Your Options With Options

A New Year’s Refresher on Stock Option Compensation

Many of us participate in family traditions, old and new, during the holiday season and New Year. One that our family has carried out for many years is a trip to the mountains in the western part of North Carolina. One of my favorite parts of this tradition is eating at Gideon Ridge, a restaurant that starts the dining experience with an amuse bouche - complimentary small bites served at the start of a multi-course dinner.

While working my way through this gastronomic experience on our most recent trip, I was reminded of an article from a journal about stock options as a form of compensation, especially in privately held and founder-led companies.The complexities of the food before me were similar to the complexities of stock option compensation. Each presents an attractive exterior but as you dive deeper in, you recognize you don’t quite understand all the intricacies, subtleties, and flavors that go into them.

Stock options are a key element of overall compensation, and net worth, for many business owners, entrepreneurs, and their employees. The ability to understand what you own, the potential impacts around exercising and selling those options, and the ability to view them as a part of your overall financial picture can play an important role in maximizing the effectiveness of those options.

My hope is the following pages serve as an “amuse bouche” of sorts as it relates to the world of stock option compensation, providing you with a high-level, bite-size, yet palatable overview.

And now for your indulgence…

First, identify the type of option you have.

Stock option compensation comes in several forms. Recognizing what you have been granted, and the mechanics of those various options, can help you develop a strategy to optimize the value of those options and reach your financial goals. There are several types of stock options: incentive stock options (ISOs), non-qualified stock options (NSOs), restricted stock units (RSUs), as well as various employee stock purchase plans, 401(k) options, etc. In this article, we will focus on the two predominant types — ISOs and NSOs.

At a high level, ISOs and NSOs are stock grants that give you the right to purchase company stock at a predetermined price. Though they look and act the same on this level, stepping down a level deeper, there are distinct differences between them.

Taxes‍

In the life of a stock option, there are two key dates: the day the option is exercised and the day the stock is sold. These dates affect the type of taxes that will be levied upon the underlying security.[1]

NSOs have an immediate tax implication when the option is exercised. Upon exercise, the amount is taxed at ordinary income tax rates and flows directly onto your W-2. At exercise, ISOs have no immediate taxes due unless an AMT (alternative minimum tax) is triggered. The complexities and planning around AMT are worth noting but not worth diving into specifically here. Both ordinary income and AMT are based on the bargain element, the difference between the exercise price and the market price[2] on the day the option is exercised.

Figure 1.  The bargain element is the difference between the exercise price and the market price on the day you exercise the options.

The wider the bargain element, with all else equal, the larger the tax liability.

Many entrepreneurs have the mindset that they will hold their options while being awarded more grants in the future, thus accumulating a large, concentrated position in company stock that can be monetized in an IPO or private transaction. As we discuss below, understanding the impact of various option strategies can be beneficial as you incorporate it into your overall financial plan.

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Figure 2. The exercise and sell dates of ISOs and NSOs affect the type of taxes that will be levied upon the underlying securities.

Then, Consider Vesting

Vesting can also play a large role in your approach to your options strategy. Vesting is simply the time between when you receive the stock award (also referred to as a “grant”) from the company and the time when you can take any action with that award. Since your first stock option grant is most likely not your last, you will have various grants in different stages of vesting. It is important to understand where your options are in their vesting lifecycle. Vesting can take many different forms; some companies have options vest 100% after a certain number of years while others have a certain percentage over a predetermined period (say 20% a year for 5 years).

Finally, Discuss Liquidity Management

When considering exercising your options there are two focus areas: 1)how you will execute your strategy and 2) when you will execute your strategy. The tools you can use to execute your strategy are a cash exercise or a cashless exercise.

A cash exercise uses outside assets (either cash or loan) to fund the purchase of the option shares you want to exercise. Cash exercises help the owner maintain and maximize the amount of stock that is held since none must be sold to fund the purchase. Taking cash or selling assets from one account and utilizing those funds to exercise/purchase your options reduces your cash position and increases your company stock as a percentage of your overall assets. Thus, a cash exercise increases the concentration within your company stock.

A cashless exercise sells a portion of the exercised options to cover the cash needed to fund the exercise, and in some situations, the tax liability associated with it. Cashless exercises help to maintain diversification across your broader investment portfolio. You are left with less stock than was originally granted since some stock was sold to cover the purchase; however, you have maintained outside cash and investment positions by not using them to fund the options exercise.

