Stock options granted to employees as part of a compensation package aren’t the same as cash—they can’t be liquidated and spent right away. In fact, the grant doesn’t give the employee outright ownership of anything. What it gives them is the option to buy a certain number of shares of stock in the company at or after a period of time.
Once that waiting period is over, the employee can exercise that option and purchase some or all of the shares they are entitled to. But exercising has a number of implications, ranging from a potential large increase in income to a bigger tax bill.
What does it mean to exercise stock options?
Stock options give employees the right to purchase shares from their employer at a certain predetermined price known as the strike price (or the “grant price” or “exercise price”). Exercising stock options means buying the shares granted at the strike price.
Exercising can only occur when a stock option vests, a process that includes a waiting period to earn the rights associated with the option. Vesting often occurs gradually, over a series of years known as the vesting period.
For the option to have value, the strike price must be lower than the current market price. However, the value of an exercised option is not necessarily liquid. To actually profit from the value, the holder must have an avenue to sell the stock—either in a liquidity event like an IPO or on a secondary market.
Stock options often come in the form of incentive stock options (ISOs) or non-qualified stock options (NSOs). Each is taxed in different ways when exercised and the shares are sold.
When can employee stock options be exercised?
The time frame for exercising is outlined in the vesting schedule of an employee stock option (ESO) plan. Vesting indicates how long an employee will need to stay with the company to earn the right to exercise the options. ESOs often vest in increments at predetermined dates to incentivize employees to stay at the company.
A one-year so-called vesting cliff is typical, meaning options start vesting only after the employee has been with the company for an entire year.
A typical vesting schedule is four to five years, usually in equal annual percentage increments before all the options are fully vested. Options also do not last forever—they typically have an expiration date, after which it is impossible for the employee to exercise the options. When an employee leaves the company, a post-termination exercise period (PTE) window is often triggered, typically giving the employee 90 days in which to exercise the options before they expire and the company reabsorbs them.
Here’s an example of how a vesting schedule works. Imagine an employee who is granted options on 1,000 shares with vesting occurring over four years at equal 25% increments per year. After the first year, the option holder can exercise options on 250 shares. In the second year, 500 and so on until full vesting after the fourth year and the employee can exercise the options and purchase 1,000 shares.
Vesting is important to understand, but it’s not the only thing determining when to exercise stock options. For example, an option holder might wait until a liquidity event is on the horizon before exercising. Conversely, the options will have no value if the current stock price is lower than the exercise price. In this case, the options are said to be “underwater.”
How to exercise employee stock options
Exercising an ISO or ESO is relatively uncomplicated, especially if the company uses an equity management platform. An employee at a company that doesn’t use an equity management platform will have to consult the company’s personnel or finance department.
The process at a company with a platform in place will involve the following steps:
- Log into the equity management platform.
- Select the stock option grant to exercise.
- Take note of how much it will cost to exercise the ISOs or NSOs, and handle payment. The equity management platform will indicate this.
- Federal and state taxes may be due, and the platform can calculate the payment.
- The management platform will notify the company that a certain number of options will be exercised, and once approved, it is sent back to the employee for final signature.
- After signature, the equity management platform will issue a stock certificate detailing the number of shares owned.
3 Strategies for exercising employee stock options
How to pay for the stock options remains a big decision for the employee. There are a number of ways to pay including:
- Cash and hold. Employees can use their own money to buy shares and hold onto them. This is the easiest method, but there is no guarantee the shares will retain their value or that the employee will have the opportunity to liquidate. If a company fails or experiences a liquidity event in which the share price falls below the exercise price, there is the risk of losing much or all of the investment. Holding so much wealth in one stock could also be risky.
- Cashless with a sell-to-cover option. Some public companies may allow the exercise of options along with the ability to sell shares to cover the purchase cost, fees, and taxes. Whatever shares remain can be used at the discretion of the employee to either hold or sell.
- Cashless exercise and sell. Public companies may allow employees to sell all their options in one transaction. Once the purchase price, taxes, and fees are subtracted, the employee can keep the rest as profit.
Other purchasing methods exist, especially for non-publicly traded companies, including traditional loans and nonrecourse financing. In these cases, the employee must repay the loan plus interest and any associated fees.
Tax implications of exercising
One of the more important considerations when exercising a stock option is the tax implications. Depending on the type of option—incentive stock options (ISO) or non-qualified stock (NSO)—alternative minimum tax (AMT), ordinary income tax, and the lower long-term capital gains taxes are part of the process.
ISOs generally are eligible to receive more favorable tax treatment than other types of employee stock options. With ISOs, the exercise isn’t a taxable event. Still, some higher earners will have to make AMT adjustments based on the difference between the current market price and the exercise price. The federal AMT tax rate is 26% to 28% versus a maximum of 20% for long-term capital gains as of 2022.
When it comes to selling, ISOs must be held for two years from the date they are granted and at least one year from the exercise date to receive long-term capital gains status.
With an NSO, a taxable event occurs at the moment the option is exercised. The tax is levied on the value above the grant price. The difference between the exercise price and the market value of the shares is considered ordinary income for tax purposes. For instance, if a stock price rose from $20 to $60 at the time of exercise, then income taxes would be owed on the $40 per share gain.
If an employee sells the shares at the time of exercise, no additional taxes will occur. But if they hold and sell later for an additional profit, more taxes are owed. If the employee sells within a year, short term capital gains tax rates—which top out at 37%—apply. Holding onto shares for at least one year after exercising them means they qualify for the lower long-term capital gains tax rate when shares are sold.
In some cases, option holders may be able to exercise before the options are fully vested. This is called an early exercise. Whether it’s an available option will be spelled out in an ESO plan at the time the options are granted.
An early exercise of an ISO qualifies for favorable tax treatment, but the shares must be held at least two years after the initial option grant date and one year after exercising. For NSOs, early exercising triggers the start of the one year holding period, thus allowing for lower long-term capital gains tax when the employee sells.
Some companies will allow early exercise upon granting. In this case, no taxes are required as long as the market value is equal to the exercise price (meaning no profit has been realized). However, a tax form 83(b) must be filed with the IRS within 30 days of the election time to avoid unwanted tax issues.
The bottom line
Timing is the key factor in exercising stock options. Vesting schedules generally last from one to four or five years and the options usually are valid for 10 years after they vest, or until the employee leaves the company, which usually starts the clock on a 90 day window to exercise before the options are canceled.
There are many factors that figure in the decision on when to exercise, including one’s ability to pay for the stock, taxes that will be incurred, and whether an investor wants to sell the shares or hold out for future gains.