Sometimes employee stock options are lucrative enough to finance early retirement. Other times, they end up being completely worthless—and it’s impossible to know which way your stock options might trend in the future, even with the help of experienced financial advisors. Your employer’s stock market performance determines how much money (if any) you’re able to earn.
If you’re new to employee stock options, here’s a brief overview of how ESOs work. Employers often grant stock options to an employee as part of their compensation package. When you’re granted ESOs, you’re being given the option to buy company stock at a preset price sometime in the future. If the company performs well between now and the vesting date (when you’re allowed to exercise your options and buy the stock), the market price for the company’s stock should be higher than what you pay for it.
There are a few significant risks associated with employee stock options. The first is the fact that options are essentially worthless until they vest. If you accept a job that offers ESOs as part of the compensation package, you’re not going to see any money from that benefit until your options vest. After they vest, there’s still no guarantee that your employee stock options will be valuable. You won’t make any money by exercising your options unless the company’s stock price goes higher than your grant price.
Another risk of employee stock options is that they may lock you into a job that you’d rather leave. The vesting schedule for ESOs often includes a cliff, or period of time that you’re required to stay with the employer before your options begin to vest. So if you have a four-year vesting schedule with a one-year cliff, your options don’t start vesting until you’ve been in your job for a year. A portion of your options may vest every year; for example, you may be able to exercise 25% of your options after the end of your second year, 50% of your options at the end of your third year, and so on. But if you leave the company before reaching the end of your vesting schedule, you’ll generally forfeit at least some of your options.
Having an unbalanced portfolio is also a risk of exercising employee stock options. If you spend the majority of your investment dollars on your own company’s stock, you’ll be in big trouble if the company fails. You could lose both your job and your investment value at the same time. Your financial advisors will almost certainly urge you to maintain a diversified portfolio, even if that means not exercising employee stock options.
Finally, the tax implications of exercising your options—while not necessarily a risk of ESOs—are something you need to prepare for in advance. Depending on what type of employee stock options you’re granted, you may be taxed when you first exercise your options and again when you sell them. Speak to your financial advisors and tax planners before making any moves with your ESOs.
With some luck and good strategic financial planning, you may be able to turn employee stock options into a substantial nest egg. ESOs can yield major returns if the company’s stock performance is strong.
Say you take a job with a startup and are granted 10,000 shares of stock with a grant price of $1 per share and a five-year vesting schedule. Five years later, your options are fully vested and you can choose to buy the 10,000 shares you’ve been granted. At $1 apiece, your price is $10,000. Let’s say the company has done well over the last five years and the market price for its stocks is now $10 a share.
At this point, you would want to reach out to your financial advisors to talk strategy. You could sell your shares for $100,000 and roll that profit into a new investment. Or, if you and your advisors think the company’s stock is going to continue to increase in value, you might decide to hold onto it and hope you can make an even bigger profit in the future. You might also decide to sell some shares and hold onto others.
It’s worth noting that you can still exercise your employee stock options when they vest even if you don’t have cash on hand to buy them outright. In a cashless exercise, a broker essentially fronts you the money to buy your shares and then immediately buys the stocks from you. You’ll pay some transaction fees that you wouldn’t pay in a cash exercise, but this strategy may be worthwhile if it means you can buy your shares without having to pull cash out of your retirement accounts or out of other investments.
Sachetta, LLC’s advisors work with clients on all elements of employee stock option planning. Whether you’re being granted ESOs for the first time and don’t know what to do, you’re ready to exercise options, or are interested in offering your employees stock options and need to talk tax strategy, we’re here to provide guidance. Contact us today.
As Senior Wealth Manager, Jeffrey R. Aron, CFP®, MSFP manages all aspects of Financial Planning and client services, including the preparation of comprehensive financial plans (retirement, education, cash flow, etc.), insurance and asset allocation recommendations, advanced estate planning strategies and of course, plan implementation.