Many businesses — especially new or young ones — offer stock options to employees in compensation packages. Having a solid stock exit strategy in place can be crucial for getting the most out of this employee benefit.
Stock options act as incentives for workers to stay with companies as they grow in value. Generally, an employee is granted the option to buy shares in a company at a set price on a set future date.
The hope is that when that date arrives, the shares will appreciate in value. The employee can then buy the shares at the original lower rate and realize instant profit if they sell them at the current higher price.
That’s the idea. But what happens when a company’s fortunes turn sour and stock value goes lower than the original purchase price?
The stock market has regained much of its value after a crash and a slow start to the 2020s. The gross domestic product (GDP) grew to nearly $23 trillion, outpacing projections from the Center For Budget And Policy Priorities. However, we know how unpredictable the market can be and that a sudden turn of events has the potential to change fortunes overnight, leaving stockholders holding the bag of devalued shares.
Gorilla Trades looks at ways to build a stock exit strategy that limits losses on the shares workers purchase through options when the company (or the economy in general) hits a rough patch.
The Trade Life Cycle of Employee Stock Options
To better understand how they function, it’s helpful to take a quick look at the typical trade life cycle of options.
Issuing the Grant
The first step in an employee stock option (ESO) transaction is the issuance of a grant. This sheet is unique to ESOs; it has no equal in the public options market. The grant lays out the following:
- The types of options being offered, including incentive or non-qualified stock options (more on those later)
- The total number of shares the employee will purchase
- The predetermined price the employee will pay for the shares, called the “strike price”
- The expiration date, or the deadline for the employee to act on the options
The grant also lays out the vesting schedule, which is the next stage in the trade life cycle.
Vesting
Typical ESOs come with a sort of waiting period, during which the employee gradually earns the right to exercise their options. Many schedules include a “cliff” period — usually a year — in which the employee’s options do not vest. After that time passes, vesting happens at a set rate over multiple years.
For example, an employee may have a one-year cliff during which they can’t earn anything. Then, they may have a four-year vesting period when they vest 25% of the options each year. After that period concludes, the employee’s option is fully vested, and they may acquire the shares.
Exercising the Option and Selling Shares
When the vesting period is over, the employee has the right to acquire the shares at the preset price in the grant. After the transaction, the employee may decide to sell the shares at their current market value, which is hopefully higher than the strike price. Alternatively, they may hold on to the stock if they think its value will continue to grow.
Expiration
Employees usually have a deadline — commonly ten years — to exercise their ESO. When the option expires and the employee doesn’t move the shares, the holder loses the options, earning nothing.
Considerations for a Market Downturn
So what happens when the share value in an ESO declines (or the employee projects that it will decrease)? Should you have a stock exit strategy in hand? First, you should take a few factors into consideration:
Potential Loss
The biggest question, of course, is, “How much will I lose?” When the new share price falls below the strike price — when it’s “out-of-the-money” — the employee will take a hit on the proceeds of the ESO. This wouldn’t happen if the price were “in-the-money.”
Length of Holding
What is the employee’s investment horizon? There’s always a chance that short-term losses will be only temporary and that future profits await. Then again, they might not. How long you hold on is part of your strategy.
Financial Situation
Can you afford to hold onto shares during market fluctuations, or do you need to generate cash now? You can free up cash by selling, but the loss is permanent and irreversible.
Tax Implications
Employees may be offered an incentive stock option (ISO), which means they don’t pay taxes when they buy the stock if they meet certain requirements or milestones. On the other hand, they may get a non-qualified stock option (NSO), in which they pay taxes on the difference between the strike price and the stock’s fair market value.
Potential Hold and Exit Strategies
Here are some methods that could help you navigate through or away from your ESOs with as little damage as possible.
Hold On to the Options
This strategy should be the first one you consider, if not follow. How likely is it that the share price will bounce back? Perhaps you believe a long-term strategy will eventually pay off. If that’s the case, and if you have the patience to stick it out, the best plan could very well be to do nothing and hold on to the options.
Be realistic about the prospects, though. Take an objective look at your company’s fundamentals and target profit loss scenarios carefully, developing a spreadsheet strategy calculator if necessary.
Sell and Harvest Taxes
If you’re resigned that the company’s fortunes won’t improve and decide to take the loss, you can sell the options. You can use the loss to offset capital gains taxes on your portfolio investments that are performing well.
This approach might be the best to take if you have non-qualified options that afford you no special tax treatment. Keep in mind that the loss is locked in. Once you sell, there’s no going back.
Average Down
Those on the fence about their company’s future may consider selling only a few of their shares and keeping the rest. This strategy lowers the overall average cost per share as it frees up cash, softening your losses a bit.
You can repurchase the shares at the current lower price in hopes that you’ll turn a profit on them. This could offset the loss down the road. Be very careful, however. Make sure to assess your risk tolerance, and remember that there are no guarantees the price will rebound.
Exercise and Diversify ISOs
This strategy is suitable only for incentive stock options. It involves exercising your ISO at the preset strike price, even if the shares are priced lower. You can deduct the price difference from your taxes, which may lower your taxable income for the year.
Then, you can sell part of your shares at the current market price, which could help you make up for some of the losses. You may also decide to hold on to the remaining shares to see whether they’ll become profitable over time.
Target Profit Loss to Get Back in Balance
Employee stock options can be great wealth generators if you’re working for the next Amazon or Netflix. You can even benefit from options in a smaller company with modest but steady growth. However, ESOs can be albatrosses for those who find their profits declining.
Even though it can be painful, it’s entirely possible to mitigate losses by carefully implementing these strategies. If you need more help devising a strategy calculator, get in touch with a final advisor to show you the way.
Gorilla Trades: Navigating Stock Exit Strategy
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