The Math Behind a Cashless Exercise of Non-Qualified Stock Options

When the time comes to exercise non-qualified stock options, the question of whether to perform a cash exercise or a cashless exercise is a common one. In many cases, option holders default into a cashless exercise—and for good reason.

Among other things, a cashless exercise may be an easy option and may result in zero cash outlay.  The ease at which a cashless exercise is performed makes it an attractive option, and subsequently, it is the one many choose to initiate.

In a cashless exercise, one goal is to pay for the associated costs of exercising stock options with the shares themselves. The net effect of this transaction is that the shareholder ends up holding fewer shares of stock after the exercise than they did before.

For many reasons, option holders are often satisfied with this post-exercise outcome. They may not have the cash on hand to pay for the associated costs, or they may want to divest a portion—or even all—of their company stock. They also may be approaching an expiration date that says it’s now or never.

Whatever the reason—and there are many—a cashless exercise may be the way to go.

All of this begs the question, what actually occurs to your shares when you choose this method?

Example of a Hypothetical Cashless Exercise

Let’s assume we have an option holder who owns the following lot of non-qualified stock options that they wish to exercise.

Option Type Number of Shares Grant Price Exercise Price
Non-Qualified 1,000 $20.00 $80.00

 

From the chart, we can see that the option holder has the right to buy 1,000 shares of stock at $20.00 per share for a total cost of $20,000. These shares are worth $80,000 on the open market, for a potential profit of $60,000. These options are “in the money,” meaning they have real value.

Unfortunately, these in-the-money stock options also incur costs upon exercise (interestingly, pre-exercise, while the shares are being held, there are no costs incurred). Specifically, two costs should be considered that may impact the cashless exercise.

  1. The cost of buying the original shares at the grant price of $20 per share
  2. The income/wage and any taxes associated with exercising the non-qualified stock options

It’s these costs that directly impact the cashless transaction.

The Math Behind a Cashless Exercise

A cashless exercise allows the option holder to use a portion of their shares (1,000 in our example) to offset the costs of the transaction. Just how many shares are used can be calculated following the steps below:

1 – Calculate the cost of buying the shares. In our example above, the number of shares being exercised times the grant price would equal the cost of buying the shares.

1,000 X $20.00 = $20,000

2 – Calculate the income tax due upon exercise, which is often a multi-step process. This is equal to the number of shares times the difference between the exercise price and the grant price.

1,000 X ($80.00 − $20.00) = $60,000

3 – Use the taxable income calculated in step 2 to calculate the taxes owed. (All tax rates are assumed for hypothetical purposes only and do not necessarily include all taxes to be incurred.)

Federal tax = $60,000 x 25% = $15,000

Social Security tax = $60,000 x 6.2% = $3,720

Medicare tax = $60,000 x 1.45% = $870

Add these three for a total of $19,590.

4 – Calculate the number of shares required to perform a cashless exercise.  The answer can be obtained by dividing the associated costs by the current share price.

Cost of buying the shares = $20,000 / $80 = 250 shares

Cost of paying the taxes = $19,590 / 80 = 245 shares (rounded up)

Add these two to obtain the total number of shares required, which is 495 shares.

5 – Calculate the number of shares remaining after the cashless exercise. This equals the total shares less the figure calculated in step 4.

1,000 − 495 = 505 shares

Exploring the Post-Exercise Impact of a Cashless Exercise

In the above example, the option holder performed a cashless exercise of non-qualified stock options that allowed them to capture imbedded gain with little to no cash outlay.

To put this another way, the option holder recognized gain, paid income tax, and reduced stock concentration with little to no cash required out of pocket.

However, by doing so, they transitioned from controlling 1,000 shares of stock to controlling 505 shares.   In our example, they went from controlling $80,000 worth of shares to controlling $40,500, which is nearly a 50% reduction. This is potentially a significant piece of a portfolio.

In addition, the remaining shares now have a cost basis equal to the exercise price ($40,500) and begin their holding period as a capital asset.

What Else Matters

So the question remains whether or not a cashless exercise is the right choice or not.

As you can imagine, there is no one right answer to this question. A cashless exercise may be the best option for someone who is seeking to minimize cash outlay or is seeking to reallocate any existing company stock.

However, a cashless exercise of non-qualified stock options may not be right for someone seeking to maximize long-term appreciation via concentration risk (while retaining the associated risk) or for someone that has adequate liquidity.

The timing of a cashless exercise may also impact the final decision. Is this decision a forced decision due to an expiration date, or is this part of a deeper options strategy that coordinates other option grants and other option types (such as incentive stock or restricted stock)?.

The above example is for illustrative purposes only and does not attempt to predict actual results of any particular investment.

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3 Responses to The Math Behind a Cashless Exercise of Non-Qualified Stock Options

  1. Adam March 8, 2017 at 5:51 pm #

    Hi, Daniel. Very clear explanation, thanks. One thing I’ve always wondered… in your example above, what happens to the $10 difference when you rounded up the number of shares you sold to cover the cost to purchase the shares and taxes? You sold 495 shares at $80 (=$39,600) but the cost of the shares and taxes was only $39,590. I perfectly understand why you need to round up to cover, but isn’t there $10 unaccounted for somewhere?

    • Daniel Zajac, CFP®, AIF®, CLU® March 9, 2017 at 5:42 pm #

      Correct – if I had rounded down, a few dollars of cash would be required to make the exercise even. Because I rounded the amount of shares up, a small amount of residual cash is likely due to the employee.

      • Adam March 9, 2017 at 11:03 pm #

        I may have to have a conversation with the brokerage that handles my options then because I checked back several exercises and they always round up and I don’t see the difference coming back to me. Is it possible they keep it and if so can that be legal?

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