Understanding Employee Stock Options

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1 Understanding Employee Stock Options Family Office Resources Compensation in the form of employee stock options tends to carry a significant level of risk and a high degree of complexity. Investors who own employee stock options are often presented with a number of difficult questions: What can I do with my options? How are my options taxed? Which options should I exercise first? How do I assess the risk embedded in my options? The financial implications associated with these decisions are driven by risk and return tradeoffs. Considerations such as company stock outlook, risk tolerance, taxes and liquidity affect the attractiveness of various strategies. The following discussion addresses each of the considerations to facilitate an informed decision-making process. What is an Employee Stock Option? An employee stock option grants the investor the right to purchase the company stock at a predetermined price (strike price) within a certain time frame (on or before the expiration date). Employee stock options are typically awarded such that the strike price equals the stock price on the day of the grant. If the stock subsequently appreciates in value, it becomes profitable to exercise the option and acquire the stock below the then current market price. Such an option is considered in-the-money with an intrinsic value equal to the difference between the stock price and the strike price. Employee stock options generally have a vesting schedule: a set proportion of the options from the same grant become exercisable over time. Investors cannot exercise employee stock options until they are vested. Subject to potential restrictions on the sale of the company stock, an investor may be able to monetize a vested employee stock option by first exercising the option and then selling the acquired stock. The net cash realized is the option s intrinsic value minus any embedded tax liability. What Can I Do with My Vested Employee Stock Options? The following considers five potential actions that investors may take in regards to their vested employee stock options. UNDERSTANDING EMPLOYEE STOCK OPTIONS 1

2 1. Exercise All Options and Sell Stock 2. Exercise Some Options and Sell Stock 3. Cashless Exercise 4. Hold Options 5. Exercise Options and Hold Stock Investors should assess the risks and benefits of each potential action by first reviewing their own outlook on the company and personal risk tolerance. If investors are concerned that the company stock may be overvalued, they can lock in the current value by exercising their vested options and selling the acquired stock. This may be particularly relevant for conservative investors who have additional exposure to the company via unvested stock units and unvested options. Some investors may have a neutral company outlook but are concerned with having too much of their net worth tied to the performance of a single company. These investors may consider a moderate strategy of liquidating (exercising and selling) a portion of their options. For investors who own multiple option grants, the order of option exercise is discussed in a later section. Investors who have a moderate risk tolerance or a neutral company outlook may also consider the strategy of cashless exercise, which refers to exercising vested options and selling enough shares of stock to pay for the exercise expenses (the strike price and the estimated tax liabilities). Ultimately, investors receive fewer shares of stock than the original quantity of options. If investors are bullish that the company stock will appreciate in value, they may be comfortable with a more aggressive approach of simply holding the options in the anticipation of benefiting from the potential future upside. Since exercising employee stock options and selling shares of stock have different tax treatment, bullish investors may consider the strategy of exercising the options and holding the stock. By doing so, investors may qualify for more favorable tax treatment on the potential future appreciation. This strategy requires investors to commit upfront cash payments for the option exercise, which may not be recuperated if the stock price declines significantly following the exercise. Therefore, this strategy is considered more aggressive than simply holding the options. Since the company stock outlook and personal risk tolerance are factors specific to the individual, investors with identical employee stock options may act differently in regards to their holdings. How Are Employee Stock Options Taxed? Employee stock options are not taxed when they are granted or when they vest. Rather, taxable income is realized when the options are exercised. The tax treatment varies with the option type. There are two types of employee stock options: nonqualified stock options (NQSOs) and incentive stock options (ISOs). Upon exercise of NQSOs, an option s intrinsic value is considered compensatory ordinary income. Investors typically pay withholding taxes on the day of the option exercise. When investors sell the acquired shares of the stock, any appreciation or depreciation in the stock price since the time of exercise is subject to capital gains or losses. For ultra-high net worth individuals, the difference between the ordinary income tax rate and the longterm capital gains tax rate can be significant 1. Thus, very bullish investors may consider exercising NQSOs early and holding the stock to qualify the 1 The highest Federal ordinary income tax rate (excluding ACA and Medicare premiums) is 37%. The highest Federal long-term capital gain tax rate is 20%. The tax rates are as of UNDERSTANDING EMPLOYEE STOCK OPTIONS 2

