Thinking About Stock Option Exercise
Opportunity in Options
While there is often great upside potential, employee stock options also offer numerous ways for executives to blow it. For example, you could paint yourself into a tax or price corner with expiring options. You could let your options expire. Maybe you don't fully understand the tax implications of Incentive Stock Options vs. Non-qualified Stock Options and miss out on favorable long-term capital gains treatment. You could overestimate your knowledge of the stock's performance and not exercise at the optimal time. The list of mistakes made with employee stock options can go on and on.
Mistakes to Avoid
What leads up to these mistakes being made? After a couple decades of helping clients analyze and maximize their employee stock options--through raging bull markets and crushing bear markets--I've noticed two common and noteworthy behaviors exhibited by a lot of people with stock options:
When discussing the options, the conversation is analytical and dominated by stock price and taxes.
When it's time to make the actual decision about when to exercise their options, clients are emotional and driven by fear and greed.
It's important to be aware of these behaviors and, in most cases, attempt to avoid them.
Remember the Big Picture
So, how should you approach your employee stock options? If you ask a tax advisor, you will likely be given an exercise analysis based, not surprisingly, on the tax implications. If you ask an investment advisor, you may be given an analysis focused on the valuation of the company stock and whether the overall market is in a peak or valley. Both of these criteria are important to exercising employee stock options; however, they're both missing the big picture: How will the money be used? Are your future financial goals (e.g., retirement, college savings, cabin on the lake, etc.) funded? How can these options have the largest positive impact on your financial goals?
Everyone's situation is different and includes unique factors and decisions points, but I've zeroed in on these key criteria to help executives optimize stock option outcomes and minimize regrets and second guessing:
Key Criteria for Exercising Your Employee Stock Options
1. Need for Funds
Working with my clients to determine the present value of financial goals provides a key decision point when evaluating stock options. We confirm all of their future financial goals identified, and then we assess if those goals are funded. If those goals are not funded--and those goals are high priority--this may indicate the need to accelerate diversification from a high potential, as well as concentrated and highly leveraged, stock option position with an uncertain outcome to a higher probability and diversified portfolio designed to fund those goals.
If your future financial goals appear to be funded with well-diversified and high-probability holdings, this situation provides you with a “risk budget,” or the ability to choose to be either conservative and accelerate your diversification, or be very aggressive and keep your options longer in an attempt to maximize wealth.
When goals, their cost, and the present value of their cost are clear, you have a solid baseline for stock option decision making--often a much more powerful baseline than measuring tax impact or waiting for a magical stock price!
2. Price Driven
Where is your company stock price in relation to a target price range? Do you have a target employee price range for your stock? If not, the answer will always be "Oh, I think it'll pop. I want at least $10/share more." Historically, markets and most company stock prices move upward and onward over time, so waiting for higher prices is often rewarded. However, with employee stock options, there are two other key factors at play: the clock running on the option's life and the inherent leverage in the options. If there is a bad market period or a negative company event and there isn't enough time left for the stock to recover, it is very easy--and painful--to watch your stock option wealth quickly vanish!
While you are still in an accumulation phase, working to build financial security, and funding for future goals and liabilities, it makes sense to have exercise price targets for your options and to systematically prune off gains on the way up, while also considering protective points on the downside.
3. Timing
Vesting periods, blackout periods, earnings releases, your retirement timeline, college tuition bills, possible job changes, the inevitable bear market that comes prowling around about once every three years. Options traders talk of the ominous "time decay," which can erode the value options, and academics named the calculation of this effect, "Theta."
Whatever it may be and whatever you choose to call it, there are many stock option planning considerations related to time that might outweigh the stock price or tax impact.
In addition to attempting to match proceeds with different cash needs or strategies, such as pairing option exercise with future year Non-Qualified Deferred Compensation elections, one basic step is to identify a "red zone" for each option, or a date at which you WILL exercise the option, as long is it is above a basic threshold price. Without an established red zone, you run the risk of having a significant stock price decline as the final grains of sand are falling through the hourglass on your options!
4. Diversification
Concentration in a winning stock can build wealth, but diversification is critical to helping maintain wealth.
When it comes to employee stock options, you'll often hear, "Don't have more than X% of your wealth tied to your company stock." I really have an aversion to financial rules of thumb because in real life, there are too many variables in each person's unique situation. Also, in my 20+ years of experience, it is often the case that as wealth rises, the times when those rules of thumb actually apply are rare--the "rules" become the exception!
If your financial goals are fully funded in diversified and high-probability portfolios apart from your company stock (back to point number 1), does it matter if 75% of your wealth is tied to your company stock? Maybe, but then again, maybe not. When your goals are fully funded apart from your company stock, the decision to exercise all or a portion of your company stock is more of a comfort-level decision. That's not to minimize that aspect of the decision-making process. Comfort with your level of concentration and exposure to risk and volatility is very important--it's not something to dismiss.
5. Taxes
Being smart with the tax planning around your option exercise is very important, but probably not as important as some of the criteria mentioned above. With the leveraged aspect of employee stock options, the value of your employee stock options can quickly be wiped out with a falling stock price. Understanding how to achieve long-term capital gains treatment instead of ordinary income, considering how the additional option income may trigger AMT, and thinking about the year over year timing of taxable income from option exercise, bonuses, potential deferred compensation payouts are all issues that can add up to real money; however, there is also a high likelihood that a relatively small downward movement in the company stock price could erase more value than what waiting for the "perfect" tax situation could save! This is why I say it's often a mistake to let tax planning (or the fear of taxes) drive the stock option planning discussion and decision-making process.
Issues to Consider Regarding Incentive Stock Options
The charts below include additional information to consider when thinking about your incentive stock options (click each image below to enlarge).
Issues to Consider Regarding Non-Qualified Stock Options
The charts below include additional information to consider when thinking about your non-qualified stock options (click each image below to enlarge).
Don't Lose Out on Your Employee Stock Options
Sure, it's fun to think about holding on and pulling the trigger on your options at the perfect price point, or that you sharpened the pencil and smartly walked away with a bigger piece of the gain after-tax than you might otherwise, but I've found that the best stock option decision making includes thinking about funding your financial goals, timing, and whether it matters how much exposure you have to your company.
Documenting your future financial goals and having a plan and path to achieve those goals is important for their success. An experienced and knowledgeable financial advisor can help you through some of the more complex and confusing choices related to employee stock options.
If you have questions about your employee stock options, give me a call. I'm always happy to help navigate these unique issues and build a plan that helps you achieve your financial goals.