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Note to production: Abrams mug last ran with Entrepreneur’s Notebook column on 2/23/98
Marc I. Abrams
The term is whispered with awe and longing around company water coolers, coffee pots and cafeteria tables.
Once a benefit only made available to the highest-level executives, stock options are now among the fastest-growing employee perks. Since 1992, the number of companies that offer stock options has almost quadrupled.
Knowing the term “stock option,” however, does not mean you’re familiar with the concept. Stock options can pay off handsomely, even miraculously in some cases, but they also carry a heavy risk.
If your employer notifies you that you’re being offered stock options, the company is essentially giving you the right to buy (a “call” option) or sell (a “put” option) stock in your company at a fixed price. This is generally based on the closing price of the stock the day the option is granted and is often called the exercise price.
You can exercise your stock options after a waiting, or vesting, period. The value of the stock is the difference between the exercise price and the current market price. Once your options are vested, if you anticipate a beneficial change in the market price of the stock, you can exercise your right to buy or sell that stock at its exercise price.
Stock options come with expiration dates, usually around 10 years, which provide a time frame to measure the stock’s worth and make a decision.
There are two common varieties of stock options: incentive stock options (ISOs) and non-qualified stock options (NQSOs). The main difference between these two is the way they are taxed.
When you exercise your ISOs, you enjoy two advantages. First, the excess of market value over the exercise price (often called “the spread”) is untaxed at that time. Second, if you’re selling ISO shares, your profit (the excess of the sale price over the exercise price) can qualify for the low 20 percent long-term capital gains rate.
To qualify, you must sell the stock more than 12 months after you buy it, and two years after the option’s grant date (when you received the stock option rights). If you can manage this, your entire profit is taxed at the lowest possible rate and that tax bill will be delayed until you have the cash profits to pay the government.
However, if you fail to meet either of the two waiting periods, you’ll be taxed at the higher rate of 28 percent.
Typically, you can exercise NQSOs a year from your grant date or hold on to them for as long as 10 years, hoping that the stock price will continue rising. In the year you exercise your option, the difference between the exercise price and the current fair-market value of the stock is considered ordinary income.
If you decide to continue holding the stock after exercising your option, and then sell it later, any further profit is taxed at the capital gains rate.
Because of this tax hit, it’s usually wise to exercise your NQSOs as soon as possible. Then, if you hold onto the stock, any gain on a future sale will be taxed at the lower capital gains rate. However, this strategy won’t always be appropriate for everyone. Contact a financial professional to help analyze your particular situation.
Generally, there are four methods for exercising your stock options: the cashless method, the target-price method, the cash-purchase method, and the stock swap.
The cashless method uses the difference between the exercise price and the current price of the stock to cover all your costs. With this method, you can either exercise and sell (also known as a “full-scale” exercise), or you can exercise and hold (also called a “partial-sale” exercise).
In either case, you are relinquishing all shares of your stock to eventually receive the balance of the sale’s proceeds less purchase price, taxes and commissions. If you exercise and sell, you take that profit in the form of cash; if you exercise and hold, you receive that value in company stock.
The target-price method allows you to specify the price at which the cashless exercise should be carried out. A broker will automatically execute the transaction at this price. This method may require an additional fee.
The stock-swap method only works if you already own shares in the company. Using this choice, you can exercise your options and buy new shares at the current exercise price by providing enough cash to cover that cost. You’ll receive the full number of your optioned shares.
The upside to the stock-swap method is you won’t pay any capital gains tax because, technically, you’re not selling any shares. The downside is you must pay withholding taxes and fees separately.
The cash-purchase method simply means you’ll provide the full cash amount for the stock you wish to buy. Taxes and commissions still apply.
In the short term, exercising your stock options early is usually best. This is especially true if your company’s current stock price is higher than the stock options exercise price, your options are set to expire soon, or you’re retiring or quitting and will have to forfeit your options when you leave.
Furthermore, if you plan on buying a house or funding a college education, and don’t have any other funds to rely on, exercising early will secure you a lower tax penalty once a transaction occurs.
If your primary goal is to attain the highest level of profit, then waiting to exercise may be your best strategy. Invest your money in other things instead.
Then, when the company’s stock has reached an optimal level, the other investment(s) can provide the cash to exercise the option, resulting in a higher overall profit.
Research your company’s value. A growing company is your key to investment success, while a dim economic future for your employer may call for swift action on your part to avoid losing the effectiveness of your stock options.
Define your investment objectives as they relate to your financial situation, and use your options to achieve these objectives.
Marc I. Abrams directs the securities industry practice group at Singer Lewak Greenbaum & Goldstein LLP, Certified Public Accountants and Management Consultants. He can be reached at [email protected].
Entrepreneur’s Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.
