Cash In or Hold Tight? How to Decide When to Exercise Your Non-Qualified Stock Options
Written by: Harmony Wagner, CFP®, CPWA®
Executives who receive non-qualified stock options (NSOs) as part of their equity compensation package may not understand how to optimize this powerful compensation type. When designing a stock option exercise strategy, several different metrics can be useful to determine the value of each option and establish trigger points. Having a clearly defined stock option strategy is key to maximizing the benefit of the options.
Before discussing NSO strategy design, let’s first review how these options work. An employee is granted stock options which have an exercise price, vesting schedule, and expiration date. If and when the employee exercises the option, they will purchase the stock at the exercise price, which they can either continue to hold or sell. At the time of exercise, the employee will have an ordinary income tax liability equal to the value of the stock at exercise minus the exercise price. For example, if the option exercise price was $40, and the stock price was $50 at the time of exercise, the option holder would be responsible to pay ordinary income tax on the $10 difference between the two. If the stock is held for more than one year after exercise, any additional appreciation after the exercise date receives long-term capital gains treatment. It’s important to note that if the exercise price is higher than the actual value of the stock, the option is considered out of the money and would not be exercised. Based on the structure of NSOs, there are several ways to determine the right point to exercise.
Concentration risk, the exposure to any single company or industry, is a key element to consider. For executives who hold significant stock in their employer, through stock options, 401k, RSUs, etc, focus should be directed towards the appropriate percentage of their overall portfolio that should be comprised of that stock. When both your income and a significant portion of your investment are tied up in the wellbeing of a single company and/or industry, it creates an elevated risk environment. Exercising and selling NSOs to invest in a diversified, or less correlated investment, can help control exposure to concentration risk to within the desired parameters.
One of the reasons NSOs are such a powerful tool is because of leverage, which allows you to profit exponentially off of even small increases in the underlying stock price. Let’s return to the previous example, with a NSO that has an exercise price of $40 and a current market price of $50. The optionholder has $10 of “equity” in the stock, meaning that if she exercises today, she will immediately gain $10. If that market price rises to $60, that would represent a 20% increase in the stock price. However, the optionholder’s equity in this case increases 50% (from $10 to $20), representing leverage.
Using leverage as a tool in decision-making involves setting a threshold, typically around 40%, and exercising NSOs when their leverage ratio drops below that threshold. As your leverage decreases, there is less profit to be made by increases in stock price, so it becomes advisable to exercise. Using leverage to determine when the exercise can help optimize the multiplication power of non-qualified stock options.
Time value ratios also aid in the decision-making process by quantifying the value of the time remaining until expiration. The more time remaining until expiration, the more time for the stock price to potentially increase. Conversely, as the NSO’s expiration date nears, there is less time to increase, and theoretically it becomes less valuable to hold. By tracking the time value of your options, you can set a threshold to sell (usually within a year or less of the expiration time frame). If you have in-the-money options (options where the stock price is higher than the exercise price) that are about to expire, you should exercise to ensure you do not leave any free money behind.
While all of these factors may influence the decision to hold or exercise NSOs, other variables exist that are more personalized. For any option-holder, the conversation on whether to cash in or hold should also explore his or her cash flow needs, tax situation, expectations about the future of the stock, to name just a few. Given the complex strategic framework around NSO decisions, it’s important to work with an expert to evaluate a custom approach to handling this powerful benefit. If you’d like to speak to one of our advisors about your non-qualified stock options strategy, please contact our office.
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