Strategies for Exercising Stock Options

Factual Questions
1

I feel like there was a time when I could have done this, but I’m just getting lost.

If one has a number of stock option grants, all at different strike prices, what’s the most efficient way to exercise them. I’m using efficiency to mean “nets the most money, ignoring tax implications.” For now, assume all are in the money.

After some years, these are vested and it’s time to exercise. Are you better off to exercise the options MOST in the money first, or LEAST in the money first? For this scenario, we are talking about cashless exercise (no money is put in, the net value of one option is used to exercise others)

If it helps, here’s what we have (not real):
Current trading price $25
Grant A: 5000 at a strike price of $5
Grant B: 7000 at a strike price of $12
Grant C: 2000 at a strike price of $20

Without putting cash in, what’s the most efficient way to exercise these?

I know the tax implications are different, but leaving those aside, is it more efficient to exercise with cash and then do an immediate sale? Something I’m not thinking of?

Sorry folks. I’ve messed around with this in excel and I just keep confusing myself, I’m embarrassed to say.

And no, I’m not looking for financial advice- this is a scenario that’s far off in the future. I’m looking for the FQ on the math.

2

IIUC “cashless exercise” is basically equivalent exercising with cash and then selling immediately enough to pay off the strike. The only difference is that someone else is loaning you the cash between exercise and sale (whom you then pay off immediately) rather than it coming out of your float. Is something else intended here?

Absent tax implications, I don’t think there is a difference based on the order you exercise. Each option is simply worth current stock value minus strike price, no matter what order they are exercised in.

3

As someone who virtually lost a lot of money doing this wrong in 2001, I’d go with exercising the one with the highest gain first, since that maximizes your return. Think about how much you’d lose if the stock price crashes to 5, say. You’d lose $100k by not exercising A, but only $10K by not exercising C.
And you are wise to exclude tax considerations. It’s tax on found money. I did worry about them, and I shouldn’t have.

4

Nope- that’s exactly what I meant. But what’s tripping me up is this: If I exercise one share of A, I net $20. Which can then be used to exercise 4 more shares of A, 1.66 shares of B, or 1 share of C.

Does that matter? I don’t know. That’s why I’m here.

Good point.

My wife has accumulated a massive number of shares at her startup. Half are out of the money, and the total value today is pennies per share. The nature of her (our) business is that these will simmer for a long time until and unless there’s good news from the clinical trials. So it’s unlikely these will be worth exercising any time soon. And possibly never. But the strike prices are all over the place.

My wife is a brilliant chemist. She detests anything related to finance, so that becomes mine to manage. The ONE time I got options, also at a pharma startup, they never got into the money before we went bankrupt.

5

Do you intend to eventually (relatively quickly so stock prices changes during exercise don’t matter) exercise all shares of all grants no matter what? It seems like in that case there isn’t much value in the order you do it in. Starting with 1 share of A means you need to start with $5 which is less than if you start with any other grant, but I don’t see anything else to optimize here.

6

AAARRRGHH!!! Stock options. Don’t talk to me about stock options.

I was persuaded, by some people I knew, to work for VaLinux, back in the day.
It had the all-time record for first-day price pop after IPO: look it up.

And ONE WEEK before my options vested, they went underwater.

Grab anything you can right now. Do an immediate sale (cashless exercise), DO NOT put cash in and leave it there.

7

My company stopped giving out stock options a long time ago, and I get the impression that many other companies did the same thing. I’m a bit out of the loop at any rate, but first: what kind of options are these? ISO or NQ? And are you anywhere close to being affected by AMT?

8

Man, I used to do this for a living at UBS and Lehmans in the 1990’s, so I’m a little rusty.

Unless you need the money or think the stock is going to tank, don’t base it on the most money or the least money. That simply ignores the option value. I’m using “option” to mean “call options”, which is what your “grants” are.

Options have value but are wasting assets. In other words, the value of the option decreases with time, and becomes worthless if you hit expiry without exercising or are out of the money. So, how much time does your options have to expiry? If Grant A is expiring in April 2024 and Grant C is April 2030, then you want to exercise the one that expires soon.

