In this section, we use the common year grant term to expiration to demonstrate the risk and reward associated with owning ESOs. As your exercise price and the stock price are the same, this is an at-the-money option. Once the stock begins to rise, the option has intrinsic value, which is intuitive to understand and easy to compute. But a common mistake is not realizing the significance of time value, even on the grant day, and the opportunity cost of premature or early exercise.
In fact, your ESOs have the highest time value at grant assuming that volatility does not spike soon after you acquire the options.
With such a large time value component—as demonstrated above—you actually have value that is at risk. This loss of time value should be factored in when computing your eventual return. Before we look at some of the issues surrounding early exercise—not holding ESOs until expiration—let's evaluate the outcome of holding ESOs until expiration in light of time value and tax costs.
Below shows after-tax, net of time value gains and losses at expiration. As a way to reduce risk and lock in gains, early or premature exercise of ESOs must be carefully considered, since there is a large potential tax hit and big opportunity cost in the form of forfeited time value. In this section, we discuss the process of early exercise and explain financial objectives and risks. When an ESO is granted, it has a hypothetical value that—because it is an at-the-money option—is pure time value.
This time value decays at a rate known as theta, which is a square root function of time remaining. You believe in the long-term prospects of your company and plan to hold your ESOs until expiration. Even if you begin to gain intrinsic value as the price of the underlying stock rises, you will be shedding time value along the way although not proportionately. The further out of the money that an option is, the less time value it has, because the odds of it becoming profitable are increasingly slim.
As an option gets more in the money and acquires more intrinsic value, this forms a greater proportion of the total option value. In fact for a deeply in-the-money option, time value is an insignificant component of its value, compared with intrinsic value. When intrinsic value becomes value at risk, many option holders look to lock in all or part of this gain, but in doing so, they not only give up time value but also incur a hefty tax bill.
We cannot emphasize this point enough—the biggest downsides of premature exercise are the big tax event it induces, and the loss of time value. After you have acquired stock that presumably has appreciated in value, you are faced with the choice of liquidating the stock or holding it. If you sell immediately upon exercise, you have locked in your compensation "gains" the difference between the exercise price and stock market price.
But if you hold the stock, and then sell later on after it appreciates, you may have more taxes to pay. Remember that the stock price on the day you exercised your ESOs is now your "basis price.
To get the lower, long-term capital gains rate, you would have to hold the shares for more than a year. You thus end up paying two taxes—compensation and capital gains. Many ESO holders may also find themselves in the unfortunate position of holding on to shares that reverse their initial gains after exercise, as the following example demonstrates. You now decide to sell one-half your holdings of 1, shares and keep the other half for potential future gains.
To summarize:. Note that this does not count the time value lost from early exercise, which could be quite significant with five years left for expiration. Having sold your holdings, you also no longer have the potential to gain from an upward move in the stock. That said, while it seldom makes sense to exercise listed options early, the non-tradable nature and other limitations of ESOs may make their early exercise necessary in the following situations:.
We discuss some basic ESO hedging techniques in this section, with the caveat that this is not intended to be specialized investment advice. We strongly recommend that you discuss any hedging strategies with your financial planner or wealth manager. We use options on Meta FB , formerly Facebook, to demonstrate hedging concepts.
For reference, the Jan. To keep things simple, we assume that you wish to hedge the potential share long position to just past three years i. Of these strategies, writing calls is the only one where you can offset the erosion of time value in your ESOs by getting time decay working in your favor.
Buying puts aggravates the issue of time decay but is a good strategy to hedge downside risk, while the costless collar has minimal cost but does not resolve the issue of ESO time decay. ESOs are a form of equity compensation granted by companies to their employees and executives.
ESOs are not the only form of equity compensation, but they are among the most common. Stock options are of two main types. Incentive stock options, generally only offered to key employees and top management, receive preferential tax treatment in many cases, as the IRS treats gains on such options as long-term capital gains.
Non-qualified stock options NSOs can be granted to employees at all levels of a company, as well as to board members and consultants. Also known as non-statutory stock options, profits on these are considered as ordinary income and are taxed as such.
While the option grant is not a taxable event, taxation begins at the time of exercise and the sale of acquired stock also triggers another taxable event. Tax payable at the time of exercise is a major deterrent against early exercise of ESOs. ESOs differ from exchange-traded or listed options in many ways—as they are not traded, their value is not easy to ascertain.
Unlike listed options, ESOs do not have standardized specifications or automatic exercise. Counterparty risk and concentration risk are two risks of which ESO holders should be cognizant. Despite the large tax liability and loss of time value incurred through early exercise, it may be justified in certain cases, such as when cashflow is needed, portfolio diversification is required, the stock or market outlook is deteriorating, or stock needs to be delivered for a hedging strategy using calls.
Basic ESO hedging strategies include writing calls, buying puts, and constructing costless collars. They should also consult their financial planner or wealth manager to gain the maximum benefit of this potentially lucrative component of compensation.
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We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. What Is an ESO? Understanding ESOs. Important Concepts. ESOs and Taxation. Intrinsic vs. Time Value for ESOs. Comparisons to Listed Options. When a stock option vests, it means that it is actually available for you to exercise or buy.
Unfortunately, you will not receive all of your options right when you join a company; rather, the options vest gradually, over a period of time known as the vesting period. A four-year vesting period means that it will take four years before you have the right to exercise all 20, options. This is where that one-year cliff comes in: This means that you will need to stay with the company for at least one year to receive any of your options.
Once your options vest, you have the ability to exercise them. This means you can actually buy shares of company stock. Until you exercise, your options do not have any real value.
The price that you will pay for those options is set in the contract that you signed when you started. You may hear people refer to this price as the grant price, strike price or exercise price. No matter how well or poorly the company does, this price will not change. You can also hold it and hope that the stock price will go up more. Note that you will also have to pay any commissions, fees and taxes that come with exercising and selling your options.
There are also some ways to exercise without having to put up the cash to buy all of your options. For example, you can make an exercise-and-sell transaction. To do this, you will purchase your options and immediately sell them.
Rather than having to use your own money to exercise, the brokerage handling the sale will effectively front you the money, using the money made from the sale in order to cover what it costs you to buy the shares. Another way to exercise is through the exercise-and-sell-to-cover transaction. With this strategy, you sell just enough shares to cover your purchase of the shares, and hold the rest. You can find this in your contract.
When and how you should exercise your stock options will depend on a number of factors. You would be better off buying on the market. Company Stock Options has the meaning set forth in Section 3. Stock Option means a contractual right granted to an Eligible Person under Section 6 hereof to purchase shares of Common Stock at such time and price, and subject to such conditions, as are set forth in the Plan and the applicable Award Agreement.
Optioned Stock means the Common Stock subject to an Option. Stock Reload Option means any option granted under Section 6. Options means any rights, warrants or options to subscribe for or purchase shares of Common Stock or Convertible Securities.
Reload Option means any Option granted under Section 6 a iv of the Plan. Share Appreciation Right means the right pursuant to an Award granted under Section 8 below to receive an amount equal to the excess, if any, of i the aggregate Fair Market Value, as of the date such Award or portion thereof is surrendered, of the Shares covered by such Award or such portion thereof, over ii the aggregate Exercise Price of such Award or such portion thereof. Unissued Option Shares means the number of Shares, at a particular time, which have been reserved for issuance upon the exercise of an Option but which have not been issued, as adjusted from time to time in accordance with the provisions of section 5, such adjustments to be cumulative.
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