My Company’s Stock Is Down. Should I Exercise My Stock Options?
The stock market as a whole – and especially the technology sector – is experiencing a swift selloff. As of writing this, the NASDAQ is down 10% from its last all-time high in November 2021. During any market selloff, however, the question for stock option holders remains the same: “Should I exercise some or all of my stock options (or stock appreciation rights) while the stock price is down?”
For those with stock options (especially qualified or “incentive stock options”) or stock appreciation rights (SARs), there may be a way to make lemonade out of lemons. Read on for 6 steps when considering an option or SAR exercise during market swings.
Step #1 – Project Your Income for the Year
Before deciding whether an option or SAR exercise makes sense, you need a best estimate of your income for the year. Why? Because your income determines which tax bracket you will be in – and how much you’ll pay in tax following an exercise – this year (we’ll cover more on assessing the tax hit in step #3).
When calculating income, be certain to factor in all sources. This can include:
Base salary
Projected bonuses
Vesting restricted stock units (RSUs)
Sales of employee stock purchase plan (ESPP) shares
Rental real estate income
Freelance or consulting net income
Other investment income
On a similar note, don’t forget to offset your income calculation with deductions you utilize. Common examples include:
Retirement plan (e.g., 401(k) or SIMPLE IRA) contributions
Health savings account (HSA) contributions
Flexible spending account (FSA) contributions
Medical and dental premiums paid by you (not your employer)
Step #2 – Calculate Your Bargain Element
Simply put, your bargain element is the spread times the number of options or SARs. The spread is the stock’s current value minus your cost to purchase the shares (i.e., the strike price). Think of the bargain element as the real value to you of your stock options or SARs; it is the value you get to keep after the cost to exercise but before taxes.
For clarity, let’s look at an example:
A sales engineer at Microsoft was granted the option to purchase 400 shares of company stock for $200 per share. The company is trading at $300 per share. The $100 difference is the spread. Multiplying the $100 spread by the 400 shares they have the right to purchase, their total bargain element is $40,000.
For clients, I always like to prepare an equity summary that outlines their position at the grant level. This degree of detail can be exceptionally useful when determining the most cost-effective grants to exercise as well as which options should be exercised to reach the targeted bargain element. Additionally, this step helps conceptualize the actual value of your equity compensation. Here is an example:
Step #3 – Assess the Tax Hit from Exercising (and the Dreaded AMT)
With your estimated income and bargain element in-hand, you are equipped to approximate the tax bill resulting from an exercise. Begin by assessing which marginal tax bracket you are likely in. For example, if you fall into a 32% federal and a 9% state tax bracket, your regular income tax on the bargain element from a non-qualified stock option (NQSO) or SAR exercise will be 41%. Payroll taxes also apply, which – in some circumstances – can tack on another roughly 8% for a total tax of approximately 49% in this illustration. Furthermore, taxes are due whether the NQSOs or SARs are sold immediately or held for more than a year. Certainly, I’d want to know this before exercising any shares!
In the case of ISOs, though regular tax isn’t levied on options that are exercised but not yet sold, alternative minimum tax (“AMT”) potentially comes into play. AMT is a complex calculation with a wide variety of factors. The calculation gets tricky, and – candidly – robust tax planning software makes a world of difference when modeling different ISO exercise scenarios. One common approach is to begin with the question: “How much bargain element can I recognize from my ISOs before AMT kicks in?” This is frequently followed by identifying the grants that must be exercised to utilize the ‘wiggle room’ while keeping exercise costs (i.e., cash required to purchase the shares) lower.
To be crystal clear, exercising NQSOs and SARs does not contribute to AMT in and of itself. Rather, if you own NQSO or SARs as well as ISOs, the gain from one affects the other and must be taken into consideration before exercising either. In my experience as a financial planner specializing in helping families with company stock, it is rare that I come across early company employees that were granted ISOs and not also recipients of RSUs, ESPPs, NQSOs, or some other form of additional equity compensation after the IPO.
Step #4 – Assess Your Current Cash Level
A key building block for optimizing your equity compensation is thoughtful cash flow planning. Needless to say, swings in your company’s stock price make this a challenge. To help in that process, below are four quick questions to ask yourself about your cash on-hand before exercising stock options or SARs:
Do I plan to hold the shares after exercise or sell to pay the taxes an exercise creates?
If I exercise the options, will I be forced to sell shares at the wrong time to cover other expenses on the horizon?
How much will it cost to purchase the shares (e.g., strike price x share quantity)?
Is this the best, most advantageous, and productive use of cash available to me?
Step #5 – Assess Your Concentration in Company Stock Before and After the Exercise
A financial planner bringing investment risk? Shocking! </sarcasm> Before taking risk, however, it is essential to go in with eyes wide open. Fortunately, this can be quantified using several different frameworks. Examples are as follows:
What percent of your net worth is / would be tied up in company stock?
What percent of your investment portfolio is / would be tied up in company stock?
If your company’s stock performs poorly, what impact would this have on your future?
If the stock performs well, what doors would that open for you?
