“Do you understand the concept of Leverage?” If you’ve ever seen the television show Breaking Bad, perhaps you recall Walter White saying this a few times. For Non-Qualified Stock Options (NSOs), this phrase sums them up. If you have the good fortune of having NSOs, then it’s critical to understand how they work and how leverage can significantly magnify your returns.
What Are Non-Qualified Stock Options (NSOs)?
NSOs are a way for you to buy your company stock at a specified price. There are four major components to a Non-Qualified Stock Option and they are:
- Vesting Date
- Strike Price
- Grant Date
- Price You Exercise
Unlike their option cousin, Incentive Stock Options (ISOs), once you exercise your Non-Qualified Stock Options, there isn’t a tax incentive to hold on to the position. This is why, once NSOs are exercised, shares are generally sold immediately. Additionally, there is no Alternative Minimum Tax (AMT) to worry about. Once your NSOs vest, you do not actually get taxed on them until you exercise. At that time, you will be taxed ordinary income on the difference between the strike price and the price you exercise at.
How Leverage Works with NSOs
Look at the chart above. At the time this employee was granted Non-Qualified Stock Options, the company stock was $10 a share. For the sake of simplicity, let’s assume they were granted 1,000 NSOs and they all vested at the same time. At this time, the strike price or the exercise price on the shares is $15 a share.
Let’s look at two paths this employee could take:
| Exercise Right Away at $20 | Wait to Exercise When the Stock is $30 |
|
Return on the Option is the spread between Strike Price and Current Price $20 – $15 = $5 x 1000 shares -> $5,000 |
Return on the Option is the spread between Strike Price and Current Price
$30 – $15 = $15 x 1000 shares -> $15,000 |
Look at the bolded numbers across the bottom of the chart. There is a 300% difference between $5000 and $15,000. The employee made triple the money as the stock went up from $20 to $30 a share.
Look at the italicized numbers across the top of the chart. That is the company’s stock price. If the employee simply owned shares in the stock, they saw a return of 50%.
This, right here, is leverage!
Leverage Won’t Always Last
So now that you understand the concept of leverage, if you have NSOs that are deep in the money, meaning the company stock price is far above your strike price, it can be tempting to simply hold and look at significant gains on paper. However, be aware that leverage begins to decay the deeper the NSO is in the money.
Let’s look at the same set of NSOs but with different exercise prices:
| Exercise at $60 | Exercise When the Stock is $70 |
| Return on the Option is the spread between Strike Price and Current Price
$60 – $15 = $45 x 1000 shares -> $45,000 |
Return on the Option is the spread between Strike Price and Current Price
$70 – $15 = $55 x 1000 shares -> $55,000 |
Look at the bolded numbers across the bottom of the chart. There is a 22% difference between $45,000 and $55,000. The employee made an approximate 22% return as the stock went up from $60 to $70 a share.
Look at the italicized numbers across the top. That is the company’s stock price. If the employee simply owned shares in the stock, they saw a return of approximately 17%.
Consider 22% and 17% vs. 300% and 50% in the first example. This is a textbook example of leverage beginning to decay on a Non-Qualified Stock Option. When you see leverage like this begins to fade, it is time to seriously consider exercising your NSOs.
Other Considerations with Non-Qualified Stock Options
When you have NSOs, understanding when they vest and when to exercise is also a critical consideration. NSOs are not taxable to you upon vesting, only when you exercise and only if you exercise them in the money. Part of the comprehensive planning we do at MDRN Wealth is structuring a multi-year game plan around the options and identifying opportunities for when it is best to exercise. For example, if you have significant deductions one year, or you know a future tax year with lower income is coming, taking advantage of these periods of time can help to potentially save you thousands in taxes.
The other aspect of Non-Qualified Stock Options that, surprisingly, slips under the radar is the understanding that NSOs expire after a certain amount of time. The maximum time the NSO can be in place is 10 years, but your employer can set expiration sooner. Because you are dealing with a specific time frame, it is a balancing act of trying to take advantage of the most amount of leverage possible and exercising NSOs in the most tax-efficient way you can.
As with any form of equity compensation, individual company risk is always present. Your equity compensation is dependent upon the performance of your company’s stock price and, in a highly volatile stock market, you could be leaving yourself at risk if an excess amount of your net worth is tied to that company’s stock. If you feel like you would benefit from a financial plan where we can help you plan around your NSOs and how to maximize them, let’s have a discussion.
DISCLOSURES:
MDRN Wealth LLC (“MDRN Wealth”) and its Wealth Advisors do not provide any tax/legal advice. Consult your own tax/legal advisor before making any tax or legal-related investment decisions.
The material on this website is provided for general informational purposes.
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