Having company stock options can be a great financial benefit. However, many people end up confused by them, don’t know what to do with them, and miss out on making the most of their stock grants. In this article, we’re going to walk you through everything you need to know in (hopefully) easy-to-understand language so you feel empowered rather than befuddled.
Key Terminology for Company Stock Options
When you are granted stock options, you are being granted the right to purchase a specific number of company stock shares at a specific price during a specific time frame.
The specific price at which you are able to buy the shares of company stock is known as the strike price. Typically, though not always, it’s the market price of the company stock at the time the shares are granted.
The grant will have a vesting schedule, meaning that you typically can’t exercise your options until the shares are vested, though you probably wouldn’t want to exercise them immediately anyway since they won’t have any value at that time. But we’ll get into that later.
Simply put, exercising your stock options is when you choose to put your right to purchase the shares into action. As mentioned above, the shares will need to meet two criteria for you to exercise:
- The shares will need to be vested, and
- The shares will need to be at or above the strike price
Types of Vesting
When it comes to your company stock options, there are two common types of vesting—graded vesting and cliff vesting.
Graded Vesting
The first type of vesting schedule is graded vesting. With graded vesting, a certain percentage of the shares vest every period. The period can vary and may be measured in weeks, months, quarters, or years.
For example, you may have four-year graded vesting where one-quarter of the shares vest each year over a period of four years. Let’s say you have 400 shares. Here’s how it would look:
- Year 1: 100 shares vested
- Year 2: 200 shares vested
- Year 3: 300 shares vested
- Year 4: 400 shares vested
Cliff Vesting
The other common vesting option is cliff vesting. This is where all shares vest at once after a specified time has passed.
In this example, let’s say you have three-year cliff vesting. If 400 shares were granted in Dec. 2021, all 400 shares would suddenly vest at once exactly three years after being granted in Dec. 2024.
Vesting Variance and Expiration of Options
The number of years and frequency at which the options vest will vary by company—and sometimes even by each grant within a company–so you’ll want to be sure to understand the vesting schedule for each grant.
It’s common for company stock options to expire after 10 years from the grant date. This means you will lose the options after 10 years if you don’t exercise them. That said, the expiration date can vary by company or even by different grants within the same company. So again, this is important to know. Also, note that you typically will lose any unexercised options when you part from your employer.
How much are your company stock options worth?
Now that we’ve covered some of the basics of company stock options, let’s dive into how to understand the value of your stock options. The terms we covered above will be coming back into play, so you’ll see them in action.
To boil down the value of company options to its simplest form, you’ll need to know the strike price of your options and the current market price of the company stock. You’ll multiply the difference between market price and strike price by the number of vested shares in your grant.
Company stock options value = (Current market price - strike price) X # of vested shares
If the market price of the stock is less than the strike price of your options (meaning the stock has dropped in value since your options were granted), then your options are underwater and not worth anything. If the current market price is greater than the strike price (i.e., the stock price has appreciated up since your options were granted), then your options are in the money and worth something.
An Example of Company Stock Options Value
Let’s look at an example. Say you were granted 5,000 options of Company ABC exactly one year ago with a two-year graded vesting schedule. At the time of the grant the market price of ABC was $50.00 per share, which is the strike price in this example. Because it’s graded vesting and we are one year into the two-year vesting schedule, half of the shares are currently vested—2,500 shares.
- Scenario 1: Let’s say the current market price of Company ABC is less than $50.00, say $45.00/share. Your options are currently underwater and not worth anything. Fortunately, they don’t expire for another nine years so you have time to wait for the stock price to appreciate in value. So although you can’t exercise right now, you may have an opportunity to exercise your stock options over the next nine years.
- Scenario 2: In this second scenario, let’s say the current price of ABC stock is $60.00/share. Here’s how much your options are worth:
Value: $60.00 [current market price] - $50.00 [strike price for this grant] ) x 2,500 [number of currently vested shares] = $25,000
When you log on to your company stock benefit account, the value of your options should appear there. But it’s still important to understand how this value is being calculated. Note that the value of your options is a pre-tax value. We will address how stock options are taxed in a separate piece.
