Another way to exercise is through the exercise-and-sell-to-cover transaction.

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With this strategy, you sell just enough shares to cover your purchase of the shares, and hold the rest. You can find this in your contract.

When and how you should exercise your stock options will depend on a number of factors. You would be better off buying on the market. But if the price is on the rise, you may want to wait on exercising your options.

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Once you exercise them, your money is sunk in those shares. So why not wait until the market price is where you would sell? That said, if all indicators point to a climbing stock price and you can afford to hold your shares for at least a year, you may want to exercise your options now. Also, if your time period to exercise is about to expire, you may want to exercise your options to lock in your discounted price. You will usually need to pay taxes when you exercise or sell stock options.

What you pay will depend on what kind of options you have and how long you wait between exercising and selling. With NQSOs, the federal government taxes them as regular income. The company granting you the stock will report your income on your W The amount of income reported will depend on the bargain element also called the compensation element. When you decide to sell your shares, you will have to pay taxes based on how long you held them.

If you exercise options and then sell the shares within one year of the exercise date, you will report the transaction as a short-term capital gain. This type of capital gain is subject to the regular federal income tax rates. If you sell your shares after one year of exercise, the sale falls under the category of long-term capital gains. The taxes on long-term capital gains are lower than the regular rates, which means you could save money on taxes by holding your shares for at least one year.

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Allocation of the stock option pool to employees and team members

Maximizing college savings. Stock price, however, is a forward-looking measure. Forecasts can never be completely accurate, of course. But because investors have their own money on the line, they face enormous pressure to read the future correctly. That makes the stock market the best predictor of performance we have. But what about the executive who has a great long-term strategy that is not yet fully appreciated by the market?

Or, even worse, what about the executive who can fool the market by pumping up earnings in the short run while hiding fundamental problems? Investors may be the best forecasters we have, but they are not omniscient. Option grants provide an effective means for addressing these risks: slow vesting. That delay serves to reward managers who take actions with longer-term payoffs while exacting a harsh penalty on those who fail to address basic business problems. Stock options are, in short, the ultimate forward-looking incentive plan—they measure future cash flows, and, through the use of vesting, they measure them in the future as well as in the present.

If a company wants to encourage a more farsighted perspective, it should not abandon option grants—it should simply extend their vesting periods. Their directors and executives assume that the important thing is just to have a plan in place; the details are trivial. As a result, they let their HR departments or compensation consultants decide on the form of the plan, and they rarely examine the available alternatives.

Employee stock option

While option plans can take many forms, I find it useful to divide them into three types. The first two—what I call fixed value plans and fixed number plans—extend over several years. The third—megagrants—consists of onetime lump sum distributions.

The three types of plans provide very different incentives and entail very different risks. With fixed value plans, executives receive options of a predetermined value every year over the life of the plan. Fixed value plans are popular today. Fixed value plans are therefore ideal for the many companies that set executive pay according to studies performed by compensation consultants that document how much comparable executives are paid and in what form.

But fixed value plans have a big drawback. Because they set the value of future grants in advance, they weaken the link between pay and performance. Executives end up receiving fewer options in years of strong performance and high stock values and more options in years of weak performance and low stock values. The stock price has doubled; the number of options John receives has been cut in half.

He ends up, in other words, being given a much larger piece of the company that he appears to be leading toward ruin. For that reason, fixed value plans provide the weakest incentives of the three types of programs.