Exercising stock options should not be a passive event that happens after a given amount of time. It's rather like playing a hand of cards: if your plays are strategic, you'll probably "know when to hold them and when to fold them." Many alternatives and trade-offs need to be considered. But, as always, rules, requirements, and regulations govern this area, and this is where we begin.

General Rules And Requirements

It's like playing a hand of cards: with a strategy, you'll know when to hold them and when to fold them.

You will be able to exercise your options and purchase the stock only after your options become vested, as explained in the second article in this series. Exceptions to this requirement are pre-IPO companies that allow reverse vesting (sometimes called early exercise).

After options vest, you may purchase the company stock at the option price any time before the options expire. But exercises, as well as sales, may be prohibited during any "blackout" periods, or allowed only during window periods. Company policies must be carefully followed, as well as federal and state securities laws. Optionholders are responsible for keeping up with current insider trading regulations.

Stock option plans usually do not restrict the number of times you may exercise vested options during a single year. Sometimes, however, companies place minimums on the number of options that may be exercised at one time, in order to hold down administrative costs. (The minimum usually is 100 options.)

Tip: Check with your company's stock plan administrator or legal counsel to be sure you meet all requirements before you exercise any options. Senior executives also must comply with SEC requirements under Rule 144 and Section 16. They may need to clear trades with a compliance officer or with corporate counsel.

Which Method Will You Use?

Companies have discretion over how exercises are conducted. The most common ways to exercise are: paying for the shares with cash; conducting a cashless exercise; and swapping stock you already own (see also a related FAQ). When NQSOs are exercised with cash or a stock swap, many companies let you use shares of company stock to cover withholding taxes due. Each company will specify whether newly exercised or currently owned shares may be used in a stock swap.

The most common exercise methods are cash, cashless exercise, and stock swap.

Two other methods of exercise may be seen in private companies. Exercise by means of a promissory note may be offered in place of cashless exercise/same-day sale. Because the stock of private companies is unregistered, no trading market exists, making cashless exercise impossible. Pre-IPO companies that allow reverse vesting may offer loans to fund early exercise. This practice enables employees to start the holding period for capital gain tax treatment.

Tip: Be sure you know which methods of exercise your company allows, and understand the tax consequences discussed in the third, fourth, and fifth articles in this series. Check the stock plan documents for each stock option grant, and complete necessary paperwork before the date you intend to exercise. Ask the stock plan administrator (or appropriate person) for exercise procedures pertaining to each method. Not all companies may have written procedures.

Cash Exercise

You purchase the shares at the option price with ready cash or with cash obtained by liquidating assets or borrowing. The cost of the transaction is either the interest rate on the borrowed money or the loss of potential earnings on money withdrawn from another investment. Margin loans may be a source of cash.

Tip: Margin loans and margin exercises can be risky choices during a volatile stock market. You risk margin calls and the forced sale of stock in your margin account.

Procedures for cash exercise vary from company to company. At most firms, you simply complete the exercise form and return it to the company along with a personal check in the amount of the exercise price. When exercising nonqualified stock options (NQSOs), add withholding taxes to the check amount.

Cashless Exercise/Same-Day Sale

Cashless exercise provides a way to exercise options if you don’t have the cash or enough shares to conduct a stock swap, or if you don’t want to hold the shares. You may sell all the shares at once or you may sell only enough shares to cover your exercise costs in a "sell-to-cover."

When available, cashless exercise/
same-day sale is the choice of most optionholders.

A brokerage firm (usually company-designated) temporarily advances funds in the amount of the exercise price plus any associated taxes and broker fees. A portion of the sale proceeds goes back to the company to pay the exercise price and, with NQSOs, the withholding taxes.

Once the exercise transaction is completed, you don’t have to leave your money with the company’s designated broker. You can move the sale proceeds and stock to the investment firm of your choice.