Exercising your options
As I mentioned at the start of this piece, exercising your options means that you are taking advantage of the opportunity to buy the company stock at the strike price. You will either outright own the shares that you buy or reap the cash value of the options.
Note: Your company likely has “blackout” periods during which you’re not allowed to trade your company’s stock. Be sure to confirm with HR that you are in an open window and able to exercise your options before doing so.
Three Methods for Exercising
When you exercise your options, there are 3 different ways that you can do so:
- Buy the shares using outside funds and hold the stock
- Buy the shares and elect to automatically sell enough shares to cover the cost of the purchase, holding onto the remaining shares (“cashless” exercise)
- Buy and simultaneously sell all shares upon exercise (also a “cashless” exercise)
Let’s go back to our example of Company ABC where you have 2,500 vested stock options with a strike price $50.00/share and a current market price of $60.00/share. Here’s how each of these scenarios plays out:
- You take money out of your bank account to purchase the 2,500 shares at $50.00 each, which will cost you $125,000. You now own stock that is worth $60.00 x 2,500 = $150,000.
Note that at the time of exercise, a portion of the shares will automatically be sold to cover withholding for tax purposes. Bear in mind that oftentimes the taxes withheld are not enough to cover the amount of taxes you actually owe. Be sure to consult with your tax advisor so you are not hit with a big tax surprise when you go to file your taxes the following year. - You buy and hold the shares but opt for a cashless exercise so you don’t have to come up with $125,000 of outside money to purchase the shares. You purchase 2,500 shares at $50.00/share for a cost of $125,000 and simultaneously sell $125,000/$60.00 = 2,083.33 shares to cover this cost leaving you with 416.67 shares at $60.00/share, worth a total of $25,000.
Like in the previous example, additional shares will be automatically sold for tax withholding. Because of this, you will end up owning fewer than 416.67 shares. - You opt to buy 2,500 shares at $50.00/share and automatically sell them all at the going market price of $60.00/share, ending up with a net of $25,000 cash. (Some of this cash will be withheld for taxes, though again not necessarily enough to cover the total taxes due.)
In all three of these examples, you are realizing the $25,000 (pre-tax) value of your stock options.
The Best Method to Exercise Your Company Stock Options
At Ametrine Wealth, we highly recommend our clients opt for exercise strategy #3: sell all shares upon exercise, particularly for Non-Qualified Stock Options (NQSOs). With Incentive Stock Options (ISOs), there is a tax incentive to hold the stock for at least one full year before selling. But of course, you then have the risk that the stock will drop in value within that first year. It’s important to consult with your advisor to better understand your ability to take on that level of risk, regardless of whether you feel inclined to do so, taking into account your particular financial situation and goals.
Having concentrated positions of individual stocks in your portfolio is very risky in general, and the risk is even larger if that concentrated stock holding is the stock of your employer. No matter how bullish you are on your company’s stock, anything can happen at any time—an unforeseen scandal or lawsuit, for example—that could potentially tank the company’s stock value. And when companies are going through tough times, they tend to lay off employees.
By holding large positions of your company’s stock, you don’t just risk losing the entire value of that stock. You also risk the potential of simultaneously finding yourself unemployed. This risk is, of course, larger if you are working for a newer, less established company. But even well-established companies can fail.
Even if the risk of this happening seems small, the potential risk of holding onto your company stock and your job at the same time could be so financially devastating that it is simply not worth it. Instead, we recommend that you immediately sell the stock upon exercise, set aside a portion of the proceeds to cover additional taxes owed beyond what is withheld, and invest the remainder in a diversified portfolio.
When Should You Exercise Your Stock Options?
The best time to exercise your company stock options is when the market price of the company stock is 2-3 times the strike price of the grant.
Returning to our example where you were granted options of Company ABC with a strike price of $50.00/share, the optimal time to exercise your options is when the market price is between $100.00 and $150.00/share. As the market price hits 2-3 times the strike price, the risk of what you could lose is greater than what you may gain. We refer to this as downside and upside risk. The downside risk is your stock options losing value if the stock price were to decrease. The upside risk is your option continuing to appreciate if the stock price increases further.
