O.K., You Have The Options. Now What?
So the company has finally recognized how valuable you are and given you stock options. You're a player; you've earned this reward. But after the novelty fades, you feel a sense of dread as you ask yourself that nagging question: What the hell do I do with these?
Whether you spend your days toiling in a cubicle or kicking back in the corner office, consider your options an investment to be managed rather than found money. You're an investor now, so start thinking like a stock analyst.
First, take a cold, hard look at both the company's prospects and your own. You'll need more insight into your company than the latest gossip around the watercooler. How competitive is it? Check the library for research from independent rating services such as Value Line Inc. Scan the newspaper stock listings for the price-earnings ratio and compare it with those of industry peers. If it is much higher, the stock may be overvalued; a lot lower, there's probably room to grow. Armed with those basics, you may want to call your broker and find out the firm's outlook for the stock.
After you get a handle on the company's future, start thinking about your own. How you play the options game will depend on the type and number of options you receive as well as on your personal financial situation and investment needs. Many lower-level employees with limited disposable income will use the option program for a quick cash-out, since raising the money to buy and hold the stock often isn't feasible. But if you have a lot of options and a higher income--and thus greater tax liability--more intricate planning is required. "Most people, including the highest-paid executives, don't fully appreciate the value of their options, so they don't develop a strategy to exercise them," says Richard Friedman, vice-president for the employee benefits group at Ayco Co., an executive financial planning firm in Albany, N.Y.
Getting the most mileage out of your options means first decoding the optionese. "There was so much jargon on the grant form describing the options that I didn't understand what they were," recalls Lynda Ollinger, a 33-year-old senior executive administrative assistant with AEGON USA Inc. in Cedar Rapids, Iowa. Since she received her first grant seven years ago, the stock price has quadrupled. Now a virtual stock market junkie, Ollinger has formed an investment club with 21 co-workers.
Most people receive nonqualified options--so called because they don't merit special tax treatment--which are granted at a fixed exercise price. Usually one year from the date of the grant, a percentage of your options is vested, or exercisable. At that time, as long as the current stock price is above the grant price, you may exercise your options--often just by placing a call to your company's benefits office. With nonqualified options, any appreciation above the grant price is taxed as ordinary income, which you must pay at the time you exercise. That spread is tax-deductible for companies--one of the main reasons they prefer to grant nonqualified options.
However, you'll need to come up with the cash to cover both the share price and taxes when you exercise nonqualified options. To avoid having to deplete your savings, most people use a cashless exercise. Many companies--including DuPont, Merck, Toys `R' Us, Warner-Lambert, and Wendy's--work with a recommended list of brokerage firms. You simply call the plan administrator, who notifies the broker. That broker then buys and immediately sells enough shares to cover the stock purchase, taxes, and commissions. Commissions vary and in many cases are negotiable, especially if you exercise and sell large blocks of shares. Since you'll technically be borrowing the cash to purchase the shares while the transaction is handled, you'll also pay the broker's margin rate for a minimum of three days. Any remaining shares can be sold for a cash profit or held. If you hold the stock, any future appreciation is taxed as capital gains when you eventually sell.
For transactions of fewer than 5,000 shares, it makes sense to use the company's recommended broker, if available, since the commissions are comparable and the execution is often faster. The first time Network Equipment Technologies information systems manager Ray Harrison, 46, wanted to exercise his options, he used his own broker. In the several days it took his broker to reach NET's plan administrator, the stock fell two points, costing Harrison $3,000. Now he goes to the company's suggested broker. Although trades must be settled in a minimum of three days, the approval process that occurs before the trade can take place may take longer, as it did in Harrison's case.
SHOP AROUND. If you have 5,000 or more options to exercise or you don't have the luxury of a company-affiliated broker, you'll need to comparison-shop. Discount brokerages aren't always the cheapest. On blocks of stock in excess of 5,000 shares, expect to pay from 5 cents to 25 cents a share in commissions. It is also essential to understand the firm's execution capabilities, because fractions of a point can make a big difference, says Gerry Klingman, a financial adviser with Robert W. Baird & Co. in New York. And find out whether the firm has worked with other employees at your company to exercise options, since its brokers will be familiar with the plan's provisions and the administrator, minimizing time spent on approval.
Incentive stock options, or ISOs--usually reserved for upper-level executives--work much the same way as nonqualifieds, with a few notable exceptions. The beauty of ISOs is that no tax is owed at the time of exercise; more important, if the stock is held for at least one year from exercise and two years from the grant date, any appreciation when the stock is sold is taxed as a capital gain rather than regular income. Because of this tax advantage, companies may grant only up to $100,000 in ISOs per employee each year. So most top management equity compensation still comes from nonqualified options.
With nonqualifieds, the conventional wisdom is to wait as long as possible to exercise, assuming you're confident about the company's future growth. Don't panic if the value of your options sinks "underwater" (when the stock price falls below the grant price) early on. When British Petroleum Co.'s stock dropped to the low 50s in 1992 as a result of plummeting oil prices, BP attorney Lynne Alfred, 54, watched years of options become worthless. When her options finally became exercisable two years later as the stock climbed back into the 60s, Alfred decided to wait. Perseverance paid off: She cashed out most of her options in 1995 in the low 80s and the rest on her retirement in February, when the stock jumped to more than 100. Since most options expire 10 years from the grant date, it usually doesn't make sense to cash out the first time the stock recovers after a dip. "If you look back over any 10-year period, the market tends to correct itself," says Peter T. Chingos, head of compensation consulting for KPMG Peat Marwick in New York.
Still, many people are tempted to cash out early to buy a house or pay college tuition when, in the case of rapidly appreciating stock prices, they might be better off holding on to their options and taking out a personal or home-equity loan. Depending on the number of options and how well the stock performs, the gain--which is tax-deferred--could more than cover any loan and interest payments, says Klingman of Baird.
