Financial planner David Berman worries that his clients have too many options--the kind that can be sold for a profit. And he frets with good reason: In 2000 he had a client who held $6 million of employee stock options in Ciena (CIEN ), a high-flying networking equipment company whose stock eventually lost 95% of its value in the tech-stock crash. Berman got $3 million of the client's money out in time, but not without a fight. "This executive was under the impression the stock would go up forever, and he was pressured by his colleagues to hold on to it," says the planner, who is based in Timonium, Md., in suburban Baltimore.
Now Berman tells the Ciena tale to clients working at mutual fund companies T. Rowe Price (TROW ) and Legg Mason (LM ), whose stocks are riding high in the bull market. "I have to argue with them," he says. "They've seen their net worth double in the last few years. It's not easy to convince them to sell the asset that made them rich."
But sell they probably should. Employee stock options are financial contracts with a limited life span, typically 10 years. The contracts, if exercised during that period, are converted into shares of stock that can then be sold for cash. But if never exercised they expire worthless. "North of 10% of valuable options expire unexercised every year," says Bruce Brumberg, editor of myStockOptions.com, a site devoted to options, restricted stock, and other forms of equity-based compensation.
Before you can exercise options, they must pass a vesting period, typically two to three years, and the price of your company's stock should exceed the options' predetermined strike price. Even before the options vest, though, you should have a well-defined exit strategy. "It's a mistake to think of options as just extra money lying around as opposed to part of your overall investment portfolio," says Berman.
Most options issued today are "nonqualified" stock options, or NQSOs. Any gains made on exercising NQSOs are taxed as income at rates as high as 35%. But until you exercise them your gains accumulate tax free. So in most cases you shouldn't rush to exercise as soon as you vest. "Unless you need the money right away or you think your company's stock isn't going any higher, you shouldn't sell before at least year 6 of a 10-year option," says Brumberg.
In fact, he recommends that most investors wait until the last two years of their exercise periods and then sell off a percentage of their option portfolio each quarter. The higher the stock price gets above the option's strike price, the more aggressive you should be about selling. One thing also to consider is whether cashing in the options will push you into a higher tax bracket. If so, you may want to exercise a smaller amount to avoid the higher rate.
There are important exceptions. "A lot of people get so caught up in exercising their options just right, they never stop to think: 'Wait a minute, I've got too much stock in this company,'" says Berman. As a rule of thumb, he recommends that clients have no more than 10% of their investment portfolio in one stock or option, nor more than 25% in one industry. This is true with any stock but doubly important with the stock of your employer, because a big slide in the stock's price could mean your company is in some sort of trouble. You could lose your job as well as your investment portfolio.
Often executives who have far more than 10% of their net worth tied up either in options or restricted company stock are not free to make changes. In many cases, the company's board of directors or its bylaws require them to maintain a large amount of stock in their personal portfolios. Moreover, because executives are privy to inside information about their company, they are forbidden to buy or sell either shares or options during "blackout periods" when earnings are reported, say, or merger talks are under way. Such executives may need to be more aggressive about exercising options when they can because their windows of opportunity are limited.
For those with large positions, there are several strategies. Many option grants today are part of an overall compensation package that includes restricted stock. Unlike NQSOs, the moment such stock becomes unrestricted for sale, the value of the entire grant is taxed as income. "If a client has both stock grants and options, typically we look to get out of the stock first," says financial planner David Strege of Syverson Strege in Des Moines. That way the client maintains the tax deferral of the options.
Strege also recommends taking advantage of what is called a 10b5-1 trading plan. Offered by many companies, the programs allow employees to exercise options and sell company shares at regular intervals throughout the year at preset prices. Such plans also allow high-level types to sell stock even during blackout periods, provided they set up the plan during a nonblackout period and had no illicit insider-type reasons for doing so. Make sure to set up your 10b5-1 correctly: The Securities & Exchange Commission has been looking closely at them.
For those locked into a large position because their options haven't vested yet, some planners recommend hedging techniques to protect against downturns. You could buy put options on your company's stock. (Puts rise in value when the stock declines.) Another approach is to buy put options on an exchange-traded fund that's invested in the same industry as your company. An ETF hedge is sometimes easier to set up, since some companies have restrictions on buying put options on their stock.
For most employees, having a simple exercise plan as your options approach expiration is good enough. A handy resource is myStockOptions.com. Much of the site's articles and tools are free, although a full membership is $189 a year. The site offers calculators that allow you to see what the aftertax gain of your options sale will be and compare it with other investments. You can also monitor your portfolio and sign up for alerts that notify you if your company's stock has hit your price target or if your options are close to expiration. You don't want your valuable options to end up among the 10% that expire worthless.
By Lewis Braham