Exploring the Details of A Cash Exercise of Stock Options

When it’s time to exercise your employer-provided stock options, you generally have one of two options: a cash exercise or a cashless exercise.

You may choose a cash exercise in the hope of achieving preferential long-term capital gains treatment on further appreciation of the stock. In addition, you choose a cash exercise in order to assume a more concentrated position in company stock.

Concentrated equity can be good, but it can also be bad. If the stock price goes up, you will be rewarded for assuming concentration risk, and your reward will come in the form of a higher account value. If the stock price goes down, on the other hand, you will be punished for concentrated risk, which is represented by a lower account value.

This risk and reward trade-off is fundamental to all investing. However, all else being equal, the risk you assume may be higher when choosing a cash exercise when compared to a cashless exercise.

One reason is that you need to pay to perform a cash exercise. And when paying for the cash exercise, you are likely taking assets that are allocated elsewhere and investing them into company shares.

Just how much does it cost? Well, that depends.

How to Pay for the Shares of a Cash Exercise

In some scenarios, paying for a cash exercise of stock options can be quite simple. If the cost to exercise is low or if you have cash on hand, you can use cash to pay for the cost of the exercise.

The cost of the exercise can be calculated using the following hypothetical example:

Number of Shares Grant Price Current Price Market Value Value Less Cost
5,000 $0.50 $25.00 $125,000 $122,500

In the above scenario, the cash required to purchase the shares of stock is small at only $2,500. This is calculated as follows:

“Number of Shares” x “Grant Price” = Cost of Exercise

5,000 x $0.50 = $2,500

In our example, the option holder can pay $2,500 to purchase the shares via a cash exercise.

Should they choose to do so, they will immediately own 5,000 shares worth $125,000. This is certainly not a bad deal, and as mentioned above, it is very easy to do because of the small cash requirement.

(It should be noted that this example does not include the associated taxes due upon exercise. The tax costs will be dependent on the type of shares being issued, either incentive or non-qualified.)

At other times, finding the cash to pay for the option shares may prove to be difficult.

Suppose you do not have any money in the bank and you want to do a cash exercise. You may need to find an alternative funding source.

Continuing our hypothetical example from above, let’s assume the grant price has changed from $0.50 to $15.00 per share. The impact of this change in grant price increases the cost of a cash exercise substantially.

Number of Shares Grant Price Current Price Market Value Value Less Cost
5,000 $15.00 $25.00 $125,000 $50,000

“Number of Shares” x “Grant Price” = Cost of Exercise

5,000 x $15.00 = $75,000

While many people may have the $2,500 required to perform a cash exercise when the grant price is $0.50 per share, not as many will have $75,000 (plus the taxes associated with the exercise). A bigger question should be asked as well: Would the same person who does have an extra $75,000 lying around want to take this cash cushion and use it to buy just one stock?

For those who don’t have the cash and wish to buy the stock via a cash exercise, some alternative sources of finding cash can include the following:

  • Sell assets from a brokerage account
  • Borrow the money from a bank
  • Borrow from a friend/family member
  • Borrow using your house (home equity or otherwise)
  • Take a loan from a 401(k)
  • Use a margin account

As you can see, a number of options exist that could allow for a cash exercise. But if you ask me, none of these are particularly attractive. Now, that isn’t to say there isn’t a time and place for certain strategies. But these all include an increased level of risk.

A Bad Scenario

The increased level of risk discussed above is best illustrated by continuing the example from above. Let’s assume that an investor chooses a cash exercise. Let’s further assume they borrow the $75,000 required to perform the exercise from a family member.

Immediately following the exercise, the shareholder owns 5,000 shares of stock at $25.00 per share, for a total value of $125,000.

If you take a snapshot right now, the shareholder owns shares worth $125,000 and owes $75,000. One could argue that this is a very comfortable position to be in.

As time passes, however, the value of the shares will fluctuate. Over time, this fluctuation will drive the price up or down. For those who choose a cash exercise, it’s not uncommon to be highly optimistic that the value of their company stock will appreciate over time, and if they are correct, they will be rewarded.

However, let’s assume things don’t go as planned and the price goes down 75%, to $6.30 per share. As the price drops from $25.00 to $6.30 per share, the value of the shares drops from $125,000 to $31,250.

Number of Shares Share Price Market Value Debt Net Value
5,000 $25.00 $125,000 ($75,000) $50,000
5,000 $6.30 $31,250 ($75,000) ($43,750)

Now the shareholder owns stock shares worth only $31,250. Unfortunately, the shareholder still owes a family member $75,000.

The leverage they used in borrowing money to buy shares has left them in an unenviable position of owing more than what the stock is worth (think of owing more on your house than what you can sell it for!).

Comparing the Bad Scenario to That of a Cashless Exercise

It’s important to explore the negative scenario when compared to a cashless exercise in order to more fully understand the risk.

If we assume this person performed a cashless exercise, we can assume they did not take a loan from a family member to pay for the shares. Instead, they used some of the shares to pay for the others (immediately exercising and selling enough to cover the cost).

Without getting too deep into the details, we can assume that the number of shares that were required to perform a cashless exercise is 3,000. This means the shareholder is left holding 2,000 shares.

Number of Shares Share Price Market Value Debt Net Value
2,000 $25.00 $50,000 $0.00 $50,000
2,000 $6.30 $12,600 $0.00 $12,600

As the share price falls from $25.00 per share to $6.30 per share, the market value drops to $12,600. While this value is smaller than the $31,250 in the cash exercise, the cashless exercise also has no debt. Therefore, the net financial position of the shareholder is likely much more comfortable.

(Should the stock price appreciate, however, holding fewer shares would mean the shareholder participates less in the upside as well.)

Is a Cash Exercise a Good Thing or Bad Thing?

A cash exercise will likely lead to owning more company stock than would otherwise be owned by implementing a cashless exercise. As we have illustrated, this concentration can be either good or bad. If the stock price goes up, you will likely be happy. If the stock price goes down, you will likely not be.

The right decision is a person-to-person and situation-to-situation decision.

Are you someone who is interested in market volatility, concentration risk, and generating wealth through investments? Or are you interested in spreading risk, allocating assets, and paying down debt?

Furthermore, what other assets and income do you have and/or expect, and do you look at your company provided stock as simply another form of compensation?

The combination of these answers may lead to a suitable stock option plan that works for you and your financial goals.

There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The above hypothetical examples are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

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