But the idea isn't just to close your eyes and hope for the best. Your personal situation may require you to start exercising early. For example, if you have good reason to believe the stock is undervalued, consider exercising as soon as you're vested and holding the stock until the price is near its peak, says Minneapolis financial planner Ross Levin. That way you'll pay ordinary income taxes on the relatively small amount of appreciation accrued the year after the grant, and all subsequent gain will be taxed at a lower capital-gains rate when you sell. Or if you plan to move from a state with low or no income tax, it makes sense to start exercising nonqualified options before you go.
SET A TARGET. Similarly, if you're thinking about leaving the company, develop a game plan well in advance. "If you don't think about what you're going to do with the options until you're six months away from retirement or a new job, you don't have many choices left," says Karen Spero, of Spero-Smith Investment Advisers in Cleveland. Exercising nonqualified options incrementally helps ensure that you aren't forced to cash out all your options at once--which could push you into a higher tax bracket--or leave some on the table.
That's why it's a good idea to set target exit prices for each of your grants. Most companies give former employees up to three months after leaving to exercise, but you should always check with the plan administrator. Not paying attention to such details caused Richard Gillman, a former top executive at Bally Manufacturing Corp., to forfeit more than $7 million in stock options. Gillman, who waited to exercise until 16 days after the company's one-year post-retirement exercise period ended, took the company to court twice and lost.
Even with professional help, you must be vigilant. When he first began receiving options in 1984, Louis Gagliano, then a vice-president for internal audit at U.S. Surgical Corp. in Norwalk, Conn., was already planning an early retirement. On paper, he became a millionaire many times over. "It seemed like there was no top to the stock price," he recalls. Strapped for time and frequently traveling, he hired a financial adviser at a well-known money-management firm to watch the stock. Unfortunately, that adviser and a subsequent money manager neglected to develop a strategy to help disentangle him from his options.
It was the start of an emotional roller coaster. Gagliano watched the stock price plummet after the announcement of a Securities & Exchange Commission investigation and then soar after a few technological breakthroughs. The share price seesawed from 4 a share in 1984 to 110 in 1991 before crashing back to 19 three years later. Although Gagliano, 51, retired two years ago on the millions his options generated, he knows it is just a fraction of what he could have earned. "People need to be self-disciplined enough to get money from their options off the table before it's too late," Gagliano says.
That's why financial planners advise you not tie up too much of your net worth in company stock through options, 401(k) plans, and other vehicles. Otherwise, even a small movement in the shares could dramatically affect your portfolio and net worth. Professionally managed mutual funds allocate no more than 5% to one security. While it's not always possible, especially at the executive level, people should make an effort to keep their exposure to company stock under 10%, advises Klingman. One solution if you have a trove of options: reduce company stock holdings within your 401(k).
With ISOs, the timing and the means of exercise is different, especially for those in higher marginal tax brackets. Here, a cashless exercise isn't always appropriate, since it defeats the main tax advantage of ISOs, says financial planner Levin. By selling portions of the stock--as in a cashless exercise--instead of holding ISOs for the required year, you pay income tax on the appreciated value. And while you could sell shares you already own to exercise the options, you would have to pay capital gains.
Instead, ISO owners are better off buying the shares directly or making a tax-free exchange of company stock they already own to exercise the options. Such a stock-for-stock swap lets cash-strapped employees exercise options they might otherwise have let lapse. The company gets the stock and you receive the shares from the exercised options. The beauty of the technique is that the Internal Revenue Service lets you defer capital gains on the original stock you swapped.
A combination of strategies may work best. Kenneth H. Thorn, an executive vice-president at the former First Fidelity Bancorp, had to exercise 50,000 options--nonqualified and ISOs--before they expired. Using a cashless transaction, he exercised and sold his nonqualifieds, investing the proceeds in mutual funds. To acquire his ISOs, he swapped other shares he already owned and took a margin loan pending delivery of the ISO shares to his brokerage account. Many people don't know that they need not sell the securities immediately, as in a cashless exercise, but can maintain a margin loan of up to 50% of the shares' value. When First Fidelity was acquired by First Union Bank, an additional 30,000 options became exercisable. Thorn used the proceeds from the cashless exercise of those options to pay off his margin loan. "The advantage was that he was able to exercise his nonqualified options without using cash, diversify his holdings, and still retain his shares from the ISOs, which have now appreciated even more," says Klingman, his financial adviser.
UNCLE IS WAITING. ISO owners might also want to consider exercising early and then holding if the optioned stock is rapidly appreciating and has a reasonable dividend. The bull market makes this strategy especially attractive. It's not uncommon for stocks to have appreciated nearly four times their original value during the 10-year option term. In that case, a stock paying a modest 2% dividend will yield an 8% return on the cash required to exercise. Those dividends may also be sufficient to cover the carrying costs of a margin loan used to exercise the ISOs.
But be warned: Exercising and holding a lot of ISOs in any one year could expose you to the alternative minimum tax (AMT), a separate calculation to ensure that taxpayers with special deductions will pay at least some tax to Uncle Sam. (Nonqualified options aren't subject to the AMT because there's no deferral; all the gains are realized at exercise.) "It's important to run tax projections before exercising ISOs to ensure that the AMT doesn't make the tax benefits of ISOs somewhat illusory," Levin says.
Steve Pennacchio, a partner at KPMG Peat Marwick in New York, tells of an executive who turned to a small tax preparer for help with his ISOs. Told that it wouldn't be a problem, he exercised all of them at once, inadvertently creating a $120,000 AMT exposure. "It could have been avoided by staggering the exercises," says Pennacchio. Indeed, making your options work can be a fruitful exercise, once you understand the rules.
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