Cash vs. Cashless Exercise – The Stock Option Conundrum

Stock option cash vs. cashless

Cash vs. Cashless Exercise

Evaluating whether to employ a cash or cashless exercise of your stock options can be difficult.  Nothing about the topic is easy, nor is it easy for amateurs to navigate.  This topic falls under financial planning 401, a graduate-level elective for the Financial Planning nerd (ahem…me).

If you find yourself holding stock options, then it’s critical that you spend some time becoming an expert.  Or even better, find someone who already is an expert!  It’s possible that a large portion of your net worth is tied up in company stock options, so you owe it to yourself to evaluate and execute a strategy that maximizes your value (within your stated goals).

The strategy you choose to implement will likely be one of the following:

Each strategy has its own advantages and disadvantages.  Below is a concise attempt to evaluate this multifaceted subject by addressing what I believe are the key issues.  Essentially, this is the Cliff Notes version of that 500-page textbook that your finance professor assigned you in college.

Option 1 – A Cash Exercise

If the goal is to control as many shares of company stock as possible, then a cash exercise is the best option.  A cash exercise entails the following:

  1. You buy shares of the company stock at the grant price of your stock options.
  2. The price you pay for your shares is the grant price multiplied by the amount of shares you wish to buy.
  3. You need to write a check for the cost of the shares. This is an out-of-pocket cost that the person holding the shares will need to supply.

Depending on the number of vested shares that you are eligible to buy, the out-of-pocket cost of a cash exercise may be in the hundreds of thousands of dollars.  Unfortunately, most of us don’t have hundreds of thousands of dollars just sitting around.  For this reason, it’s not uncommon for employees to be “priced out” of this option, forcing them to employ a cashless exercise or an outright sale of the stock.

If you are one of the lucky few with that sort of cash on hand, these are a few highlights of a cash exercise:

  • A cash exercise maximizes the total amount of shares owned outright.
  • It typically results in anti-diversification. The buyer of the shares often holds a concentrated position of company stock that encompasses a large percentage of their net worth.  You’ve surely heard of not putting all your eggs in one basket.  This strategy is basically the opposite of that.
  • If you have incentive stock options, then a cash exercise increases the likelihood that you will be subject to the alternative minimum tax.
  • It often requires the use of cash on hand, or the liquidation of other assets to pay the up-front cost of buying the shares.

Typically, clients who choose a cash exercise are planning to hold the company stock in the medium and long term.  Holding on to the company stock exposes the investor to both the upside and downside risk of the markets.  If the stock price goes up, you win.  If the stock price goes down, you lose.

Option 2 – Cashless Exercise

If the goal is to have “some” shares, then a cashless exercise is a good strategy.  A cashless exercise is often the default option for people who don’t have hundreds of thousands of dollars readily available (i.e., most of the population).

A cashless exercise consists of the following:

  1. You buy shares of the company stock at the grant price of your stock options.
  2. The price you pay for your shares is the grant price multiplied by the amount of shares you wish to buy.
  3. You will need to pay for the shares of stock. However, instead of writing a check for the shares, you pay for your shares of stock…with other shares of stock.
    1. This means that you will immediately exercise and sell some of your shares, while also exercising to hold on to other shares.
    2. The amount you exercise and sell will be dependent on a number of factors, including your grant price, the current stock price of your company stock, and your personal goals.

A cashless exercise can be designed to cover only the cost of the shares that you need to purchase, the tax liability you will incur on the exercise of your shares, or both.  Again, the choice of how many shares you wish to buy and hold and how many shares to buy and sell depends on the grant price of your shares and the current price of the stock.

Now that you understand some of those details, let’s take a moment to understand what this all means.

  • A cashless exercise is exactly what it sounds like – you are not required to use any of your own money to exercise your stock options. You will use a portion of the embedded value of your stock options to exercise the rest.
  • A cashless exercise neither maximizes nor minimizes the amount of shares you own outright. You likely end up “somewhere in the middle.”
  • It’s possible that you will still own a concentrated position in the company’s stock, but it will not be as concentrated as your position after a cash exercise.
  • If you have incentive stock options, then a cashless exercise may still lead to an alternative minimum tax hit, but that hit will be lower than that of a cash exercise.

If you are a “get your feet wet, I’ll have a little of this and a little of that” type of person, or if you simply can’t afford to transact a major cash exercise, then you may find yourself in this scenario, and a cashless exercise may be your best option.

What Now?

When you are given stock or stock options as part of your compensation package, it may offer a fantastic opportunity to create substantial wealth.  Because of this opportunity, you should take the adequate care to ensure the decisions you are making are opportunistic and in your best interest.

It’s also fair to note that the potential tax and investment issues associated with exercising stocks options are complicated.  Often more complicated than what a novice can handle.

If you find yourself in this situation, I encourage you to be a quick study or to hire the services of a qualified professional.

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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