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What Does It Mean to Exercise Stock Options?

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Sample Cap Table Simple Sample. Thank you Thank you. We use cookies to improve your experience on our site. Exercising more options is likely better than exercising less options should the stock price continue to appreciate in the future. If you plan to hold your incentive stock option shares after you exercise them, a lower stock price may be a perfect time to exercise.

Assuming that you sell the shares in the future for a higher price, exercising at a lower stock price will not mean a greater percentage of the overall final sale will be subject to preferential long-term capital gains treatment should you meet the qualifying disposition standard , but it does mean that you may not need as much cash to make it work.

So if you want to hold the stock anyway and you want to limit the cost of doing so, exercising when the stock price is lower may be your best bet. If you do, you may be get some or all of your AMT back as a credit. One of the great features of incentive stock options is a qualifying disposition. Meeting this standard means that you will pay long-term capital gains treatment on the entire gain from the grant price to the final sales price of your incentive stock options. This benefit could save you hundreds of thousands in taxes, depending on how many options you have.

The difficult part is that you must hold your incentive stock option shares at least one year past the date you exercise them to obtain this benefit. This is not the only requirement, so be sure you meet the others, too. Often, in an attempt to avoid paying AMT , you may find yourself holding your options as opposed to exercising them.

While this does avoid paying AMT, it does not allow you to begin your holding period requirements. A falling stock price or a lower price might be a great opportunity to exercise and hold your shares, pay less in AMT, and begin your holding period. An early exercise means an earlier date that you can sell your shares, obtain the advantageous tax treatment, and potentially diversify away into something else.

A single concentrated stock position can be a great thing if your stock price continues to appreciate.

Exercise Stock Options: Everything You Need to Know

In fact, a large position of a significantly increasing stock may create more wealth that what you even need to reach your goals and fund the life you want to live. But there is, of course, absolutely no guarantee this will happen, and hoping it will happen is often too great of a risk to take — because a concentrated stock position can also lead to massive portfolio losses. But that does not mean the right answer is an immediate sale of your stock options.

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What this does mean is that when you diversify, you need to strike a balance between the benefits or goals of generating wealth, minimizing AMT, obtaining a qualifying disposition, and diversifying away assets as soon as possible. The magic is finding the balance that works for you. A falling stock price may be a great opportunity to combine several of the steps above into a plan that allows you to achieve the diversification goal.

We all want the value of our stocks and stock options to go up. The more they go up, the greater wealth we can generate. The problem is, investment growth is never linear. When we look back over time, hopefully, we see a line that slowly trended upward in our favor.

Should My Company Allow Early Exercise of Options?

Instead of locking in on the value of your portfolio being down, a more prudent approach may be to look past the current value and look at the fact that you now have an opportunity on the table that could let you enjoy tax savings and help meet diversification needs. Should you believe that the trend line of the stock will continue to be up, then exercising when the stock price is down may be your best bet — but keep in mind it takes careful planning and consideration to know the right move.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment. First, companies are required to list their option expenses in a footnote to the balance sheet, so savvy investors can easily figure option costs into expenses.

Stock Options 101: The Essentials

Even more important, activist shareholders have been among the most vocal in pushing companies to replace cash pay with options. In my view, the worst thing about the current accounting rules is not that they allow companies to avoid listing options as an expense. That discourages companies from experimenting with new kinds of plans. As just one example, the accounting rules penalize discounted, indexed options—options with an exercise price that is initially set beneath the current stock price and that varies according to a general or industry-specific stock-market index.

Although indexed options are attractive because they isolate company performance from broad stock-market trends, they are almost nonexistent, in large part because the accounting rules dissuade companies from even considering them. The idea of using leveraged incentives is not new. Most salespeople, for example, are paid a higher commission rate on the revenues they generate above a certain target.

Such plans are more difficult to administer than plans with a single commission rate, but when it comes to compensation, the advantages of leverage often outweigh the disadvantages of complexity. You also have to impose penalties for weak performance. The critics claim options have unlimited upside but no downside. The implicit assumption is that options have no value when granted and that the recipient thus has nothing to lose.

But that assumption is completely false. Options do have value. Just look at the financial exchanges, where options on stock are bought and sold for large sums of money every second. Yes, the value of option grants is illiquid and, yes, the eventual payoff is contingent on the future performance of the company.

But they have value nonetheless. And if something has value that can be lost, it has, by definition, downside risk. In fact, options have even greater downside risk than stock. Consider two executives in the same company. One is granted a million dollars worth of stock, and the other is granted a million dollars worth of at-the-money options—options whose exercise price matches the stock price at the time of the grant.

The executive with options, however, has essentially been wiped out. His options are now so far under water that they are nearly worthless. Far from eliminating penalties, options actually amplify them. The downside risk has become increasingly evident to executives as their pay packages have come to be dominated by options.

Take a look at the employment contract Joseph Galli negotiated with Amazon. The risk inherent in options can be undermined, however, through the practice of repricing. When a stock price falls sharply, the issuing company can be tempted to reduce the exercise price of previously granted options in order to increase their value for the executives who hold them.

Although fairly common in small companies—especially those in Silicon Valley—option repricing is relatively rare for senior managers of large companies, despite some well-publicized exceptions. Again, however, the criticism does not stand up to close examination. For a method of compensation to motivate managers to focus on the long term, it needs to be tied to a performance measure that looks forward rather than backward. The traditional measure—accounting profits—fails that test.

It measures the past, not the future.