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Employee Stock Options: Investing and Mitigating Risk

Employee Stock Options: Investing and Mitigating Risk

For clients who are employed in some capacity by a publicly traded company (and occasionally private companies), there may be the opportunity to receive stock options from your employer. These options are somewhat different from the options we may employ in your portfolio to either hedge or protect a position that we own or may be short.

Options granted by your employer give you the right to buy a specific number of shares of your company's stock during a time and at a price that your employer specifies. The price that the employer sets on the stock is known as the "Strike Price" and is the price that you will have to pay your employer for the right to purchase the number of shares they grant to you. The benefit that you receive is that you bear very little risk for the investment. If the underlying stock appreciates beyond your strike price, you can exercise your options and either sell to make a profit or hold the stock. If the market price does not rise above the strike price, you can wait and it doesn't cost you anything.

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Further, when you choose to exercise your options to sell, most advisors/brokers are able to facilitate a "cashless" options transaction, where the money you owed to your employer for the options is sent from the proceeds of the sale of the stock.

In the example above, options were granted at a $15 Strike and if sold at $40, you would receive $25 per share, your employer would receive the difference.

It is also important to understand that most employers set a vesting schedule related to the options they issue. The amount of time you must wait to exercise your options or to be considered "fully vested", varies from employer to employer, but in our experience, 12 months is fairly common.

NQOs vs. ISOs
There are two types of options that employers typically grant their employees. The first type are known as ?Non-Qualified? Stock Options (NQO's). The value of an NQO is not included in the employee's income at the time of grant and the employee is taxed at ordinary income rates on the difference between the exercise price and the fair market value of the stock on the date of exercise.

The second type of option issued by employers are known as Incentive Stock Option (ISO's) and their value, conversely, is not included in the employee's income at the time of grant. Generally, there is no tax event with Incentive Stock Options until the stock is received from the exercise of the option is sold. If the stock is held for two years from the date of grant and one year from the date of exercise, then when the stock is sold, the difference between the sale price and the exercise price is taxed at the long-term capital gains rate. However, depending your tax status, the Alternative Minimum Tax (AMT) may apply.

Further differences between the two types of options arise when looking at the potential transactions surrounding the options. Below is a study based on the scenario from page one, where options are granted with a $15 strike price and the options are exercised while the underlying stock trades at a market price of $40 per share. The first thing you will notice is the difference in net proceeds at the end of the transaction. In both scenarios, ISO's provide the greater initial benefit to the investor.

The second item to be mentioned that is not so readily visible are tax consequences for each type of option. While many agree that US tax codes are complicated to the degree that most Americans cannot complete their own income tax returns, things can get increasingly obscured when options are involved- Matters of timing, change in residency and other ownership related nuances can prove be beyond the capacity of most public accountants who are general practitioners. Most executives would be well-served by a CPA that has a competency in equity based compensation.

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