As with any investment, knowing exactly when to sell employee stock options for maximum value is an impossible task. Markets are unpredictable as a whole and when we narrow our view to predicting the short-term fluctuations in price of a single stock, you may do just as well flipping a coin. Layer in the fact that everyone has their own specific set of financial goals and circumstances and it becomes clear that there is no ‘one-size-fits-all’ solution.
However, with careful consideration of the inherent risks, it is possible to formulate a disciplined, goals-based strategy upon which to make your decisions.
First, evaluate the risks. While factors of risk in the investing world are innumerable, the following are those most specifically applicable to granted stock options.
- Time to Expiration – All stock options have an expiration date. The closer an option gets to its expiration, the shorter the window of time in which it must reach its desired value. Retaining options up to the date of expiration risks the potential for substantially reduced profit and in extreme circumstances total loss of value.
- Opportunity Cost – Broadly defined as the loss of potential gain from an alternative, in the world of stock options opportunity cost represents the potential return of an investment other than the stock options you hold. In other words, what other investment vehicles could potentially provide a better expected return or more advantageous risk profile than granted options.
- Concentration Risk – Discussed in greater detail later in this series, concentration risk is the potential for exaggerated effects on the performance of an investment portfolio due to a single investment holding being disproportionately large.
- Volatility Through Leveraged Value – Another topic addressed in this blog series, due to the leverage created in stock options through grant pricing, stock option values fluctuate much more than the value of the underlying stock.
- Tax Consequences – When formulating a stock option exercise strategy, taxes should be among the most critical considerations. An exercise and immediate sale of shares results in an instant ordinary income liability on the full value at sale. An exercise and “hold” of granted shares allows deferment of income on the capital gain portion of the shares, but also incurs an ordinary income liability on the portion attributable to the “purchase” – a liability for which you may not have cash on hand. Where possible, it is prudent to realize these taxable events in years where income is lower.
With a sound understanding of these factors, it’s time to strategize. So, when should you exercise your options? The answer – don’t think about it as much in terms of “when”, but rather focus on how many you should exercise. The solution I propose is one built around the practice of Dollar-Cost-Averaging (DCA). DCA is the practice of placing or removing funds in an investment vehicle incrementally over time in order to mitigate the impact of price fluctuations. By exercising a portion of your options on a systematic and incremental basis, you reduce the likelihood of realizing both extremely high and extremely low values on the granted shares. Instead, the objective is to capture a fair value for your shares so that the proceeds may be deployed in in support of your financial planning goals and your targets for risk, return, and diversification.
Because companies often grant option shares on a recurring basis and these shares are granted at market price, each grant has a unique value. To tune the exercise strategy more finely, one should consider using price targets for each specific stock option grant rather than a single, aspirational value for the company stock.
Rather than waiting until the price hits say $100 to exercise any shares, simply target a specific level of appreciation over the grant price. A reasonable price target may be somewhere between 30%-75% over the grant price (dependent on market conditions, historical company growth, and level of comfort by the option holder). For instance, shares granted at $30 could be reasonably exercised at a price of $39-$53 using this strategy. Whereas shares granted at $40 would not be considered for sale until reaching a market price of $52-$70. Again, such methodology allows the option holder to receive a fair value for the shares over time.
The methods described above serve to mitigate the risks discussed earlier.
- Options are less likely to be held to expiration.
- Proceeds are re-deployed elsewhere in the investment portfolio, reducing the impact of missed opportunity cost.
- Portions of company stock are removed from the portfolio incrementally as new grants are received, reducing concentration.
- DCA reduces the impact of leveraged value by selling shares at an average value over time.
- Income from the exercise of shares is spread over multiple tax years which ideally will result in a lower effective tax rate.
While there is no perfect solution for exercising options and each individual will need to customize their strategy to their own unique circumstances and goals, these methods can provide the cornerstones for a sound plan of action. At the risk, of being repetitive, I’ll quote the esteemed Warren Buffett one more time: “Successful investing takes time, discipline and patience”. Short and sweet, but if there is one phrase by which to build your plan, I can think of none better.
