How to decide when to exercise your stock options

Stock options can potentially be a very rewarding benefit for an employee—one that may let you financially gain when the value of their company’s stock climbs. But deciding when to exercise your stock options can be tricky. The following can help you determine whether you should exercise your stock options now or wait until later.

What does exercising stock options entail?

When you receive stock options, you’re afforded the right (but not the obligation) to buy shares of your company’s stock at a pre-determined price known as the “strike” or “exercise” price, which is outlined in your stock option grant. This essentially means you can buy the shares at that strike price, regardless of the fair market value.

Key factors as you consider exercising your options

The following are some key factors to reflect on when you consider exercising your options.

1. Strike price versus current market price

The difference between the strike price and the current market price is possibly most important.

If your stock’s value is substantially above the exercise price, you may decide to exercise and secure those gains. For example, if your strike price is $20 per share and the current price is $100, exercising your options lets you buy those shares at what is ostensibly an $80 discount (and possibly sell them for a profit).

But if the share price is less than the exercise price, you may opt to wait. Why? Because in such a case, exercising your options would result in you paying more than the current value of the asset to acquire it. Therefore, you might decide that the sensible strategy here would be to wait until the value of the company increases before exercising the options.

2. Tax implications

The timing of your exercise can have important tax implications.

When you exercise stock options, you may cause a tax event, which could result in income taxes or capital gains being owed. If the company is private and the market for the shares is illiquid, then you may then need to use your own capital to cover the tax liability (in addition to having already paid the exercise costs out of pocket).

For non-qualified stock options (NSOs), the difference between the strike price and the market price at the time of exercise is taxed as ordinary income. However, from exercise to liquidation (sale), the character of the gain or loss changes from ordinary income to capital gain/loss.

With Incentive Stock Options (ISOs), there is generally no ordinary income tax due when the ISO is exercised. ISO tax treatment depends on how long you hold the shares after exercising them, before selling them. If you sell the shares within a year of exercising, the gain is deemed ordinary income. If you hold them longer (more than one year from exercise, and more than two years from when the option was granted) you may qualify for long-term capital gains treatment.

The Alternative Tax Minimum (AMT) is a parallel tax system designed by the IRS to ensure that high-earning individuals pay at least a minimum amount of tax—even if they have significant deductions or credits under the regular tax system. When you exercise ISOs, the difference between the exercise price and the fair market value at the time of exercise is not taxed under regular income tax immediately. But for AMT purposes, that element is considered income in the year of exercise.

3. Company growth prospects and future stock value

The potential for your company’s value to rise or fall in the future is another key consideration.

If your company is still in its growth phase and you think the share price will climb significantly, waiting might enable you to exercise your options at a time when they have a much greater intrinsic value (i.e. the company valuation far exceeds your exercise price). But there are risks to this approach given that company valuations can be volatile and waiting to exercise may not necessarily yield the expected returns. And it’s important to further recognize that delaying an exercise can push off long-term capital gains treatment to the future, versus starting the holding period.

4. Expiration dates and vesting schedules

Stock options routinely have expiration dates, which means there are limited windows in which to exercise them.

If your options are approaching expiration, you must determine whether to exercise before that date, even if the stock price hasn’t climbed to the level you hoped.

Exercising early may seem like a smart move, but bear in mind that you’ll still need to cover the cost of the options at the strike price, as well as cover any taxes owed.

Further, stock options often vest over time. If you have unvested options, you may not be entitled to exercise them at any stage. It’s important to monitor the vesting schedule and factor this into your decision about when to exercise.

5. Your financial situation

Your current financial situation could impact your decision about when to exercise stock options, because upfront capital is required to exercise the options to buy the shares.

If you cannot afford to do so, you might need to explore alternative financing options such as selling assets or taking out a loan.

Exercise now or wait?

Deciding when to exercise your stock options depends on your financial goals, tax situation and the outlook for the company’s future, among other considerations. If the stock’s market price is favorable, your tax implications are manageable, and you have the required capital, it may be the best time to exercise your options. But, if you predict that the company’s stock is rising in the future, or if you seek to minimize tax liabilities, it might be prudent to wait. By mulling over these factors, you’ll be better prepared to make the best decision possible for your unique situation.

If you want to learn more about how to sell your private company shares, please read this guide. Or, if you’re ready to get started, create a Forge account today.