3 Stock Option Exercise Strategies You Need to Know

Incentive Stock Options, ISO's

How to best exercise stock options

Receiving stock options from your employer is great, as it indicates that your company sincerely values you.  They want to keep you, and keep you happy!  Furthermore, stock options can be a fantastic opportunity to make a lot of money!

However, knowing how to optimize these potentially winning lottery tickets is no easy task.  You need to consider things like income tax, alternative minimum tax, holding periods, vesting schedules, concentrated equity, valuations, etc. In other words, it’s easy to become overwhelmed.

Instead of being paralyzed by that complexity, you should focus your energy on asking the some key questions, both of which are actually quite simple: “How do I feel about my company stock?  And how much company stock do I want to hold?” 

Your answers to these questions should dictate how you develop a plan and implement a strategy to achieve your goals.

In my experience, every client answers these questions differently, but their answers all seem to fall under one of these three mentalities:

  1. I think the stock is going through the roof. I want to keep as many company shares as possible.
  2. I have too much tied up in my company already. I want to sell my stock as soon as possible and diversify.
  3. I want the best of both worlds. I’ll keep some shares and diversify the others.

That’s it!  It’s that easy.  Just pick one of these approaches and move on.

Well, sort of… but not really.  That’s just the beginning.  Let’s take a closer look at what each one of these goals means for your long-term financial plan.

Keep as many shares as possible – Big risk, big reward

You have to bet big to win big.  For some, betting big on company stock ownership is a risk that they are willing to take.

By following this strategy, the employee will accumulate and hold as many shares of company stock as possible.  The singular goal is to obtain, maintain, and concentrate a large portion of one’s net worth in the company stock.

If the company stock price goes up, then the employee will be a big winner!  If, however, the company stock goes down, then the employee could lose big…. potentially very big!

To implement this strategy in the most effective way, employees hold restricted stock units after they vest (vesting occurs after a period of time determined by the employer.  Once shares vest, you have control over them – Until that point, you don’t!).  They use cash to exercise non-qualified and incentive stock options (simply known as a “cash exercise”).  With a cash exercise, the employee is often using “other” personal assets to buy more and more shares of the same company.  Basically, this is the opposite of diversification.

Keep zero shares – Treat it as compensation  

Many employees who receive company stock or stock options decide to treat those shares as compensation.  This means that the employee will sell their shares of the company stock as soon as possible (immediately upon vesting), and then reinvest the proceeds into a diversified portfolio.

By following this strategy, the employee will make no attempt to be tax efficient, time the market, and/or play other investment “games.”  The goal is simple – to sell the company stock as soon as possible in order to diversify and reinvest elsewhere.  Quite simply, this strategy that means you have no interest in holding the stock.

Often, employees implementing this strategy feel that a significant part of their life is already tied up in one company, including their income, their health benefits, their 401(k), their life/disability insurance, and now possibly a large portion of their net worth.  With so much connected to one company, the employee feels more comfortable shifting their investment exposure away from that one company.

Keep some shares – Dipping your toes

The most common strategy that I see employees choose is “somewhere in the middle”.

Employees frequently choose to retain some company stock “just in case” the share price skyrockets.  Who wants to be the only employee at the water cooler holding zero shares, with no one to high five, when the company quadruples in value?

On the other hand, these employees also don’t want to be left out to dry.  The stock price could go down.  By holding too much stock, you put yourself at risk to lose a lot of money should the company fail.

The range of how many shares to hold differs across the board.  Some clients choose to maximize their exposure without putting personal assets into the mix by exercising a cashless exercise.  Others use a financial planning benchmark, such as 10% of their net worth being kept in one stock.

Next Steps

Before you find yourself digging too deep into the details of discussing the alternative minimum tax, 83(b) elections, and the differences between incentive stock options and non-qualified stock options, take a step back and a deep breath.

Take some time and review your goals.  Is your goal to keep as much company stock as possible, knowing that you could lose it all?  Or is your goal to get rid of it all right away?

Once you determine your goal, you can begin to develop an effective strategy to accomplish that objective in the most efficient way possible.

None of the information in this document should be considered as tax or legal advice.  You should consult your tax and legal advisors for information concerning your individual situation. Diversification does not guarantee a profit or protect against a loss.

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