Exercise Stock Options: A Step-by-Step Guide
So you've been working at your company for a few years now and some of those stock options you were granted as part of your compensation package are ready to vest. Exciting, right?
Your hard work is paying off, literally. But now you have to decide whether to exercise your stock options or not. If you don't exercise them, you'll lose them. But if you do exercise them, you have to come up with the money to buy the shares. Not so easy.
What Are Stock Options?
Stock options give you the right to buy shares of your company's stock at a fixed price within a certain period of time.
How Do Stock Options Work?
When your company grants you stock options, they give you the option to purchase company stock at a discounted price. The price you can buy the stock at is called the "strike price" or "exercise price." You have a set amount of time, typically 10 years or less, to exercise those options before they expire.
If the share price rises above the strike price, your options become valuable. You can buy shares at the strike price and then sell them at the higher market price. The difference is your profit.
For example, say your company granted you options with a strike price of $10 per share. If the share price rises to $15, you can exercise your options, buy at $10 and sell at $15, netting $5 per share in profit.
Not all options may be vested when granted. Vesting means the options become available for you to exercise over time, based on a schedule. A common schedule is vesting over 4 years - 25% vest each year. You must stay with the company for the options to continue vesting. Unvested options are forfeited if you leave the company.
Exercising options is often a smart move, but there are tax implications to consider. When you exercise options, the difference between the strike price and the market price is considered income, and you may owe income tax on those gains. You should talk to a tax professional to determine the best strategy based on your financial situation.
With the potential to profit and build wealth, stock options can be an attractive benefit. But it's important to understand how they work and make the most of this opportunity. If used strategically, stock options could significantly boost your net worth over the long run.
Deciding if and When to Exercise Your Stock Options
Deciding if and when to exercise your stock options is a big decision that could significantly impact your finances. Here are some things to consider:
Tax implications
Exercising your options means buying company stock, which could push you into a higher tax bracket if the stock value has increased a lot since they were granted. However, waiting too long to exercise could mean missing out if the stock price starts to drop. Consider your current tax bracket and financial situation to determine the best time to exercise from a tax perspective.
Company performance and stock value
If the company is doing well and the stock price has been going up over time, it may make sense to exercise sooner rather than later to maximize your gains. However, if the company has been struggling or the stock price volatile, you may want to wait until performance and value improve before exercising. Monitor your company's financial reports and stock performance regularly to help determine the optimal time.
Your own financial needs
Your own financial situation should also play a role in your decision. If you need access to funds for a down payment on a house or to pay off high-interest debt, for example, exercising may make sense even if the other factors aren't perfectly aligned. On the other hand, if you don't have an immediate need for the money, you may be able to wait for a more opportune time.
Considering all these factors together can help ensure you make the choice that maximizes the value of your stock options and fits your own financial needs. While it may require some patience, choosing the right time to exercise is well worth the effort.
Understanding the Tax Implications of Exercising Options
Exercising your stock options is a big decision that comes with important tax consequences to consider. As with any financial decision, you'll want to understand how it may impact your tax liability before moving forward.
Taxable Income
When you exercise non-qualified stock options, the difference between the grant price and the market price of the shares at exercise (called the spread) is considered taxable income. This income is reported on your W-2 and is subject to income tax withholding. The withholding rate can be up to 40% depending on your income level and company policy.
You'll owe taxes on this income for the year you exercise the options, even if you hold onto the shares. The withheld amount may not cover your total tax bill, so you'll want to plan for any additional amount due. You may be able to avoid a big tax surprise by exercising early in the year or over multiple years.
Some companies do allow early exercise of options, where you exercise before the options are fully vested. This starts the capital gains holding period clock ticking and can provide tax benefits if the stock price appreciates over time. However, if you leave the company before vesting is complete, you would forfeit any unvested shares.
Alternative Minimum Tax
Exercising incentive stock options (ISOs) can trigger the alternative minimum tax (AMT), which ensures that higher-income individuals pay at least a minimum amount of tax. The spread between the grant price and market price at exercise is counted as an adjustment that can push you into the AMT range.
You may owe AMT in the year of exercise and regular income tax in the year you sell the shares. Strategies like exercising early in the calendar year or spreading exercises over multiple years may help minimize AMT impact. It's a good idea to consult a tax professional to determine your potential AMT liability before exercising ISOs.
