Conclusion
Non-qualified stock options can represent a significant wealth-building opportunity, but they also come with strategic considerations. To optimize the benefit of your options, it's important to understand the terms of your stock options, assess your individual financial and tax situation, and identify your financial goals before deciding on an exercise strategy. Furthermore, changes in personal circumstances or tax laws could influence the optimal strategy for exercising NQSOs, so periodic reviews and adjustments of your strategy may be necessary.
If you have questions regarding your exercise strategy, tax implications, or other nuances of holding options, consult with a tax professional or financial advisor who can help you make informed decisions. If properly managed, your NQSOs can fast-track the fulfillment of your financial goals.
Tad Jakes, CFP®, EA, ECA
