Non-qualified stock options can easily burn a hole in your pocket. The temptation to exercise can be strong, especially as excitement grows within the company! But exercising should not be done without careful planning. Acting too quickly can limit the financial benefits you reap.
If you’re thinking about exercising your non-qualified stock options or if you could be forced to exercise soon, here are a few things to consider before you make the move.
How will you exercise your options?
Typically you have two options for exercising:
- Write a check to your employer to cover the exercise price of your options and the withholding taxes.
- Participate in your company’s cashless exercise. (Most companies offer a cashless exercise in which the company sells enough shares to cover your exercise price and all withholding taxes.)
Are you prepared to pay for your bonus?
When you exercise non-qualified stock options, the shares you receive are treated as compensation. This means you must pay federal and state withholding on value of the resulting shares, as well as Social Security and Medicare. Because you’re receiving stock and not cash, you’ll have to come up with the price of the options plus taxes, Social Security, and Medicare.
Until you exercise, you have a risk-free investment.
This should be one of your first considerations. If you choose to exercise, you’re going to be pulling money out of your pocket or using shares to complete the transaction or using shares to do a cashless exercise.
This means you’re either putting money at risk by paying the exercise price and taxes or, if you use the cashless exercise, instantly reducing your future appreciation. So before you go any further, be sure exercising makes financial sense.
How material are the dollars to your overall wealth?
If you’re paying for the shares and taxes (i.e., writing a check to your employer), how material are these dollars to your overall wealth? For example, if your option exercise price is a penny a share, and the fair market value is 5 cents a share, exercising may be cost effective and worth it to get capital gains moving forward.
Can you sell the resulting shares on an open market?
Before you exercise, it’s important to know if there are restrictions on the resulting shares. Are they closely held? Subject to blackouts? If restrictions exist, your risk is increased. You may be stuck with the stock for longer than you’d like, or you may not be able to sell on your timetable.
When can you exercise and sell the shares on the same day?
If you’re going to use your company’s cashless exercise, it’s a good idea to wait until you can exercise and sell all the shares on the same day. This way you’ll get appreciation on all of the shares. If you exercise early, you’ll lose the appreciation on the shares you used to pay the taxes and exercise price.
The right day to exercise is when you and your financial advisors give the green light and you meet your company’s vesting and/or employment requirements.
What do your tax and financial advisors say?
Exercising non-qualified stock options tends to be a popular topic at the workplace water cooler; everyone seems to have an opinion. It’s important to avoid getting caught up in what everyone else is doing. To make the most of your non-qualified stock options, be sure to talk to your tax and financial advisors first.