With some forethought and planning, you can make the most of your stock options and be prepared for the resulting tax implications. Doing your homework upfront will help avoid unwanted surprises come tax time.
Step-by-Step Process for Exercising Your Stock Options
Once your stock options have vested, you have the right to exercise them and purchase the company stock at the grant price. To do so, you'll need to follow a few steps:
Gather the Required Information
To get started, you'll need:
- Your employee stock option agreement which outlines details like the grant price, number of shares, expiration date, etc.
- Funds to purchase the shares at the grant price. This is the price you pay per share to exercise your options.
- Your company's stock plan documents which describe how to exercise your options. Check with HR if you need help locating these.
Submit an Exercise Notice
This is the official notice to your company that you want to exercise your options. It typically includes details like:
- Your name and employee ID
- Option grant IDs you want to exercise
- Number of shares for each grant you want to exercise
- Total exercise price
- Payment method (check, wire, etc.)
Follow the instructions in your stock plan documents to submit the proper notice. This is usually done online through your brokerage website or company portal.
Provide Payment and Any Required Forms
Along with your exercise notice, you must provide payment for the total exercise price in a method allowed by your company like:
- Personal check
- Wire transfer
- Cashless exercise where you sell enough shares to cover the cost
You may also need to submit certain forms like an 83(b) election. Check with your company to see if any additional documentation is required.
Receive Your Stock Shares
Once your company receives proper payment and all required paperwork, the stock shares you exercised will be deposited into your brokerage account, usually within 1 to 2 weeks.
Congratulations, you now own shares of your company's stock!
Be sure to hold onto these for at least a year to get long-term capital gains tax treatment.
Exercising your stock options is a straightforward process, but be sure to follow all steps carefully and meet important deadlines to avoid losing out on this valuable benefit. Let us know if you have any other questions!
FAQs About Exercising Stock Options
You probably have a lot of questions about exercising your stock options. Here are some of the most frequently asked questions to help clarify the process.
Do I have to exercise all my stock options at once?
No, you do not have to exercise all your stock options at the same time. You can exercise some or all of your vested stock options whenever you want up until the expiration date. It may make sense to exercise options in batches over time. This allows you to spread out any tax liability and also gives you more flexibility.
What happens if I leave the company before my stock options vest?
If you leave your company before your stock options fully vest, you typically forfeit any unvested options. However, you still have the right to exercise any vested stock options for a limited time after you leave, known as the post-termination exercise period. The exact terms will depend on your company's stock option plan. It's best to check with your company for the specific details on your option grant.
Do I have to pay taxes when I exercise my stock options?
Yes, when you exercise stock options, it is considered taxable income. You will owe taxes on the difference between the exercise price you pay for the shares and the fair market value of the shares at the time of exercise, known as the spread. The taxes owed will depend on whether your options are non-qualified stock options or incentive stock options. It's a good idea to consult a tax professional to understand your obligations.
What happens if the stock price decreases after I exercise my options?
If the stock price decreases after you exercise your stock options, the value of your shares will go down. However, you are purchasing the shares at the exercise price, so you can still sell them for a profit, even if the price has dropped. Of course, you want the stock price to increase substantially so you can maximize your gain. But there is always a risk that the stock price could decrease after exercising. You need to go in with a long-term perspective.
Can I sell my shares right after exercising my stock options?
Yes, once you exercise your stock options and purchase the shares, you own them and are free to sell them whenever you want. However, if you sell them too quickly after exercising, you may face additional taxes. It's best to check with a tax advisor on the rules around selling shares obtained from exercising stock options.
Conclusion
So there you have it, a step-by-step guide to exercising your stock options. While the process can seem complicated, breaking it down into manageable steps makes it much more achievable.
Remember, you've earned these options through your hard work and commitment to the company. Exercising them allows you to reap the rewards and build wealth for your future. Even if you decide not to exercise all your options right now, at least get the ball rolling - start planning, meet with your financial advisor, and determine your strategy. Your future self will thank you for the effort and for taking advantage of this opportunity. Now go out there, believe in yourself, and get to work making these stock options really pay off. You've got this!
If you want to learn more about options and other types of startup equity, contact WOWS Global at contact@wowsglobal.com. We have a comprehensive library of content that walks through everything related to cap table and equity management—from stock options and RSUs to 409a valuations and dilution modeling. Schedule a call today and see how we can help.