Besides relieving the cash pinch, cashless exercise/same-day sale is a convenient way to exercise options. Company records show that when it’s available, most optionees choose this easy approach to exercise.

Alert: Carefully weigh the convenience of cashless exercise against potential lost appreciation of shares you sell to pay for the options and taxes. Before making a cashless exercise, figure out how many shares (even all of them) you want to sell at the time of exercise to reach your financial goals. Then instruct the broker accordingly.

Stock Swap (Stock-For-Stock Exchange)

The stock swap has been available in most plans for several years as a means of exercising options without relinquishing ownership of existing shares or selling newly acquired shares. Currently owned company shares (valued at market price) are swapped to exercise as many stock options as possible (valued at the option price).

With a stock swap, you end up owning fewer shares of company stock than you would with a cash exercise.

You need to check your company’s policy regarding sources of previously owned shares. Typically, these shares have been purchased on the open market, obtained from previous stock option exercises, or purchased through the company’s employee stock purchase plan (ESPP). There are tax complications when using ISO and ESPP shares.

You might not be responsible for delivering the certificates of the swapped shares to your employer. Many stock option plans permit you to exercise with shares you already own, through a process called "attestation." You complete an affidavit of ownership and submit it with proof of stock ownership (such as a copy of stock certificates or recent brokerage statements).

With a stock swap, you end up owning fewer shares of company stock than you would with a cash exercise. (See the example in the next section of this article.) Expectations about the movement of the company stock will be especially important when considering a stock exchange.

Summary Of Exercise Methods

Method Cash paid to exercise Cash received at exercise Shares used to exercise Shares received at exercise
Cash exercise Yes No No Yes
Cashless exercise No Yes Yes No
Sell-to-cover exercise No No Yes Yes
Stock swap No No Yes Yes

Examples Of Exercise Methods

These assumptions are used in all the following examples:

  • Options granted: 100 ISOs
  • Option (exercise) price: $20 per share
  • Market price at exercise: $40 per share
  • Number of previously owned shares: 60

Cash exercise.
You pay $2,000 ($20 x 100) for 100 shares. You already own 60 shares. Therefore, after the exercise, you will own 160 shares.

Cashless exercise.
You acquire 100 new shares, giving you a total of 160. You simultaneously sell 50 shares of the exercised options to pay the total exercise cost ($2,000 ÷ $40 = 50 shares), leaving you with 110. Additional shares must be sold to pay for broker fees and, if exercising NQSOs, withholding taxes. After the exercise, you might own less than the 110 shares.

Stock swap (Stock-for-stock exchange).
You use 50 of the shares you own ($2,000 ÷ $40 = 50) as payment for the option exercise. In exchange for 50 existing shares, you exercise 100 options, producing a net gain of 50 new shares of company stock. After the exercise, you will own 110 shares [(60 - 50) + 100 = 110].

Procedure For Exercising Options

Once you decide that your financial situation calls for exercising your options, you must follow the exercise procedures set forth by your company. The steps will vary, but they will resemble the ones given below.

  1. Select an exercise method that is allowed under the particular grant and stock plan.
  2. Determine the number of options to exercise and note the market price, to determine your approximate net proceeds. Look in your stock plan for how the "market price" is determined.
  3. Complete a stock option exercise form. Each method of exercise may require a separate form. At smaller companies, the exercise request may be made in a simple letter.
  4. Send the completed form to the company, the stock plan administrator, and the brokerage firm the company may require you to use. Your exercise method will determine the specifics.
  5. Establish a brokerage account and authorize the broker to execute the stock sale, if required.
  6. Keep accurate records for tracking your shares and for income tax reporting. You’ll need copies of the exercise statements and 1099-B forms from the broker.

Sometimes, employees are required or allowed to exercise their options via websites (or via an IVR phone system) provided by brokers or transfer agents. In these cases, steps three, four, and five above will be completed online at these sites. But don’t expect to complete all exercise methods online: this is up to each company.

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.