Stock options give investors the right to buy or sell a specific number of shares of company stock at a pre-set price, for a fixed time period. The time period is known as a vesting period, and usually spans 3 to 5 years. During this time frame, certain percentages vest which means that you've earned the shares. However, you will still need to exercise the options, in essence purchasing them.
It is important to note that there is no obligation to buy or sell for the investor. It is merely an option for the investor, one with potential big advantages. How do stock options work though? Let's take a deep dive in and review what you can use stock options for and how to potentially cash in early.
How Do Stock Options Work?
Stock options are a great way to retain employees or bring in prospective employees. Employees who have been given stock options have higher incentive to stay with a company. This is because the options aren't vested until a certain timeframe. Options won't be granted to the employee until the end of the scheduled vesting period.
For potential employees, stock options give them a chance to own stock in the company at a reduced price. Having an option to own company stock at a lower price than what you can buy on the open market is a great incentive to a new hire.
Understanding Stock Terminology
In order to fully understand what stock options are, we need to understand some of the basic terms used. With stock options, you may have seen the following:
For the buyer of the stock options, the price they are willing to pay is called the bid price.
For the seller of the stock options, the price they are willing to sell is called the ask price.
The strike price is the price that is set when you are allowed to exercise your options.
A call option provides the stock option owner the right to buy the stock during a set timeframe at a predetermined price.
A put option provides the buyer of the stock option the ability to sell the shares during a set timeframe at a fixed price.
Stock option shares usually vest over a set period of time. The date at which you can exercise the option on vested shares is known as the vesting date.
The expiration date is the date at which the options must be exercised prior to them expiring. Once they expire, the stock options are essentially worthless.
Vested vs. Unvested Stock Options
You may have heard or vested and unvested stock options, below we will explain what each option is and the differences between the two.
Unvested Stock Options
Perhaps your company has put aside an amount of stock for you. There may be certain stipulations on them before these stocks can be granted to you. If there are defined terms that must be met prior to the stocks being assigned to you, this means that they are unvested. Having unvested stock options means that your potential shares have not yet met the requirements to be vested.
Vested Stock Options
Let's say that you are offered stock options by a company. You are unvested in these stock options within a certain pre-set time period. Once that time period has lapsed, you will become vested. There are usually milestones where you will become more and more vested up until a certain point.
There is usually a 1-year cliff where you are unvested up until that point. Then there are month to month increments of gained vesting percentage. Typically at a point around 3 to 5 years, at which you will become fully vested. At this time you can choose to purchase the company's stock at the set price.
Can You Cash In Stock Options Early?
The short answer is yes, you can cash in stock options early. But should you? A company may have awarded a stock option to its employees, for example. If they so choose, the employees can cash in on these options in order to perhaps get a better tax outcome.
The downside of this option is that the employee will have to cover the cost to purchase the shares prior to the vesting date. The shares that are purchased will still need to follow the company's vesting schedule as well.
As an example, let's say that an employee has 20,000 options to buy stock in her company at $20 a share. The shares vest after 4 years, but she chooses to exercise half of those options after 2 years. Exercising 10,000 options at the current price of $30 will cost $28,000 (based upon a 28% AMT). Said employee can lower the federal tax percentage by hanging onto the exercised options for the remaining 2 years. This will allow the employee to meet the requirements necessary for capital gains taxes.
Can You Exercise Stock Options Without Cash Upfront?
Like in the example above states, you must buy your stock at the current price in order to cash in on their options. This might be a difficult task if you do not have the cash up front - but you have options. Your financial advisor might have lending options available to you specifically tailored to exercising your stock options early. They can walk you through the process to reduce your tax liability while still following the guidelines in your vesting schedule.
When to Cash in Your Stock Options Early
Cashing in your stock options early is a big personal financial decision to make. There are a few circumstances in which this may be in your best interest however. Here are some of the instances when you may want to consider exercising your options.
Meet With A Financial Advisor
When you make any decision regarding your finances, you need to consider meeting with a financial advisor. This should be a no brainer, especially when it comes to stock options. These could have tax implications that you may not be aware of.
Paying Off High-Interest Debt
You may want to consider paying off high-interest debt as opposed to seeing if the company will outperform the market. If you have lots of debt, paying that off is always a smart decision.
Enhancing Your Emergency Fund
If you feel anxious about your current financial situation you may want to look into boosting your rainy day funds. This is one way to achieve peace of mind by getting money that is easily accessible.
Down Payment For A House
It may be time to move into a house and you may be lacking the down payment. Cashing in your stock options early could present you with the opportunity to get the funding needed to kick the process off.
Shocking news of the day: Tuition is costly. If you are struggling to come up with the money to pay off your children's tuition, consider cashing in your stock options early. This could be one avenue to gain that seed money.
Other Investment Opportunities
Perhaps your company is not performing up to your expectations. It may be time to invest in other opportunities that may be more profitable in the long term. This is another possible outlet for you if you cash in your stock options early.
Knowing Your Stock's Worth
Stock options can be a great investment opportunity for investors, contractors, consultants or employees. It is important to know what the contract is worth, what the strike price is, what the expiration date is, etc. All of these factors lead into deciphering how much your stock is worth and how you can use them to their fullest potential.
There may be reasons to cash in your stock options. Depending upon your goals and what the stock is worth, it may be a worthwhile exercise. Checking in with a financial advisor is always a good choice if you are unsure of what to do with your stock options.
Athanassios Panagiotakopoulos is an Investment Advisor Representative with Dynamic Wealth Advisors dba Life Managed. All investment advisory services are offered through Dynamic Wealth Advisors.