The Impact of Stock Options on Cash Flow

Turning stock option contracts into real money takes some know-how. I’ll be the first to admit, managing your stock options involves a long list of financial goals, opportunities, and even constraints. Be that as it may, understanding how the fundamentals of stock options mesh with other aspects of financial planning is paramount to achieving your goals. I’ve written about the basics of stock options, including the ins and outs of taxation — but for this post, I want to highlight the not-so-apparent impact of stock options on cash flow. 

Stock Options Are An Expense

As you might recall, stock options have the potential to be a wealth-building tool due to the growth of the underlying company stock. This ongoing buildup of equity proves to be a viable resource to meet both short and long term financial goals. On the other hand, stock options don’t come without a price. When you exercise the right to buy your employee stock options, you must pay the exercise price via a cash exercise or cashless exercise. 

Knowing your options may seem easy in theory, but evaluating which strategy to employ significantly depend on your unique circumstances. Not only can the math behind the scenes of a cash or cashless exercise get tricky, but the decision to exercise stock options also have an impact on cash flow, and how many shares you will own after the exercise is complete. 

As Millennials, a considerable portion of your net worth is likely associated with your equity compensation, so you owe it to yourself to assess and act on the strategy that yields the most value as it pertains to your goals. 

Option 1: Cash Exercise

If your goal is to own as many shares as possible, a cash exercise may be the best choice. Compared to a cashless exercise, a cash exercise is quite simple:

1. You purchase shares of company stock using the agreed-upon exercise price per share. 
2. The total price you pay is the exercise price per share multiplied by the number of shares you want to exercise. 
3. Send your company or your custodian (the financial institution where your stock is held) the cash amount equal to the total price of the options exercised. It is also common to write a check.

Considering this process, a cash exercise is an out-of-pocket cost, where funds will need to be readily available. Depending on the number of options exercised and the exercise price, you can end up with out-of-pocket costs into the hundreds of thousands of dollars. Needless to say, financial planning is critical here.

Unfortunately, many startup employees may not have that type of cash laying around, making the cash exercise somewhat obsolete. In turn, this often causes employees to be priced out of the stock options, electing for a cashless exercise. And if you need me to say it, yes, it’s a bad idea to take out loans to cover the costs of the shares. 

If you’re lucky and forward-thinking, you’ll likely take the initiative to devise a plan to accumulate the amount of cash needed to exercise your stock options.

Here are some things to know before you perform a cash exercise:

• A cash exercise maximizes the number of shares you will own after the transaction, thus effecting your portfolio. 
• The shares you own may lead to a more concentration position.
• A cash exercise requires liquidity for the up-front cost of shares.
• If you have ISOs, a cash exercise may trigger the Alternative Minimum Tax.

Option 2: Cashless Exercise

A cashless exercise is frequently the default option if you don’t have the actual funds to pay for the shares. Primarily, with this alternative, you are exercising and selling the shares simultaneously. In doing so, you are covering the costs of exercising the shares with the proceeds of the sale. 

Here are some focal points of a cashless exercise:

1. You purchase shares of company stock using the agreed-upon exercise price per share. 
2. The total price you pay is the exercise price per share multiplied by the number of shares you wish to exercise. 
3. Instead of paying in cash, you’ll immediately exercise and sell some of your shares. You’ll also exercise and hold some of your shares.
4. The amount you exercise and sell will depend on the total cost to exercise the shares.

Under these circumstances, you can design cashless exercises to cover the costs of purchasing the shares, the tax liability you incur when exercising the shares, or both. 

Develop a Plan

Planning strategies for stock compensation begin with a “financial plan first” mindset. Always keep in mind that your stock option strategy must integrate with every other part of your financial picture, specifically your cash flow, investing plan, and tax strategy. Decisions about your equity compensation can only be optimized through the lens of your current circumstances and hopes for the future. Get proximate with your true desires, and the role stock options can play in building your wealth to achieve your life goals. After all, if you don’t plan for it, who will?