3 potential future appreciation as long-term capital gains instead of ordinary income. Non-Qualified Stock Option (NQSO) Thus, investors who plan to monetize their ISOs should consider exercising the options one year prior to the anticipated sale in order to qualify for the more favorable tax treatment. at Sale Incentive Stock Option (ISO) at Exercise Potential Appreciation Taxed as Capital Gains Intrinsic Value Taxed as Earned Income at Sale at Exercise Potential Appreciation Taxed as Capital Gains (offset by AMT credit) Time AMT Taxable Income Increases by Intrinsic Value Option Granted Option Exercised Stock Sold If certain criteria are met, ISOs may provide more favorable tax treatment than NQSOs. Investors do not pay withholding taxes when they exercise ISOs. Instead, their taxable income for Alternative Minimum Tax 2 (AMT) purposes increases by the amount of the option s intrinsic value. Of note, if an AMT liability is triggered as a result of an ISO exercise, investors generally earn an AMT credit, which may be used to offset taxes in future years. If the acquired shares of stock are sold more than one year since the exercise date and more than two years since the grant date, the sale is considered a qualifying disposition. The difference between the sale price and the strike price, if any, is taxed as long-term capital gains. If the acquired shares of stock are sold within one year since the exercise date or within two years since the grant date, the sale is considered a disqualifying disposition. The difference between the sale price and the strike price, if any, is taxed as compensatory ordinary income. In the case of a disqualifying disposition, investors do not need to make an adjustment for AMT purposes. 2 The alternative minimum tax (AMT) is a supplemental income tax. A taxpayer must pay the greater of the AMT or regular tax. Time Option Granted Option Exercised Stock Sold For both NQSOs and ISOs, there are potential tax benefits associated with exercising the options and holding the stock. Nevertheless, investors should thoroughly assess the embedded risk before committing to this strategy. When investors exercise options and hold shares of the stock, the maximum value that they stand to lose is greater than by holding the options. If the stock price goes to zero, investors will lose the amount of money that was required to exercise the options versus a paper-loss of the options becoming worthless. The withholding taxes paid at the time of NQSO exercise are based on the ordinary income tax rate, which is higher than the long-term capital gains tax rate. If the stock price declines significantly after exercising the options, investors may not be able to fully recuperate the withholding taxes paid upon exercise. For investors who own ISOs, a qualifying disposition typically creates more favorable tax treatment, but it may result in investors being subject to AMT. The risk of this strategy lies in the scenario where the stock price plummets after the option exercise, as UNDERSTANDING EMPLOYEE STOCK OPTIONS 3

4 the proceeds from the stock sale may be less than the AMT liability. One mitigant is to sell the stock within the same year of the exercise to create a disqualifying disposition. Which Options Should I Exercise First? An employee stock option grants the investor the right to purchase the underlying stock at the option s strike price 3. The intrinsic value of an in-the-money option is the difference between the stock price and the strike price 4. For options that are transferrable, their fair market value is typically greater than their intrinsic value. Such excess value is referred to as time value. An option with time value is more valuable than its intrinsic value because investors have the right, not the obligation, to exercise the option. Most employee stock options are non-transferrable. In order to monetize an employee stock option, investors must first exercise the option and then sell the acquired stock. Time value is lost when an option is exercised. Thus, the most pre-tax value that investors can realize on an employee stock option is limited to the intrinsic value. Intrinsic Value Include Time Value While NQSOs and ISOs don t provide investors with time value, time value as a concept may be useful for investors to understand the potential return payoffs of their employee stock options and to determine an appropriate order for option exercise when investors own multiple option grants. Below is an example of why time value as a concept is relevant for non-transferrable employee stock options: The price of a stock is $100/share. If the option s strike price is $90, the intrinsic value of the option is $10. If the stock price subsequently goes from $100 to $85, the option will become out-of-the-money. Its intrinsic value declines from $10 to $0. An investor who owns the option will experience a decline in value of $10 5. In an alternative scenario, assuming the stock price is $100, the investor exercises the option, effectively capturing the $10 intrinsic value of the option by paying $90 for a share of stock that is worth $100. If the stock price subsequently falls from $100 to $85, the investor who owns the stock will experience a decline in value of $15. Option Value Option Return Stock Return Profit & Loss *Option Return Reflects Change in Intrinsic Value $0 -$10 $90 $100 Current -$100 3 An employee stock option grants the holder the right to purchase the underlying stock; it is a call option. Unless otherwise specified, the options in this whitepaper refer to call options. 4 A call option is considered in-the-money if the stock price is greater than the strike price, out-of-the-money if the stock price is less than the strike price, and at-the-money if the stock price equals the strike price. The intrinsic value of an at-the-money or out-of-the-money option is zero. The $5 of additional decline ($10 vs. $15) in value in the alternative scenario reflects the stock price depreciation from $90 to $85. Such 5 The $10 loss reflects a change in the option s intrinsic value. UNDERSTANDING EMPLOYEE STOCK OPTIONS 4

