In this week’s post we are going to deal with one simple question. If your company offers you non-qualified stock options, should you accept them? The answer is YES. A big, fat resounding YES.
Now, if I stop here this will be the shortest article I have done yet. Honestly, you could stop reading here, but I need to provide some data to back this position up. Some of this will be a repeat from other posts, but that’s fine. It is too important not to cover.
First off, let’s give a bit of background of why I am talking about Non-Qualified Stock Options. To keep things simple, I will mostly call them company stock options going forward. It saves me a few extra words. I want to stress I am NOT talking about Incentive Stock Options, better known as ISOs. I don’t deal with those. Plus, last data I saw showed 95% of stock options are Non-Qualified ones. In Ohio we have more of the older companies that provide more traditional stock options, such as Sherwin Williams, Smuckers, Proctor and Gamble, etc, as opposed to start-ups offering ISOs. So, my focus will be on Non-Qualified Stock Options.
As I review the reasons why you should always accept company stock options, please keep in mind I am not putting the reasons in any order of importance. Well, there will be one most important reason and I will be sure to identify that one.
The first reason to accept company stock options is they are a way for you to directly participate and hopefully benefit from your employer’s success. You know, assuming the price of the stock goes up. Although for the last decade it may not feel like stocks do go down, they certainly can and do. And if your company stock options do go down before you exercise, this has no impact on you. I promise this will make sense by the end.
Getting back to participating in the success of the company. Let’s say you have worked for your employer for years and years. The company has done well and your company stock has also done well and increased in value during this same time. Company stock options provide a direct way for you to participate in this success and increased stock value, and without risk just in case the stock does go down. A recent study on equity compensation showed that over half of employees value company stock because it gives them a direct way to participate in the company’s growth. This saves you from having to go out and buy the shares of the company stock on your own.
Reason number two to always accept company stock options is there are no taxes with stock options until you exercise them. This is different than if your company provides you a cash bonus.
Before I forget, the reason they are called nonqualified stock options is because there are no special tax rules applied to them. Basically, they do not qualify for any special tax treatment. That’s it.
I need to give you some more background on company stock options to help explain the tax situation with them. A Non-Qualified Stock Option is simply an agreement that provides terms under which you can buy a specific number of shares at a set price during a determined timeframe. The details are included in your employer’s stock plan document and be sure to get a copy of it so you know the rules unique to your employer. And do NOT throw it away!
When you are granted stock options you have the right to purchase a set number of shares at a specific price during a fixed timeframe. The specific price is referred to as the Exercise Price, Grant Price or Strike Price, and when you decide to purchase the shares you have Exercised your options. Until that point when you actually exercise the options there are NO taxes for you. So, if you never exercise them there is no worry about taxes.
There are a couple of time periods to mention with NSOs. The first is vesting. I’ve talked plenty about this and it is rather simple. It is the period of time before you can exercise your options. The more important time period is the overall exercise period. This is usually ten years in length. If you do NOT exercise them within this period you lose your options. The most recent data shows that 11% of in the money options, which means they are above the grant price, are allowed to expire every year. There may be a reason why people let these in the money options expire, but I’ve never heard of a legit one. Odds are it is because the options holder and/or the financial advisor were not paying attention.
Let’s walk through a quick example here. You have 4,000 shares of company stock options awarded to you and your employer has cliff vesting of 4 years. These shares have been awarded when the stock price is $20.
- After 4 years all shares are fully vested.
- After this time, the stock price has increased to $35 a share.
- You now have the ability to exercise these options and buy the 4,000 shares at $20, even though they are worth $35 a share. So, you pay $80,000 for shares that are worth $140,000 on the open market. A profit of $60,000 is not too bad!
Now to when you exercise your options and how you pay for them. Most employers allow you different ways to pay that $80,000 bill.
- If you have the cash, they may permit you to just pay the $80,000 bill.
- Others may permit a salary deduction. This is going to be more common if your bill is $800 vs $80,000.
- Finally, and this is what I see most often is a cashless exercise. Here shares are sold immediately when you exercise your options and the proceeds will pay that $80,000 bill and associated taxes.
I mentioned before about 11% of in-the-money stock options expire and also how there is no risk for you with stock options. In-the-money is when the stock price has increased above the grant price when you were awarded the options. In our example it was a grant price of $20 and the stock was worth $35 when you actually exercised it. So, this was in the money by $15. Now, if the stock price drops below the exercise price you do not have to exercise your options as it would be cheaper to buy the company stock on the open market. For example, your exercise price is $20 and the stock drops below this to $10 and never recovers before the options expire. You have no risk either way. If the stock appreciates you technically do not own the stock until you exercise the options and if the stock drops in value, well, why would you spend more than the stock is worth?
I mentioned earlier the name nonqualified stock options simply refers to these options not qualifying for any type of special tax treatment. This makes the tax issue for NSOs pretty simple. When you exercise nonqualified options you will have to deal with taxes. Sorry. A term to become familiar with is compensation income. This is the difference, or spread, from your exercise price and the actual stock price when you exercise. In our example it is the difference between $20 and $35, or $15. The IRS treats this as ordinary income and you have to pay taxes on it that include Income Tax, Social Security and Medicare. Down the road when you sell the shares any proceeds above or below the $35 price will be taxed at capital gains and losses rates.
But one more time – there are no taxes with company stock options until you actually exercise them. Until that point of exercise, you do not own them so there is nothing to tax.
Your third reason is one identified in the same survey I mentioned earlier about why people value equity compensation so much. Actually, this is the most important reason survey respondents identified. The reason is because it helps them to build wealth. I believe the full survey response was to “significantly build wealth.”
Again, the concept of equity compensation allows employees to directly participate in the success of the company through the increased value of company stock. Company stock options provide you a direct and no-risk way to participate and hopefully “significantly build wealth.”
I now want to cover the most important reason to always accept company stock options if offered by your employer. You may have guessed this already as I have touched on it a few times. It is because there is no financial risk to you until you exercise the options. That’s it. You have no risk when you accept Non-Qualified Stock Options until the point at which you actually exercise and take control of the options. Until you take control there are no taxes too. And to stress here, there is no requirement that just because you accept stock options you have to exercise them.
As mentioned previously, your company offers you some company stock options. You go ahead and accept them. Once your clock starts, which usually lasts 10 years, you have until the end of that time period to decide whether to exercise the stock options and become the owner of them. If during that ten-year period the stock options never get above the grant price, well, it would most likely make sense to NOT exercise the stock options. The reason is because it would be cheaper to buy the company shares on the open market at a lower price than the grant price.
Now, if the stock options go up in value and are now what we call In-The-Money, or as one of my equity compensation clients likes to call them – Show-Me-The-Money, you most likely will want to exercise them. When specifically during the ten-year window is dependent on your personal situation. Things my clients and I look at include the full value of the options via things like Black-Scholes, taxes, cash flow, and more.
Regardless, if the price you would pay to exercise them is above the price at which they were granted, odds are you should exercise them. I referenced earlier that 11% of In-The-Money options are not exercised annually. I hope to one day find out why that number is so high, but until then my guess is because clients and their advisors just were not paying attention. Talk about throwing away wealth.
This seems like a good place to stop. Hopefully this did not get too boring. Again, the short answer to the question of whether you should accept Non-Qualified Stock Options if your employer offers them is a big, fat YES. There are lots of reasons, but it comes down to this is a no-risk way for you to build wealth. Finally, if you want to talk more about your stock options and other forms of equity compensation, click here to schedule some time for us to talk.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.