Given the company is a start up with big potential should it progress in the clinical trials, it does not follow a standard distribution but has a fat tail. Because your wife works there, she may have some insights (but nothing that would be insider trading) as to how well the company is run and confidence in the trials. [But she also might be smoking her own crack]. So, if you have long dated options, there is a small probability that it will have an abnormally high share price gain and that adds to the option value.

If you look at a simplified Black-Scholes derived formula. IIRC, Call option value = (Spot - strike) - carrying costs (interest rates) - dividends + Volatility Value. I assume this company does not issue dividends

Delta value is important. Grant A is deep in the money, and probably trades around a 90 Delta or tracks pretty closely to the share price. Share price goes up $1 to $26, in an efficient market at 90 delta, the call option will go up about 90 cents to be worth about $20.90. Spitballing that grant C has 50 delta, so it would only go up 50 cents or to about $5.50.

Say this a different way, if one of the clinical trials hits and the share price doubles to $50. All the grant deltas will increase but will ignore that for simplicity. Again spitballing, but Grant A should gain $25 * .9 or $22.5 of that $25 increase. It’s worth $20 now before the $25 jump in underlying stock value ($25 - $5) + $22.50 or $42.50. Grant C is worth $5 + ($25 * .5) = $17.50

Net net, grant A is practically “stock without the dividends” because it is so deep in the money. Ask yourself if you want to own this specific stock? Or would you rather sell the option and get the cash to diversify into something else or blow it on fun?

Grant C is kinda like betting on a long shot but it is worth $5 right now

Finally, I repeat that options do have value and you need to consider when they expire vs what has the biggest/lowest gain.

(I had 10 year stock grants as a signing bonus, and grants were phased out the year I joined. These came in the money at about 9 years and 9 months, and paid for my kitchen. Hindsight is wonderful, and had I converted to shares, 20+ year later would have increased about 20x vs the 3x for the house value.)

9

I’m pretty sure they’re NQ. She also has a handful of Restricted Stock, which are not options at all but fully vested shares. However, because of her senior position, she cannot sell these right now. I don’t know the details, only that she is blocked from doing so. On the brokerage account that manages all this (ETrade), there’s a note to call someone at the company about that.

Lots. She’s been there 4 years, and all the options have 10 year expiries.

The above was just an example to illustrate the question. In the real world, about 1/2 of her options are in the money and 1/2 not. Those in the money are literally in the money by $1-2. Those out of the money are out by about $5.

Since we’re both in this business, we have a pretty good idea how these things work:
If they enter a P3 with a drug that has good commercial potential, there will be a spike in the price with that announcement. Trials can take years, so generally there will be a tailing off of the price over the course of the trial, as (I think) investors get impatient or lose interest. Trials almost never go as fast as predicted, so I think those delays are what drives that. I don’t know.

Anyway, once the results of the trial are available, one of two things happens, either a big spike or a big crash. It should be noted that it’s fairly common for these startups to be acquired somewhere along the way by one of the big boys, like Bristol-Myers.

Those are just my observations.

And no, if she were not an employee this would not be a stock I’d hold, because I’m pretty conservative, 95% index funds.

Given the small value of the options today, I think it makes sense to hold on for some movement. But when the time comes, I wondered how to handle them.

Thanks for all the thoughtful replies.

10

oldolds, you have a long-dated batch of lottery tickets. I’d let them run waiting for the boom or bust cycle assuming you don’t “need” the money. If you do need the money, I would look at selling the ones closest to maturity (lowest “option value”). And if you really need the cash, balance the time to maturity vs how deep in the money stocks are to meet you cash demand.

Honestly, pretty fun to dust off the cobwebs from the 90’s to explain this again. hope this has been helpful.

11

Exactly my plan. But I’ll tell you that if the stock moves in a big way, we will exercise 1/2

But as I said, what I really wanted to know was if there’s an appropriate strategy for which ones to execute first.