How much more stock are you on track to obtain in the future through ESPP, additional RSU grants, other vesting shares, or bonuses?
Naturally, substantively answering these questions goes far beyond the scope of just one blog post (perhaps an idea for a future series?). Nonetheless, at a bare minimum, putting hard numbers to these questions can be illuminating in understanding how reliant you are (or aren’t) on your company’s performance. After all, if you own your company’s stock, you’re not only an employee – you’re an investor! In real-life terms, this is a risk multiplier.
The bottom line: if you aren’t clear and/or can’t quantify the risk of owning your company stock as it specifically relates to achieving your life goals, don’t skip this step. If you have plans for those shares – such as enabling you to change jobs or professions, retiring early, traveling, or making a big purchase – spending time on this step is doubly important.
Step #6 – Determine If Exercising Is Worthwhile
The rubber meets the road here. Let’s break it down by equity type:
NQSO and SARs – The case for exercising NQSOs during a drop in the company’s stock price relies on ‘yes’ answers to at least four essential questions:
Do you believe the stock price will rebound?
Are you willing to hold the shares for at least one year?
Can you afford the total cost to exercise?
Is the concentration risk right for you?
If the optionee 1) holds the shares after exercise for at least one year and 2) the share price rebounds, the difference between a) the sale price and b) the market value at exercise is taxed at (usually) lower long-term capital gains (LTCG) rates.
Here’s the rub:
It is possible that the share price will fall below your purchase price, meaning you paid higher ordinary income taxes on the bargain element and are holding an underwater investment (at least for a period of time).
Ordinary income taxes must be paid upon exercise regardless of whether the shares are held or sold immediately. If you are forced to sell shares to cover the taxes, the potential benefits of exercising while the stock price is down are greatly reduced or eliminated altogether.
If your net worth is already concentrated in your company’s stock, this strategy increases your concentration, dependency on the company performing well, and risk.
There is no point in exercising out-of-the-money options or SARs, since you could purchase the shares for less on the stock exchange.
Bottom line: the 1) tax hit, 2) concentration risk, 3) need for cash to make this approach work limit the scenarios in which the strategy makes sense. Though rare, however, they do occur (ex: the strike price is low and current concentration is nominal).
ISOs – There is a better case to be made for exercising ISOs during a decline in the company’s stock price. The reason? The potential for favorable tax treatment. As anyone owning ISOs is likely to have researched, ISOs may be taxed at (again, typically) lower LTCG rates if the shares are held two years from grant and one year from exercise. What is favorable tax treatment? In the case of ISOs, it equates to a federal capital gains tax rate at sale between 0% and 23.8% plus your state income tax rate.
What’s the catch? Well, there are a handful of downsides to exercising ISOs such as:
As alluded to earlier, AMT can result in a ‘phantom’ tax of 26% or 28% federally on the exercised bargain element even when the shares aren’t sold and no cash is received in your account. Ouch!
As a result, a significant amount of cash is typically required to tax-efficiently manage ISOs.
The concentration risk is significant. Not only do you have your own cash tied up in purchasing the shares, but the potential out-of-pocket cost to cover AMT can add up quickly. These forces amplify the effect of company stock on net worth.
ISOs are most commonly issued to employees when a company is earlier on in the business lifecycle. Smaller companies tend to have larger swings in stock price and, by their nature, are often riskier investments.
Snowball strategy: for clients that are weighing the decision of exercising ISOs right now, I often discuss the concept of a snowball strategy. In short, this strategy uses a relatively small initial exercise and eventual sale to generate capital for additional future exercises. A snowball starts the clock on LTCG rates for a small portion of the total position and allows for additional exercises with proceeds from selling the initial shares. As an added benefit for situations in which limited cash is available, selecting lower strike price grants can further reduce the cost to exercise. Is a snowball strategy right for everyone? Of course not. For large ISO positions, it may require multiple years to complete. The increased length of time 1) retains concentration risk for longer, 2) limits the optionee’s choices for leaving their employer to avoid grant forfeiture, and 3) keeps capital tied up in company stock versus being used toward other goals or investments. Nonetheless, it is an interesting and potentially powerful approach for the right scenarios.
Bonus
What about my ESPP? In short, it depends. Most commonly, the discount for ESPPs is based upon the lower price at either the beginning or ending date of the purchase period. If the purchase period has just begun, or the stock price remains depressed through the end of the purchase period, participants may benefit from acquiring shares at a lower share price. With that in mind, a key question (among several) for employees with an ESPP to consider is: “Should I increase my contribution amount for the next purchase period?” Given the complexity of factors in answering this question, reach out to discuss your specific situation.
The Unsurprising DisclaimerThis is a blog post and is not intended as investment, tax, or legal advice. Please do not misconstrue this post as any of those things. This content is intended for informational purposes only and should not be relied upon for making investment or financial decisions. Rather, it is designed to help readers think about their equity compensation. Everyone’s situation is different; obtaining guidance from licensed, experienced professionals prior to taking (or deferring) any action is advised.