This may go without saying, but you also want to exercise any stock options that are about to expire if they are in the money (have any value) before they expire. And if you currently have any stock options where the current market price is more than 3 times the strike price of the grant, you should seriously consider exercising those options as soon as possible.
Why Exercising at 2-3 Times the Value is Optimal
Why is it optimal to exercise your options when the market price of the stock is 2-3 times the strike price? Let’s explore this from a mathematical lens. (This section is optional for those who want to gain a deeper understanding of the optimal exercise price. If you’re not a math person, feel free to skip this section!)
Now, back to our example of the option grant with a strike price of $50.00/share. Let’s say the market price of ABC stock right now is $55.00/share, or 1.1 times the strike price. The option value is $5.00 per share ($55.00 - $50.00). Over the next month, the stock performs very well and increases in price by 10%, reaching $60.50/share. The option’s value is now $10.50 ($60.50 - $50.00). Notice that while the stock’s market price increased by 10%, the value of the option actually increased by 110% ([$10.50 - $5.00])/$5.00)!
Now, let’s see how a 10% change in the market price of the stock impacts the change in value of the options when the market price of the stock starts at two times the value of the strike price:
The market price of the stock would have to be $100.00 to be twice the strike price of the option. The initial value of the option is $50.00/share ($100.00 - $50.00). From there, let’s assume a 10% increase in the stock’s market price, so the stock price increases to $110.00/share. The value of the option is now $60.00/share ($110.00 - $50.00) which is an increase of 20% ([$60.00 - $50.00]/$50.00). Okay, so it’s not a 100% increase in value, but there is still a decent amount of upside to holding the option over the stock when the market price is two times the strike price.
Let’s move to a final example where the market price starts at three times the strike price before a 10% increase in market price.
The stock’s market price would have to be $150.00 to be three times the strike price of the option. The initial value of the option is $100.00/share ($150.00 - $50.00). From there, the 10% increase in the stock’s market price takes us to $165.00/share. The new value of the option is now $115.00/share ($165.00 - $50.00), which is an increase of 15% ([$115.00 - $100.00]/$100.00).
As the stock price’s value continues to increase, the additional upsides to the value of owning the option become equivalent to essentially owning the stock itself. In other words, as the market price of the stock increases to 4, 5, or 6 times the value of the strike price, the increase in value of the option will inch closer and closer to the amount of the additional increase in the market price. By the time you get to six times the strike price, a 10% market price increase will result in the option’s value going up by just 12%. Also at this point, decreases in the market value of the stock result in a much larger decrease in the option’s value. It, therefore, makes sense to instead hold the stock itself to substantially reduce downside risk without substantially impacting upside risk. However, what is better than outright owning your company’s stock? Owning a diversified portfolio!
So to sum it all up, you should:
- Exercise your stock options when the market price of the stock is 2-3 times the strike price
- Sell all of the stock upon exercising, setting aside enough of the proceeds to cover any additional taxes that you may owe due to this transaction
- Invest the remainder of the proceeds in a diversified portfolio
Wrapping Up
Whew! We just covered a lot of ground. There’s a lot to understand when it comes to company stock options, and missteps could result in going from a lot of potential value to nothing at all. I try to break down these concepts into bit-sized pieces on my Instagram. And if you’re not on Instagram, I cover the same topics on my YouTube and LinkedIn.
If you have any questions related to your company stock options—or any type of additional compensation from your employer—you can grab a time on my calendar here.
About the Author
Carla Adams is a CERTIFIED FINANCIAL PLANNER™ practitioner who specializes in helping women build strong financial plans around their equity compensation, including Restricted Stock Units (RSUs) and company stock options. With over 15 years of experience in financial services, Carla has in-depth knowledge and expertise geared toward helping clients with complex financial situations. She enjoys boiling down complicated scenarios through practical examples and down-to-earth conversations.