The below chart can be a helpful, albeit not exhaustive, guide:

Figure 3. Cash Exercises and Cashless Exercises Provide Different Strategic Benefits

For liquidity, one might employ an immediate exercise and sell strategy.
Entrepreneurs might immediately exercise their options and sell them as they vest if they: want to build out a diversified portfolio away from their company stock, want to utilize the funds for other lifestyle or personal needs, or expect future stock grants which will maintain company stock exposure. This strategy helps create liquidity, though it can create adverse tax implications depending on the type of options owned and the client’s overall tax picture for the year in which they are exercised and sold.

For financial and tax planning flexibility, one might employ an immediate exercise and hold strategy.
‍The second strategy, which is a slight deviation from the first, immediately exercises the options when they vest but holds the stock rather than selling it. This strategy provides flexibility from a financial planning and tax planning perspective as entrepreneurs may evaluate the specific circumstances, both market-driven and personal, that would lead to the selling of shares. Many times, this strategy is beneficial when holding ISOs, as you can “start the clock” on the 12-month holding period to take advantage of long-term capital gains rates.

For building a concentrated position, one might delay exercise after vesting.
Entrepreneurs and early employees who remain bullish on the company stock and look to build and maintain a concentrated position can hold onto their vested shares and not exercise them until a future later date. Depending on the type of option, the bargain element or spread can become large, creating outsized AMT or income tax liabilities. You must also consider the expiration date of those options, which is simply the date which you can no longer exercise the option. The industry standard is typically 10 years from the date of issuance and once that date has passed, any shares you have not exercised are forfeited.

For exercising options with mitigated tax impact, one might employ a rolling exercise/selling strategy.
‍The last strategy we will mention is a rolling exercise/selling strategy. This approach is a systematic process that removes a lot of the emotional decision making around company stock and creates a framework based on several qualitative and quantitative planning decisions. It typically will involve exercising or selling a predetermined number of shares at different times or if selling, doing so at a predetermined price target. To the extent it is possible, a rolling exercise strategy can be a beneficial way to exercise vested options and help mitigate the tax impact.

Example Case Study: 

The below grid is an example of a rolling selling strategy to build a$10M liquid portfolio through the sale of incentive stock options exercised over 12 months prior to any action being taken. This allows the options to be sold at a more favorable long-term capital gains rate.

The rolling selling strategy seeks to utilize pre-determined stock price targets to sell a pre-determined number of shares each month to accomplish the goal but also maintain ongoing exposure to the company stock.

This allows dollar cost averaging into a diversified portfolio of equities, fixed income, and private capital over time. It also seeks to alleviate concentration risk in a single security and spread the tax impact over two calendar tax years.  

Figure 4. A Sample Rolling Selling Strategy

Common Pitfalls: Avoid viewing options as distinct and separate from the rest of your financial picture.

Many entrepreneurs think about their stock compensation through the lens of the company’s balance sheet rather than their personal balance sheet. While we all recognize the importance of business owners and entrepreneurs “eating their own cooking” and remaining invested in their company, it is equally important to step away from the excel spreadsheets and AMT calculators to determine the more behavioral aspects of stock option planning. It is important to factor in aspects such as concentration risk and liquidity management around the exercise of your options, which can go a long way in meeting your financial goals. Asking questions such as “how much company stock do I want to own relative to my other assets” and “how do these options factor into my broader financial picture and goals” help assist in assessing and determining the right strategy as it relates to the more quantitative decisions. A few helpful questions would be:

1. What is your optimal comfort level with concentration risk? (the risk created when you amass substantial wealth from one source or asset) What is the potential volatility associated with holding a concentrated position?
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2. At what point would you be willing to sell any or all your shares?
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3. Consider your personal consumption and lifestyle goals – how do these balance against the liquidity constraints of company stock?

I have yet to find a business owner or entrepreneur that is not bullish on his or her own company stock, and knowing how to optimize the complexity of stock option compensation and consider the relevant factors such as income tax, AMT, vesting schedules, concentration risk, and liquidity management through the lens of your overall financial goals and picture can ultimately help develop a strategy to accomplish them.

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_{[1] Exercising stock options means you're purchasing shares of a company's stock at a set price. Selling is when you dispose of the stock in an open market transaction receiving cash in exchange.}

_{[2] Exercise price is a set price for which you can purchase shares of a company’s stock. Market price is the current fair value of the company stock. For public companies, this value is determined through an exchange. For private companies, the market price is normally the price at the last 409A valuation.}