Stock options are a popular form of compensation for employees, especially those working for start-ups, high-growth companies, and tech companies. When an employee is granted stock options, they are given the right to purchase a specific number of shares at a set price on future dates based on a vesting schedule.
Before considering how to exercise the stock options, the first step is to consider the prospects of the company and your personal financial and career goals. For example, if you are working for a private company, when is the ultimate liquidity event (i.e. IPO or acquisition) expected to occur? Is it your plan to stay with the company for that length of time? For public companies, a valid question to consider is what is the upside/downside potential of the stock price and where is the stock price in the company’s growth cycle when you purchase the stock and where will it be when you sale it? These questions are extremely important to consider before even moving forward with a plan to capitalize on the stock option opportunity, but are outside the scope of this article.
If you’ve answered those questions and are bullish on the company’s future and your place within it, the next step is to figure out how to build and execute a plan for exercising and selling the stock over the vesting period. Knowing the different methods to finance the exercise (i.e. the purchase) of your stock options is a critical component to building a holistic plan for the purchase and sale of your stock options.
The goal below is to identify the differences in financing stock option (primarily incentive stock options) exercises with a focus on the tax effects for each, and not which method is the right method for you given your personal finances. You should work with your financial advisor and tax advisor in determining the best overall strategy for you.
Cash Exercise
The most straightforward way to exercise stock options is to pay for them with cash. This means you pay the strike price multiplied by the number of shares you’re purchasing. For example, if your strike price is $10 per share and you’re exercising 1,000 options, you’ll need to come up with $10,000 to purchase the shares. If you have enough cash on hand, this can be the easiest and most cost-effective way to exercise your options. If they are incentive stock options, doing so may trigger AMT (alternative minimum tax) for the year exercised if those same shares are not sold by year end. Engaging in robust tax planning can be valuable in determining if you’re subject to AMT and strategic ways to get out of it.
“Sell-to-cover” Exercise
If you don’t have enough cash on hand to exercise your options, you may be able to do a sell-to-cover exercise. This is only available for public company stock and not for private companies since typically there isn’t an active market for private company stock. This involves selling enough shares to cover the cost of the options, plus any taxes owed. In other words, enough of the stock is sold at the current market value to pay for the exercise costs with you receiving the net amount of the shares. For example, if you have 500 incentive stock options with a strike price/exercise price of $10/share and the current market value is $50/share, there would be 100 shares sold to cover the exercise cost (100 * $50/share = $5,000) and you would receive the remaining 400 shares. This can be a good option if you don’t want to finance the exercise out of pocket, but you’ll need to consider the tax implications of shares sold. The portion of shares sold to cover the exercise costs is considered a “disqualifying disposition” and that value will be added to your pay stub and W-2 for that year. The issue is that there aren’t any income tax withholdings paid against that income so you would need to determine how much tax to pay on the disqualifying disposition.
Cashless Exercise
Cashless exercises are similar to a sell-to-cover in that you sell shares to cover the cost of exercising the options. However, with sell-to-cover, you only sell enough shares to cover the cost of the options, not any taxes owed. Cashless exercises generally also sell enough shares to cover any taxes owed as well. As a result, they are more common for non-qualified stock options, though the terms are sometimes used interchangeably. As opposed to incentive stock options, there are no direct AMT issues for non-qualified stock options.
Stock Swaps
If you already own your company’s stock through previous incentive stock option exercises, then you can use that old stock to purchase newly vested stock options. It works similar to the sell-to-cover exercises in that you use your current company stock (at its current market value) in exchange to pay for your newly vested stock options (at the exercise price). Generally, this should only be done using long-term stock that has been held at least 1 year from exercise and 2 years from the grant date. This method is very complex and requires basis tracking of the various shares in play and the tax ramifications can vary greatly depending on which shares are being used. Consult with your tax advisor on the viability of this strategy.
Loans
Another option for financing stock option exercises is to take out a loan or line of credit. This could be a personal loan or a loan specifically designed for stock option exercises. With a loan, you’ll have to pay interest on the amount borrowed, so this can be a more expensive option than paying cash or doing a cashless exercise. However, it can be a good option if you believe the stock price will rise and you want to exercise your options before the price goes up. The interest paid should be deductible as investment interest if you use itemized deductions on your tax returns. Also, if the note or loan is considered a nonrecourse note (i.e. you are not personally liable for the note) then it is not considered a valid exercise for US tax purposes. Compare this with a loan with a third party bank where the stock is pledged as the collateral against the loan. This is generally considered a valid exercise of stock for US tax purposes.
Financing stock option exercises can be a complex process with various methods to choose from. Each method has its pros and cons, so it’s important to consider your financial situation and goals before making a decision. If you’re unsure which option is right for you, it’s always a good idea to speak with a financial advisor and tax professional to develop a plan tailored to your situation.