Understanding the Complex Landscape of Executive Stock Options

by
Ken Dugan, CFP®

Interview of Ken Dugan, CFP®, Managing Director at LEO Wealth

Executive stock options are often a vital component of corporate compensation packages, offering a mechanism for aligning the interests of senior management with those of shareholders.

Stock options grant executives the right to purchase company stock at a predetermined price within a specific timeframe. As a form of executive compensation, stock options require more detailed planning than simpler forms of pay like cash bonuses or 401(k) matches.

This article, by Ken Dugan, Managing Director at LEO Wealth, explores the fundamental aspects of stock options, strategic exercise planning, and tax implications.

What are Stock Options for Executives?

Stock options are not actual shares of stock. An option is the right to buy stock at a specified price (strike price) within a specified time period. At the end of that time period, the option expires at a set expiration date.

There are two primary types of stock options: Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs), each with distinct tax treatments and conditions.

When your company awards you stock options, you will receive a stock option grant, which entails:

  • The type of stock options you’ll receive (ISOs or NSOs)
  • The number of shares you can purchase
  • Your strike price
  • Your vesting schedule

Your stock option grant should also specify its expiration date. In general, options expire 10 years from the date you’re granted them.

The vesting schedule outlines when executives can exercise their stock options, based on continued employment or performance milestones.

For instance, an option may vest over four years, with 25% vesting annually. This incentivizes executives to stay with the company and align their performance with its long-term goals, influencing their strategy and timing for exercising options.

Should the value of the stock go up, it can lead to substantial financial gain as the strike price of the stock option remains the same.

The Power of Leverage in Stock Options

A stock option provides a leveraged investment. It lets the holder control a significant amount of stock without the full upfront cost of directly buying the shares.

Leverage in stock options acts like an interest-free, non-recourse loan.

  • The benefit of the economic investment in the stock, without the current cost of a market acquisition, does not carry an interest cost to the option holder.
  • The loss in value of the investment over time, thus rendering the options worthless, does not cause any incremental economic cost to the option holder.

When the market price of the stock is close to the strike price, leverage is at its highest because small changes in stock price can significantly affect the value of an option.

Conversely, as the stock price moves significantly above the strike price, the leverage effect diminishes, reducing the additional value provided by the option.

When the stock’s market value reaches 2.5 times the grant price, the leverage within the stock options begins to dissipate. This is a crucial threshold where there is little difference between holding the stock and holding the option, as the benefit of leverage is essentially exhausted.

At this point, it is generally an opportune time to exercise options, as the mathematical advantage of leveraging the options has diminished.

The Role of Time Value

The ‘time value’ of stock options represents the potential for additional gain due to the stock’s performance over the option’s duration.

Factors like market volatility and the time until expiration influence this time value. A volatile stock has a higher upside potential over time. The higher the volatility, the higher the time value is.

As the expiration date approaches, the time value decreases.

One must consider the optimal timing for exercising their options, balancing the intrinsic value with the time value to maximize potential returns. The intrinsic value is the difference between the fair market value of the stock and the exercise (strike) price.

Typically, if a stock option has only two years remaining until expiration, we advise clients to consider exercising sooner rather than later.

This approach is particularly prudent in volatile markets, where a significant correction could erase the value of the options. For instance, during the great financial crisis, it took two years for the market to begin its recovery.

Waiting too long could mean losing the opportunity to exercise the options when they still hold substantial value, especially as they approach expiration.

Strategic Considerations Before Exercising Stock Options

Executives must evaluate several factors before exercising their options. The decision whether to exercise, hold, or sell stock options should be based on:

Your Current PositionPotential Considerations & ConstraintsFuture Objectives
– Views on underlying stock
– Current overall asset allocation strategy
– Amount of portfolio in a single stock
– Your current risk tolerance
– Leverage
– Time value
– Option expiration dates
– Current and future economic position in company stock
– Current and future individual federal and state income tax situation
– Share ownership guidelines (if applicable)
– Evaluate upcoming cash flow requirements
– Retirement timeframe
– Financing/liquidity objectives

Once your stock options are vested, you are eligible to exercise them, which involves arranging the necessary funds to purchase the shares.

For example, if you have a contract for 2,000 shares at $50 per share, you would need to spend $100,000 to buy all of them, plus any trading commissions and fees for the transaction.

After exercising, you can hold the company stock, similar to purchasing them off the stock market.

Alternatively, you can sell the company stock.

