Get the Most from Your Company Stock Options

Thinking about what to do with your stock options can be a complicated process. First, you need to understand the basic terminology surrounding stock option grants. Read "Stock Option Basics" for more on these terms. Second, you need to structure a decision-making framework to carefully evaluate what can be one of the biggest decisions in your financial life.

Factors to Consider
So, what factors should you consider when deciding what to do with your options? Here are some of the major questions to ask:

* What's the remaining time value or leverage that remains in your options?
* What are your most important financial goals?
* How concentrated are you in your company stock?
* How can you manage the tax you'll need to pay when you exercise and sell the shares?

Framework for Decision-Making
Let's walk through a structured approach to analyzing your options.

First, take an inventory of your options. You'll need to know the following:

* Do you have Incentive Stock Options, Non-Qualified Stock Options, or a combination of both? (My "Stock Option Basics" article can help you understand the implications of both types of options.)
* What is the current market price of your company stock and what is the exercise price (sometimes called the strike price) of each option grant you hold?
* Do you have vested and nonvested options? The vested options are available to you now to exercise. Nonvested options aren't available until a future date.

Second, to calculate the "in-the-money" value of your options, take the fair market value of the stock, subtract the exercise price, and multiply by the number of vested shares in that stock option grant. For example, say your company stock is trading at $10, and you have 1,000 vested options priced at $2. That means you have in-the-money value of $8,000.

Third, to get to a cash-out value of those vested options, you'll need to reduce your proceeds by a tax factor. To keep things simple, let's say you are in the 28% marginal tax bracket, so your $8,000 proceeds are reduced by $2,240. That means you'd net $5,760 if you exercised your stock options and sold your shares.

Now you can go through this process for all of your stock option grants.

Time Value of Stock Options
What makes stock options different from salary or bonus is that there is a leverage factor involved over time. You wouldn't necessarily want to give up your options for a bag of cash today because they have the potential to be more valuable in the future.

The trick is how to value that leverage.

The best way to value that leverage is to seek help from an advisor, who is a specialist in these matters. That person can help you enter the correct variables to crunch the numbers (most likely using a Black-Scholes formula) and interpret the results. If you want to give this a try on your own, you can search the Web for sites that offer Black-Scholes calculators.

The Black-Scholes valuation model uses these factors:

* The current fair market value of the stock
* The exercise price for the option
* The volatility of the stock (you can find an appropriate number using the company's most recent 10K report)
* The time until expiration of the option grant
* The dividend yield of the stock
* The risk-free rate of return

The result will be a combination of the in-the-money value of the option (see above) plus the time value.

There are a few general assumptions we can use to evaluate the time value of an option:

1) The time value decreases as the expiration date gets closer.
2) The greater the in-the-money value, the less important time value becomes.
3) The higher the volatility of the stock price, the greater the time value.
4) The higher the risk-free rate, the higher the time value.

If you find that the time value of your options is not very high, you have good reason to consider exercising the option sooner rather than later.

Do You Have More to Gain or to Lose?
Part of the leverage effect of a stock option is that for each incremental move up or down in the stock price, there is a disproportionate movement in the value of your option. So, for example, let's say the value of your company stock goes up 20%, from $10 to $12. As the stock price goes up, the deeper in the money your option becomes. Therefore, you now have less to gain in upside value than you have to lose in downside value.

So, the question eventually becomes, how much is enough?

To get to a realistic answer to that question, you need to do some thinking about what your most important financial goals are: paying off a mortgage, putting aside enough money to get your kids through college, never working again--and so forth.

Once you've pondered that question, you need to quantify those goals. That can be as easy as using a financial calculator to find the present value of any of your financial goals.

Say you want to figure out how much you'd need to stop working and be able to spend $50,000 a year for the next 25 years. Using a conservative rate of return of 4%, the present value would be $781,100. If you know your ultimate "freedom" goal is $781,100, ask yourself this question: How close to your goal will exercising your options get you? Will you have 50% of your goal? 80%? Approaching the issue this way helps you to think about just how much is enough.

Lack of Diversification Equals More Risk
You've heard it a hundred times--concentration in one or very few stocks is risky. If you happen to work for the same company you are invested in, it magnifies the problem of being overly beholden to the future of a single firm. Unfortunately, investors who understand the risks of being overexposed to company stock tend to downplay those risks in their own portfolios; they always think it will be someone else's stock that will drop catastrophically.

The question isn't whether you should diversify your concentrated position in company stock, but rather how and when. As you get closer to retirement, this issue becomes even more important. It may mean that you give up some upside in future stock returns to be able to start building a more well-rounded portfolio.

Putting It All Together
Now you're ready to make some good decisions. You'll need to think through these factors:

Event-Driven Factors: Think about when your options will expire and when they vest. Both of these can influence when you exercise your options. Don't wait until the last minute with ISOs--you may be giving up the ability to manage your tax hit.

Valuation Factors: What are your options worth with and without the time value? If there's not much difference, that may lead you to exercise sooner rather than later (because you have more to lose than you have to gain). You also need to think about how close you are to your overall financial goals and ask yourself how much is enough to get from the value of your stock options.

Stock Price: While this is probably the most important factor to consider, it's not the only one. Take a look at where your stock price is historically (at an all-time high?) and how it compares with its peers. Think about the sustainability of the current stock price and expected future growth.

Diversification: How much risk can you afford to take? How can you diversify your concentrated position over time? Think about how much diversification you want to achieve over specific time periods.

Tax Management: Once you've come to some decisions about when and how you want to exercise your options and sell that stock, you need to think about how to do that in a way that manages your tax burden. Stock options are notoriously tricky because ISO exercises are one of the primary triggers of Alternative Minimum Tax. (For more on AMT, see the "Stock Option Basics" article.) And if you're exercising both ISOs and NQSOs, you'll need to run tax projections to see how both types of exercises/sales affect your bottom line.

If you have employee stock options, you may have a very valuable "gift." It's up to you to make the most of it. Get qualified professional help if your option stake is high. Be forewarned: Don't take advice from brokers who may offer advice on the fly, and be sure your accountant is well versed in the tax effects of stock options.