When it comes to company incentives, one of the most prevalent in the tech industry are stock options. However, because many tech professionals rely on financial advisers for all things stock related, most of them don’t understand what to do with their options when they receive them.
Today I want to provide you with some valuable insight into stock options – mainly, how and why you should be exercising them. All too often, recipients will lose out on a substantial payday because they didn’t know what they should do with their company stock, and I don’t want you to fall into the same trap.
With that in mind, let’s dive into the world of stock options – what they are, how to exercise them, and how to use them in your long-term financial strategy.
What Are Stock Options?
If you work for a publicly traded company, you may be offered stock options as part of your benefits package. A stock option is a benefit offered by employers to their employees to buy stock at a reduced or discounted rate. There is no obligation to buy the stock, but the employee does have the right to do so.
Typically speaking, stock options have specific terms that have to be met before you can take advantage of them. Usually, this is in the form of a waiting period (i.e., three to five years) before you can buy the stocks at the fixed price. The reason for this is so that the company can incentivize employees to stick around for a while before heading off to another firm.
Stock options will also come in two different varieties – non-qualified and incentive. Let’s look at the primary differences between the two.
Non-Qualified Stock Options
One thing that many people forget is that selling stock is the same as earning income. This means that you have to pay taxes on the money you make. With non-qualified stock options, you will have to pay more taxes (i.e., payroll tax) because they are not qualified for preferential treatment (hence the name).
With NQSOs, you will typically want to sell them quickly (as long as you can pay the taxes) because there is not really much incentive to hold onto them. That being said, if you have no investment in your company already, you may decide to keep some stock for the long term so that you can let it appreciate in value.
Incentive Stock Options
Unlike NQSOs, these options have better tax rates. However, to get these rates, you have to keep the stock for a predetermined period. For example, you have to wait to sell them until a year after exercising them (more on that in a minute), and at least two years since you received the option.
Overall, you’ll pay less in taxes by waiting, so it’s usually a good idea to do so. Even if you sell them immediately, you won’t have to pay payroll taxes, so no matter what, you’re going to save money.
What Does Exercising Stock Options Mean?
As I mentioned, you will have to wait a set amount of time before you can turn your options into actual stock. Once you’ve reached the date, then you have the opportunity of “exercising” them. This simply means that you’re buying stock based on the parameters set forth by the option.
The term used to describe this process is called “vesting.” Your options will be unvested until the agreed-upon date. Once they vest, you can exercise them.
So, let’s say that you get 500 shares as a hiring bonus. The company you work for says that you have to wait two years before you can exercise them. In most cases, the business will release partial amounts of your shares at different intervals so that you can take advantage sooner rather than later. For example, you may be able to exercise 200 shares after one year, and the rest after two years.
Typically speaking, there is an exercising period, which means that you have to take advantage of your options before they expire. If you wait too long, then you won’t be able to use them or get any money from them.
In some cases, your employer may automatically exercise your stock options when they vest, so you want to check and make sure if that’s the case. In some instances, you won’t want to exercise your options right away.
When NOT to Exercise Your Stock Options
Overall, the point of having stock in your company is to make money. Otherwise, what are you doing with them? Thus, if you don’t stand to make a profit by exercising your options, then you don’t want to go through with it. One of the most common situations when this happens is when the stocks are “underwater.”
Part of having stock options is that you get to buy them at a preset price. Ideally, this amount will be less than what the stock is worth when they vest. For example, if your options allow you to buy stock at $30 a share and it’s worth $50, you can make a tidy profit by selling them immediately.
On the flip side, if the stock is worth less than what you have to pay (i.e., only $20 per share), there’s no point in exercising them. When this happens, the stock is “underwater.”
While the value of the stock can go up in the long term, there may some additional risks if you exercise them at a bad time. One of those risks is if you have a non-qualified option and you have to pay taxes on them when they get exercised. If that’s the case, you could lose a lot of money in the process.