Each strategy has advantages and disadvantages, as per the table below. Your strategy can be a hybrid approach combining the different alternatives presented in the table, depending on what combination provides the optimal result when considering your planning objectives and risk tolerance.

 AdvantagesDisadvantages
Hold Options– Opportunity to share in appreciation with no cost
– Limited downside risk
– Do not own stock
– No voting rights
Exercise and hold stock– Share in long-term appreciation of stock
– Receive dividends (if any)
– Potential LTCG tax treatment for post-exercise appreciation
– Accumulate company stock
– Have to make cash/stock outlay for option price, unless cashless option exercise is available
– Market risk of owning stock
– Lack of diversification  
Exercise and sell stock– Receive cash
– Eliminate risk of drop in stock value
– Diversification
– Do not benefit from any stock growth  

Be careful not to hold too much of your company’s stock in your overall portfolio. It’s generally safer to diversify your investments rather than concentrating too much wealth in the stock of a single company.

Tax Implications of Stock Options

The taxation of stock options is complex and can significantly impact the net benefits received.

If you are an American working abroad with stock options granted by an American company, the taxation on these options remains the same as it would be if you were residing in the United States.

Non-Qualified Stock Options

NSOs are taxed as ordinary income at the time of exercise, based on the difference (spread) between the stock’s market value and the strike price. The ordinary income tax rate can go up to 37% for federal plus state tax, making it a significant consideration.

Any subsequent appreciation when you sell the stock, is taxed as capital gain at 23.8% plus state tax. To qualify for the lower long-term capital gains rate, you must hold shares for at least a year before selling. Otherwise, the gains are taxed at the higher short-term gains rate, the same as your income-tax bracket.

Incentive Stock Options

ISOs, on the other hand, offer a potentially more favorable tax scenario. They are not taxed under ordinary income when exercised. Instead, if certain conditions are met, the gains may be taxed as capital gains at a lower rate of 23.8%, plus state tax.

However, to qualify for this treatment, the stock must be held for at least 1 year after the options are exercised and 2 years after they were granted. This holding period introduces a risk if the stock value decreases during this time.

The spread is considered a deferral adjustment for purposes of Alternative Minimum Tax (AMT), but not for regular taxes purposes. A credit is available for AMT generated due to the ISO status.

Strategic Tax Planning

Effective tax planning is crucial when it comes to exercising stock options. Executives must be strategic about when they exercise their options to manage their tax liabilities efficiently.

For instance, exercising NSOs can increase your ordinary income, potentially pushing you into a higher tax bracket.

Exercising ISOs in a year when one has higher ordinary income can help mitigate the impact of the AMT.

By carefully planning the exercise of stock options and the subsequent sale of stock, you can maximize tax benefits and manage the risks [RR1] associated with stock value fluctuations.

If not handled and planned properly, stock option taxation can lead to unnecessary additional tax to be paid for.

Managing Risk and Timing

The timing of when to exercise stock options can significantly impact financial outcomes due to the volatile nature of stock prices.

If stock options have appreciated substantially, exercising them at strategic times can lock in gains and spread the tax burden over multiple years to manage cash flows more effectively.

However, it’s important to remember that stock options are like double-edged swords. The .com bubble is a stark reminder of how quickly fortunes can change. Many executives faced financial ruin when they exercised their options only to find their stock values plummet, leaving them with hefty tax bills related to AMT exposure.

Stock Option Advisory at Leo Wealth

Stock options are a powerful tool for wealth generation, but many miss out on maximizing their value due to lack of understanding or planning.

It’s crucial not to underestimate the complexity and importance of handling your stock options. Executives considering their options should engage in thorough planning and seek professional advice to avoid common taxation pitfalls and maximize potential benefits.

It is important not just to have a plan, but also to have a knowledgeable advisor to guide you through the process and help adjust the strategy as market dynamics evolve.

Contact LEO Wealth today to begin crafting a plan that grows with you and your ambitions.


DISCLOSURES

The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.

Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market.  They are methods used to help manage investment risk.

Options are not suitable for all investors. There are risks involved in any option strategy. Individuals should not enter into option transactions until they have read and understood the option disclosure document titled “Characteristics and Risks of Standardized Options,” which outlines the purposes and risks of option transactions. This booklet is available from your Financial Advisor or at http://www.theocc.com/about/publications/character-risks.jsp.  Supporting documentation of claims will be supplied upon request.

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