5 depreciation is captured only in the change of the stock price, but not in the change of the intrinsic value of the option. In other words, when the stock price falls below the option s strike price, an investor would have been better off holding the option instead of the stock. Investors are not obligated to exercise employee stock options when it s not profitable to do so. The magnitude of the hypothetical time value reflects how valuable this optionality is. For investors who own multiple grants of options with different strike prices and expiration dates, the concept of time value is a useful tool that investors may leverage to determine an appropriate order for option exercise. Generally, options with the least time value per share should be exercised first. The time value of an option decreases as the time to maturity decreases and/or when the option becomes deep inthe-money. Potential Benefit $ Portfolio Value Today Before Option Exercise Cash () Option "Hold Option" Scenario $ Portfolio Value at Option Expiry (assuming stock price does not change) Interest on Cash Cash () After Option Exercise Stock "Exercise Option, Hold Stock" Scenario Dividends on Stock Stock At times, investors may find that the hypothetical time value calculated by using an option pricing models is zero or near zero for some of their options. In addition to the factors listed above, this may be attributed to a high dividend yield, if any, of the company stock. While option holders do not receive dividends, stock holders do. All else being equal, the higher the dividend yield, the less time value is associated with the option. When the dividend yield is sufficiently high, investors who own in-the-money options may consider exercising early and holding the stock to capture the future dividends. The potential benefit of doing so equals the dividends received less the foregone interest that could have been earned on the upfront cash payments made to exercise the options. Of note, this is not a recommendation that investors should exercise their options early and hold the stock solely for the purpose of receiving future dividends. The purpose of this observation is to recognize that, in some circumstances, holding the options may be a sub-optimal choice given the alternatives available. How Do I Assess the Risk Embedded in My Options? Investors who receive employee stock options as a part of their compensation may have a substantial portion of their net worth tied to the company stock performance. While investors are generally aware of the risk associated with having a concentrated stock portfolio, the risk associated with having a concentrated options portfolio is more difficult to assess. Option "Hold Option" Scenario "Exercise Option, Hold Stock" Scenario UNDERSTANDING EMPLOYEE STOCK OPTIONS 5

6 Intrinsic value is not a good representation of the risk (i.e. volatility) embedded in an option. A percentage change in the stock price generally corresponds with a greater percentage change in the intrinsic value of an in-the-money option. For example, if the price of a stock falls from $100 to $99 per share, this represents a loss of 1%. If an investor owns a concentrated portfolio of options on the corresponding stock with strike prices at $90, the intrinsic values of the options will fall from $10 to $9 per share, this represents a loss of 10%. Notional value, which is the market value of the underlying shares of stock multiplied by the number of shares held by the investor, is a better representation of the economic exposure of in-themoney options 6. For equal market values 7, a portfolio of options may have significantly greater economic exposure and volatility than a portfolio consisting of only the corresponding stock. Conclusion Ultimately, the appropriate strategy for investors who own employee stock options should be driven primarily by the investors company outlook and risk tolerance. While investors stand to benefit from holding employee stock options if the stock appreciates in value, a concentrated portfolio of options on a single stock carries significant risk, including idiosyncratic risk that can be mitigated through diversification. Investors with concentrated employee stock options should thoroughly review the potential tax, legal and financial implications when assessing the risks and benefits of various strategies. 6 In-the-money options have similar price changes as the underlying stock on an intrinsic value basis, if the options remain in-the-money. This approach does not consider time value and assumes that the delta of inthe-money options is constant at 1. 7 The market value of an option position is represented by its intrinsic value. UNDERSTANDING EMPLOYEE STOCK OPTIONS 6

7 Important Disclosure This material has been prepared for informational purposes only and is subject to change at any time without further notice. Information contained herein is based on data from multiple sources and Morgan Stanley Smith Barney LLC ( Morgan Stanley ) makes no representation as to the accuracy or completeness of data from sources outside of Morgan Stanley Smith Barney LLC. It does not provide individually tailored investment advice. Be aware that the particular legal, accounting and tax restrictions, margin requirements, commissions and transaction costs applicable to any given client may affect the consequences described, and these analyses will not be suitable to discuss with every client. The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. Tax laws are complex and subject to change. This information is based on current federal tax laws in effect at the time this was written. Morgan Stanley Smith Barney LLC, its affiliates, Financial Advisors or Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters Morgan Stanley Smith Barney LLC. Member SIPC CRC UNDERSTANDING EMPLOYEE STOCK OPTIONS 7