And yes, very helpful

12

Good plan to sell 1/2 if there is a spike (and suggest at least 1/2 of that the day the spike hits based on my experience with small pharma stocks). If you don’t need the money, then sell the shortest dated options first (because they have the least “option value”).

13

THIS!!!
When the Bubble burst, a bunch of people who exercised their options but did not cash out got royally screwed because they owed tax on what they made, but by the time they had to pay it the stock price had crashed so far that the stock wasn’t worth what they owed.
Take the money and run.

14

I appreciate what you’re saying. I hope it’s clear: Take the money and run IS the plan. I just want to know the best strategy.

Were I to do a cash exercise, it would only be to immediately take the cash. If that were more efficient.

Right now the net value just isn’t worth it. It’s worth about 8% of the cash I have now.

15

I really don’t see the problem? Do an immediate cashless sale on each option which is in the money.
The ‘cash’ to purchase the options is just subtracted from the sale proceeds in each case by the brokerage which handles the transaction (and returned to the issuer of the stock). The order of execution doesn’t matter at all.

Unless there is some restriction in place that requires you to ‘purchase’ the option stock and hold it for some length of time before selling? But as long as it’s vested, I don’t think that can apply.

UNvested options are a completely different kettle of fish. Those are a gamble…but you said in the OP that these are vested.

16

Oh, I know. But I figure a lot of people reading this are too young to remember the problem from 2001. A lot of smart people got caught, and it turned a nice benefit into a nightmare.

17

This points to, after the cashless exercise (or regular exercise + sell stock to cover the strike price), you should at least sell enough of the stock to cover the tax right away, but there’s no additional downside risk to holding whatever stock is left over (if you think it’s a good investment).

It isn’t always a 2001-type situation where you expect all stock to go down so selling everything as soon as possible is always prudent.

18

Sorry if I wasn’t clear. The examples in the OP were to illustrate my question, which is a math question at it’s base: If I’m going to cash out some, but not all, options right now, does it matter whether I cash out the most or least in the money options first/in some order?

Later, in the course of discussion, I explained the actual case, which is that the options are a mix of in- and out- of the money.

There are what I consider to be a substantial number of options. Were the stock price to hit $75, we’d be set for life. Right now, the price is less than $4. The highest strike price is just around $10, and the lowest is $3. I am well aware that market cap is the number that I should be looking at for potential price/share, but I’m trying to give a sense of where we are without giving a sense of how much money we’re talking about, because that’s obnoxious (my rich is your poverty, is his middle class)

The dollar value right now is not material to our financial situation. Whether that’s $12 or $12 million, there’s NO upside to cash out today.

Given what they are trying to treat, the POTENTIAL value is insane. But I’ve been 30 years in pharma (my wife too), and if you can predict whether any given drug will succeed, you could easily turn $1000 into $1 billion. And even though I’m an insider, at an executive level, I couldn’t do that for any of the Dev projects I’ve worked on.

19

In 2001 we expected all the stocks to keep going up. That’s where everyone ran into trouble.
Kind of like today.
The problem with owning a lot of stock in your company is that if it crashes, there is a greater chance that not only is your stock going to be worth less but that you’ll be laid off also, and could have used the money. That’s why a lot of companies don’t even have their stock in their 401Ks. I know someone who was working for IBM, had his 401K exclusively in IBM stock, and then got screwed when exactly this happened.
The only time keeping the options in stock is a good idea if you think the stock will outperform a more diversified portfolio. Why accept the risk that it won’t?

20

Back to the OP: When I wanted to raise a specific amount of cash, I would always cash in the lowest strike price first. Minimizes the number of shares that needed to be sold, so I would have more shares to capture future stock increases.

Just make sure you sell enough to cover taxes on the proceeds. I’ve heard horror stories of people who exercised the options, which then generated income, but didn’t have tax witheld, figuring that the stock would continue to go up and they could sell at a higher price. The stock cratered after they exercised but before they sold, leaving them with a huge tax liability from the exercise with nothing to pay the tax with. Bankruptcy ensued.

This assumes non-qualified options which do not have a taxable event when they vest, only when they are exercised.