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Stock options aren't just for the folks on "mahogany row" any more. Companies make them available to employees below the executive level.

Splitting compensation between hard cash and stock has definite benefits for both employer and employee. But turning stock option certificates into the real green stuff takes some know-how. It doesn't happen by itself.

Realizing huge sums are involved, people are looking for help with managing their stock options. Heading the list of most frequently asked questions, at least at my company, are:

My articles address these questions and share some of the knowledge and experience that we, as financial counselors at AMG National Trust Bank, have gained. I hope the series will help guide you toward an effective strategy that integrates stock options with your overall financial plan.

Turning stock option certificates into real green stuff takes some know-how.

Before I delve into strategies, I want to make sure you understand the fundamentals of how options mesh with other aspects of financial planning. This may seem a little tedious at first, but as the saying goes, you need to crawl before you can walk. This bears out whether we're learning the three Rs, a new job, or a new sport. In addition to the basic rules of the game, we must understand the jargon. Knowing the difference between a "birdie" and an "overhead," for example, is essential before we can venture onto the golf green or the tennis court.

With this in mind, let me begin by telling you what a stock option is: a contractual right granted to you by your company to purchase a specified number of shares of company stock at a specific price, for a specified period. You will find the exact terms in your stock grant agreement.

From your perspective, stock options are a risk-free opportunity to share in the appreciation of your company's stock. In return, your company expects you to act and feel like an owner: to work toward increasing the company's performance and, consequently, its stock price.

Financial-Planning Basics

Managing your stock options involves a long list of financial goals and issues. These may include cash-flow needs, retirement security, income taxes, investment strategy, estate planning, and job tenure, along with company and legal requirements. Looking at this long list, you might be tempted to overemphasize some variables and neglect others. Reducing income taxes, for example, is a topic that grabs a lot of attention these days. Always keep in mind that the stock option strategy must be integrated with every other part of the financial picture.

Avoid the knee-jerk reaction to exercise/sell immediately at vesting: it can be a big mistake.

If your potential stock option gains are substantial, you may want to develop a master plan and consult with multiple advisors for input. Financial planners, stockbrokers, estate attorneys, tax accountants, and your employer's legal counsel are some resources to consider.

You also need to step back and assess your exercise strategy from the following points of view:

  • stock market volatility
  • the disparity between the rates of ordinary income tax and capital gains tax
  • provisions that might have been added to the stock option plan (particularly noncompetes, termination, and transferability of stock options)

A stock option plan has the potential to be an effective wealth-building tool, due to the growth of the underlying company stock. This continuing buildup of equity may be used to meet short- and long-term financial goals. Nonetheless, first-time optionholders frequently succumb to the desire for instant gratification as soon as their options vest, and exercise and sell the shares.

By all means avoid this type of knee-jerk reaction: in the long run it can be a big mistake. All decisions and every action should be dictated by your stock option strategy.

Know The Terms Of Your Stock Option Grant

You must understand the provisions of your stock option plan and corresponding stock grant agreement for each grant you receive. Although plans and grants from various companies may resemble each other in a number of ways, no standard stock option plan exists. Features of plans and grants may vary even within the same company.

No standard stock option plan exists. You need to understand the documents and terms of each grant.

There are two basic types of stock options: the nonqualified stock option (NQSO) and the incentive stock option (ISO). The primary differences between NQSOs and ISOs are the tax consequences at the time of exercise and sale, which I will explain in detail later.

Components of stock grants include the items below. (Links take you to sections or specific content about these topics.)

In Part 2 of this series, I explain vesting and expiration of options.

Marilyn Renninger (now retired) was the Chief Knowledge Officer of AMG National Trust Bank, a leading provider of financial advisory services to corporate employees and wealthy individuals. Before joining AMG Guaranty Trust, she held posts as professor, analyst, and advisor in the areas of finance, insurance, risk management, and HMO financing. This article was published solely for its content and quality. Neither Marilyn nor her firm compensated us in exchange for publication of this article.