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Employee Stock Options. Part 2: Profiting from Your OptionsOct 16 '00 Write an essay on this topic.These days, it seems like everyone with a high-tech job has employee stock options. Options can be a great source of additional income or even a chance to amass great wealth. Unfortunately, most option holders will never realize their full financial potential because they lack knowledge about options, taxation and investment in general and they use misguided strategies for managing their options. Profiting from your employee stock options can be a 10-year or longer project involving dozens or even hundreds of individual financial decisions. There's no way I can give you comprehensive advice here. For complete coverage I suggest you read Kaye A. Thomas's Consider Your Options: Get the Most From Your Equity Compensation. What I will do here is list the most important decisions you have to make and give you a series of do's and don'ts I've picked up while managing a dozen options of my own and watching fellow employees manage (or mismanage) theirs. Option Management Decisions The nature of the decisions you have to make is fairly limited: 1) When to exercise your option(s). 2) When you do exercise, how many shares to buy (typically you don't have to exercise an entire option at one time). 3) When to sell the shares you bought and how many to sell. 4) Whether or not to make the Section 83b election when it is applicable. 5) How to raise the cash needed to exercise your option. Unfortunately, the timing of these decisions is very difficult because the most important decision factor--the stock price--is unpredictable. Do's - Know which of the two major types of option you have: non-qualified options (NQOs) or Incentive Stock Options (ISOs). Since the taxation of NQOs and ISOs is completely different, the distinction has a profound effect on your overall option management strategy. - Review and understand every word of your individual option agreement, including number of shares covered, price per share, period of time during which you may exercise the option, restrictions on exercise and subsequent sale of the shares, process for exercising the option, effect of merger, acquisition or other change in ownership of the company, what happens if you are fired, etc. - Know everything you can about taxation of the type of option you have. If you have an ISO, you'll have to learn about the alternative minimum tax (AMT). Be sure you know the difference in tax rates on ordinary compensation income, short-term and long-term capital gains. - If your option agreement restricts your ability to sell shares immediately after you buy them, familiarize yourself with the tax code's Section 83b election, which may reduce your tax liability. - Learn everything you can about investment in general, especially the importance of diversification, methods of hedging against downturns in stock price (such as writing covered calls, buying puts, and selling short against the box), and the risks associated with holding stocks. - Know a good thing when you see one. If you can exercise an option profitably, it may be a good time to do it. This is especially true if you have additional options. Regularly exercising profitable options is a form of time diversification akin to the well known dollar cost averaging method of accumulating stock or mutual funds. - Know your levels of risk tolerance and personal financial strength and work within them. If you think a money market fund is risky, you'll probably get an ulcer if you borrow money to exercise an option and than hold onto the stock. On the other hand, if you're comfortable with high risk, exercising and holding are probably right for you. - Enlist the aid of a well qualified financial planner and tax advisor to help you plan your option strategy. Make sure these advisors have lots of experience with option holders. - Before you exercise an option that does not immediately yield vested stock, consult a trusted tax advisor about the Section 83b election. You must make this election within 30 days of exercising an option, and once made, it is irrevocable. Be sure you understand both the advantages and disadvantages of making the election. Don'ts - Don't assume you can predict the futures price of your company's stock. You can't. - Don't assume the stock price will simply increase over time. It won't. Just ask the employees of Yahoo!, Amazon, ETrade, PriceLine, Cisco, etc. This is especially true of startups which often have their day in the sun before going bankrupt. - If you're working for a startup, don't assume your company will succeed. Realize that about 7 out of 10 startups fail and that only 1 in 10 becomes a huge success. It may be wise to take advantage of any runup in the stock price to exercise and bail out. - Don't assume undue risk just to save on taxes. Many people hate taxes so much that they will do almost anything to avoid them. They tend to hold onto the stock in the hope of eventually realizing some profit in the form of lightly taxed long-term capital gains. By doing so, they assume the risk of a price decline. It may be great to turn a $40,000 tax liability into a $25,000 one, but imagine losing $100,000 in stock value just because you abhor paying $15,000 more in tax. - Don't rely on advice based on hindsight related to stock prices (e.g. "I should have waited a year to sell because the price went up; therefore you should wait to sell"). Remember, stock prices are unpredictable. Some Psychological Factors As you deal with your options, you will undoubtedly experience greed, fear, doubt, helplessness and other strong emotions. These emotions will not help your decision making because they tend to deny the reality of your situation. For example, greed may cause you to forego exercising a profitable option in anticipation of an even more profitable exercise which might never materialize; helplessness or doubt may cause you to hang onto stock whose price is declining when you really should sell it. Combined with wishful thinking, these emotions can be downright hazardous to your financial health. Wishing that the stock price were higher won't make it so. Try to keep firmly grounded in reality. Realize that you can only know the value of your company's stock today and realize that it may not be the next hot stock. Some Warnings I am not a financial consultant, but I have managed more than a dozen of my own options very profitably. There are very important differences between NQOs and ISOs, especially with regard to taxation, that are not treated here. If you have ISOs, beware of the alternative minimum tax.  |
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