If you do not know how to exercise stock options, you will miss out on their associated rewards. Exercising stock options are a critical part of improving your investment outlook and making positive returns, so you should familiarize yourself with this process as much as possible.
With this in mind, let’s now explore how to exercise stock options so you can make the most out of your investment.
Stock options also tend to be a great way for early-stage companies to compensate startup employees without money.
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What is a Stock Option?
A stock option is simply a legally binding agreement. If you have a stock option, it means that you have agreed with the management of a business, that you can buy shares in that business under specific circumstances. When those circumstances are met, you get the “option” to buy.
This means that you, the “holder” of the stock option, have the right to buy shares at a set price. You are not obligated to do so and may decide not to take up your option to buy.
Usually, the shares you can buy during an option are “common stock”. These are also known as ordinary shares or voting shares, and give you partial ownership of a business. Included with these are often voting rights allowing your vote to influence the direction of the company.
Who Gets the Stock Option?
Stock options are usually offered to employees, management, board members, and both current and potential investors. Employees and management are often encouraged to stay with a company so that they can meet the requirements to gain stock.
Board members benefit from increasing the share value of a business. Many of these will already be investors, though some may not.
Lastly, stock options can be used to bring in new investors who will see the opportunity when reviewing a pitch deck to benefit from a stock option in the future when a business is hopefully performing better. They cannot exercise the option immediately but will be able to take up the option at an agreed date.
When is the Best Time to Receive Stock Options?
Investment is about generating revenue and profit. The best time to take up an option is when the share price is at a premium while you have an agreed lower purchase price as part of the option.
For example, if you had as part of your employment contract the right to buy shares in the business after working for them for a duration of 5 years, you could take up the option. If your option stipulates that you can buy shares at $5 but the current share price is $30 per share, then it’s clearly a brilliant bargain.
Likewise, if you have the option to buy at $5 but the share price is lower than that, then you might decide against it.
The share price isn’t the only factor, however. Even if your option buy rate costs more than the current share valuation, it might be difficult to get a hold of shares and so you could decide to purchase them anyway.
Two key terms to be aware of at this stage: Vesting is the date when you can take up the option. Stock Expiration Date is the last day when the offer to buy is still valid. After this, your option means nothing, so don’t wait past this date if you want to buy it!
Strategies for Stock Options
There are four primary approaches to exercising stock: Exercise and Hold, Exercise and Sell, Exercise and Sell to Cover and a Stock Swap.
Exercise and Hold simply mean that you activate the option, buy the shares at the agreed price and then hold onto them. There are two main reasons to do this. The first is that if you hold the shares and do not sell them, you will generate revenue from any shareholder dividends.
The second reason to exercise and hold your shares is to wait until the stock increases in value over time. If the shares are worth a lot more in the future, then that will be the best time to sell to maximize your profit. Of course, there are no guarantees that the shares will accrue value.
Exercise and Sell is another great strategy. Here, you exercise the stock option, buy the shares, but sell the entire amount. What’s great about this approach is that most brokers will allow you to do this without using your own money.
What this means is that you can buy the shares without handing over any cash. The generated sale money will cover the costs. What’s left, goes straight into your bank account!
Exercise and Sell to Cover is essentially a mix of the first two strategies. Here, you sell just enough shares to cover the costs but then hold onto the remaining shares. This allows you to take up the stock option without handing over cash and you will still generate revenue with dividends and share value increases
A Stock Swap is your final option. This occurs when you already own stock in a company and swap it for the new shares. This can avoid any attached fees or taxes. However, you will be legally required to then hold onto the new shares for a set period, usually one to two years.
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Stock swaps generate a profit as the shares you hold will be valued at the current amount, while the stocks you are buying will be discounted to whatever rate was agreed when you signed the option.
Imagine your option values each share at $10 and you are allowed 10 shares, but the current marketplace value is $100. If you already own stock, you could swap just one share for the other 10. This is a “swap ratio” of ten to one!
Once in your possession, those ten new shares would be like any other and valued at $100 each. Now that’s a great profit.
Learn More about Stock Options and Investment
I hope you found my article about how to exercise stock options helpful. If you would like to learn more about this and many other business strategies, check out The DealMakers Podcast. On each episode, I interview expert entrepreneurs who share advice on how to maximize profits and become a business success story.
Remember that storytelling plays a key role in fundraising. This is being able to capture the essence of the business in 15 to 20 slides. For a winning deck, take a look at the pitch deck template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
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