To help you understand more about your options and if or when to exercise them, I want to go over some of the most common questions to ask before going through with exercising your stocks.
When Do They Expire?
If you have a few years to cash in and make money from the stock, then you aren’t in a rush to make a decision. During this time, the stock price may go up, which means that you can get a bigger payday when you finally do exercise. Alternatively, though, the stock could go down, so there’s a bit of a risk.
If, however, you only have a few months to decide before your options expire, you want to figure things out as quickly as possible. Ideally, you will be thinking about what to do with your stock options as soon as they’re offered (but before they vest) so that you can pull the trigger quickly if necessary.
Should I Sell Them or Keep Them?
While you may be able to make a short-term gain by selling the stock immediately (i.e., if you can buy them at a lower price than what they’re worth), but you may decide that a long-term strategy is the best move.
For example, if the prospects for your company are looking great, you may realize that holding onto company stock for years can be a good investment. As the business flourishes, your value goes up, and you can make even more money overall.
Do I Have Too Much Invested in My Company?
As a general rule, I would suggest that you don’t invest more than 10% of your total assets in your company. If you’re not familiar with investing, the reason for this is because you don’t want to have too much of your money tied to the success (or failure) of one business. Essentially, you want to avoid putting all of your eggs in one basket, just in case the company goes under.
Thus, if you already have about 10% invested, then there’s no reason to keep the stock once you exercise your options. However, if the stock price is not worth the effort, you may decide to skip the whole process until it gets higher.
Another thing to consider is the prospect for your company as a whole. Are things looking up? Is your employer growing in the industry or are they relatively stagnant? If things are going well, you may decide that having additional stock can be a good idea. If prospects look bleak, then you may want to sell all of your stock before the price drops in the future.
Do I Need the Money?
Another primary question to ask yourself is whether you need the immediate financial benefit of selling your stocks. If you’re doing renovations on your house, for example, then it can be a good idea to exercise and sell as quickly as possible. If you’re financially stable right now, then there isn’t as much of a pressing need to earn money with your stock options. In that case, you may decide to hold onto them until you need the cash.
What About Taxes?
One of the most significant mistakes that I see people make when exercising stock options is that they don’t plan for paying taxes. If you have non-qualified stock options, this can be a huge problem because you may eliminate much of your profit because you’re spending so much on taxes.
Before you sell, you want to make sure that you’re ready to pay all of the necessary fees. It’s also imperative that you pay attention to how much will be left, as that can affect your decision as well.
One option to make it easier on yourself is to utilize a cashless option or hold. In this case, you use the money earned by the stocks to pay for taxes and other fees so that you don’t have to pay out of pocket. In many cases, this is an ideal strategy because it allows you to keep your profit without having to worry about having enough money on hand when you exercise them.
There are quite a few different ways that you can save money on taxes when you exercise and sell your stocks. For example, holding onto them for at least a year can qualify you for capital gains tax, which is likely going to be lower than your income tax rate.
If you’re not sure how to save on taxes and fees, you’ll want to discuss options with your financial adviser. It’s much better to trust an expert on the subject than try to do it on your own. Also, blindly paying taxes without consulting an adviser can cost you a significant portion of your earnings.
What if I Leave the Company?
For many tech professionals, upgrading to a better position with another company is part of the industry. However, leaving your current job means that you’ll forfeit any stock options you have that are unvested.
Thus, you may want to consider the benefit of waiting until they do vest so that you can make some extra cash before you leave. If it’s only going to be a few months before you can exercise your options, it may be a good idea to wait. That being said, if you do get a golden opportunity, that can outweigh the profit gained by selling stock.
For the most part, stock options are an excellent way to make additional income from your company. However, it’s imperative that you understand as much about them, including any qualifiers or rules regarding how and when you can exercise them.
I would highly recommend that you go through your company’s employee stock purchase plan (ESPP) to figure out what kinds of discounts you can receive. In many cases, you can earn a higher profit by taking advantage of these lower rates, which can help you create a bigger and more sustainable nest egg for the future.