Keeping Your OPTIONS Open
Stock options amplify wealth creation because of the leverage they utilize. They allow the option holder to benefit by the increasing share value on all the shares of stock covered by the option for little or no cost, at least until the option is exercised. For example, say you hold a vested option for 10,000 shares that is already “in the money.” Every $10 increase per share increases your net worth by $100,000, even though you have not yet paid anything for the purchase of the shares. That’s a great deal! However, if the per share value later falls below the strike price, the option may become temporarily or permanently worthless.
The type of stock options we usually see as a part of executive compensation packages are non-qualified, compensatory stock options. They give the executive the right, but not the obligation, to purchase a certain number of shares of their company’s stock at a given price (the strike price) at a future date sometime between when the options vest and the date the options expire. If the per share value of the underlying stock is greater than the strike price, the options are said to be “in the money.” If the per share value of the stock is less than the strike price, the options are considered “out of the money” and are essentially worthless.
The Initial Strategy Then Is:
• Hold (and not exercise) options for as long as possible if you think the per share value of the underlying stock will be increasing; or…
• Exercise the options if they are “in the money” and sell the acquired shares immediately if you think the share price is going to fall soon; or…
• Hedge your bet by exercising the “in the money” options immediately, but hold onto the acquired shares for potential future appreciation
In the real life situations we have seen, it is never that clear cut. Options may have to be exercised before they lapse, at a less than optimal per share stock price. The corporate executive may be subject to black-out periods or minimum holding requirements that restrict their ability to otherwise exercise options and sell the acquired shares. Or, they may be nearing retirement. Their desire to reduce their concentrated investment risk and diversify their portfolio by exercising options and selling off some of their holdings of company stock may be more important than gain maximization on their options.
Even if there are none of these time constraints, there can be additional monetary ones. When a non-qualified, compensatory stock option is exercised, the strike price must be paid immediately and income taxes will generally be due on the difference between the value of the stock acquired through the option and the strike price paid. These amounts (strike price and income taxes) can be funded by the sale of some of the newly acquired shares of stock, if allowed. This is sometimes referred to as a “cashless” options exercise, but will result in a significant reduction in the net shares acquired because of the immediate sale of shares necessary to pay the strike price and income taxes.
Alternatively, other resources or borrowed funds can be used to pay the strike price of the option and the related income taxes. This technique results in a much higher number of acquired shares than the “cashless” transaction described above.
Your Options With Options
Ordinary income tax rates generally apply on the spread between strike price and exercise price. Capital gains tax rates generally apply on the spread between exercise price and sales price of the acquired stock. For the stock that is sold right away in a cashless transaction, there is usually little to no capital gains tax, and if there is, it’s short-term and taxed at the same rate as ordinary income. If the acquired stock is held for more than a year and then sold, the gain could be taxed a long-term capital gains tax rate that could vary between zero percent and 23.8 percent depending on your adjusted gross income at that time.
New layers of annually granted options will each contain a unique number of shares and a unique strike price based on the date of grant. We have also seen company option programs change over time, resulting in various vesting schedules and various expiration periods. This adds even more complexity to this already complex opportunity.
Stock options are aprime example of golden handcuffs that connect a company’s economic success to that of the executives that run it. Intentional planning and a series of integrated actions are required to assure that all your options contribute to your golden financial future.
Tom Kirk is president, founder and WealthCoach at FirstWave Financial in Satellite Beach, Fla. For more information, visit FirstWaveFinancial.com