As a financial planner who specializes in helping tech professionals with employee equity, I hear this question from many of my clients who work at pre-IPO tech companies. Typically, the short answer is, you should exercise and immediately sell your NSOs once you’re within a year or two of their expiration date. Since NSOs typically expire after 10 years, this means you’ll usually want to exercise and sell them in their ninth or tenth year.
This rule of thumb assumes two things. It assumes your company is publicly traded, and you plan to stay there through the end of the expiration period. If you leave a company before your NSO expiration period ends, you often only have 90 days after your last day at the company to exercise your options.
Having said that, the better and more comprehensive way to decide when you should exercise your NSOs is based on multiple factors including
- Whether the NSOs are causing you to be overconcentrated in your company stock
- How exercising your NSOs may impact your tax planning
- How to make best use of the NSOs’ intrinsic and time values (which we’ll define further down)
This article will help you understand these factors, and give you a framework for deciding when to exercise your NSOs.
Table of Contents
What are NSOs?
Non-Qualified Stock Options or NSOs are options that give you the right to buy shares but not the obligation to buy those shares after you have vested those NSOs.
Please note that Non-Qualified Stock Options are different than Incentive Stock Options or ISOs, especially in how their tax treatment works. You should confirm what specific type of employee stock options you have by looking at your options paperwork or in your online account.
Companies that are still private or pre-IPO are the types most likely to grant NSOs. Typically, when you start to work at such a company, you are granted a specific number of NSOs, at a set exercise price and a specific vesting schedule. You then vest, or earn ownership of your NSOs over time.
A common vesting schedule in Silicon Valley tech companies enables you to vest 25% of your NSOs after your first year of service at a company, and an equal portion of the remaining 75% on a monthly basis for the next three years. After four years, you are 100% vested in your initial NSO grant.
For instance, let’s say you receive a grant of 10,000 NSOs when you start working for your current company. The exercise price is $1.00, and your options will vest over 4 years, with 25% vesting after one year, and the remaining 75% vesting monthly over the next three years.
After you complete year one at your company, you vest 25% or 2,500 NSOs. You now have your first opportunity to exercise some of your NSOs, although you don’t have to. Let’s look at why you might or might not actually do so,
What if I exercise my NSOs as soon as they vest?
First, let’s assume your company had its IPO six months after you started working there (because you cannot exercise your options until the company has gone public).
We’ll also assume the stock price has increased to $100/share since its IPO. Here’s where it gets interesting. If you decided to exercise your options as soon as they vest, you’d pay your $1.00/option exercise price, or $2,500 total, and now own 2,500 shares in your company stock. The 2,500 shares for which you paid $2,500 are instantly worth $100/share or $250,000 in the public stock market!
This is the happy path. What if the stock price has instead decreased to $0.50 per share post-IPO? You could still pay $2,500 for 2,500 company stock shares, but those shares would only be worth $1,250 on the open market. In this scenario, you’d be unlikely to exercise your vested NSOs right away, because you’d pay more for them than they’re currently worth. Since you can, you’d probably want to wait and hope the stock price rises.
How concentrated are you with your NSOs?
The next question to ask yourself is: How concentrated are you in your company stock with your NSOs? Put another way, what is the current fair market value of your NSOs, and what percent does that represent of your total investable assets?
Why does this matter? Being highly concentrated in a single stock means you’re taking on much higher risk and potential volatility than if you hold a broadly diversified, globally allocated portfolio. If you’re highly concentrated in your company stock, you’ll likely want to focus more on reducing your concentration than on minimizing taxes.
For instance, if you are 95% concentrated in your company stock with your NSOs, you likely want to focus on reducing your concentration vs. if you’re 5% concentrated with your NSOs, in which case you may want to focus on minimizing taxes.
My general guideline is, if you own more than a 20% concentration in your company stock (including your NSOs and any other vested employee equity), then you are highly concentrated. I suggest focusing more on reducing your excessive concentration risk over minimizing taxes. If your concentration risk is lower than that, you are better positioned to prioritize tax minimization.
History is filled with sad tales of employees who were highly concentrated in their company stock. Enron is an infamous example. Its stock price skyrocketed for years, to as high as $90 per share, until news about accounting fraud surfaced and the stock dropped to less than $1 per share within months.
Many Enron employees were highly concentrated in company stock. This was because their company 401ks could be invested in company stock and the 401k company match was also made in Enron stock. Some employees with high concentration in company stock lost hundreds of thousands of dollars including most of their savings for retirement.
It is quite common for tech professionals at pre-IPO companies to end up highly concentrated in their company stock. Clients often come to me starting with concentrations of 50%, 80%, and 95%. Enron provides an example of the very real risk of being too highly concentrated in your company stock including your NSOs.
How Do You Calculate Your NSOs Concentration?
Here’s how you can calculate your concentration with your NSOs.
Step 1. Total up the value of your vested NSOs and other employee equity, including Incentive Stock Options (ISOs) and Restricted Stock Units (RSUs).
Step 2. Total up the value of your other investable assets such as investments, stocks, bonds, ETFs, mutual funds, 401ks, and other retirement accounts. Add the value of your other investable assets to the value of your vested employee equity and this gets you your total investable assets.
Step 3. Divide the value of your vested NSOs and other employee equity by your total investable assets. This shows you your concentration percentage.
Here are details on how to calculate your concentration. Again, my general guideline is that if your concentration is more than 20%, I’d say you are highly concentrated, and should focus on reducing your concentration in your vested NSOs.
How do taxes work with your Non-Qualified Stock Options?
Now that you understand your NSO concentration risks, let’s consider how NSOs are treated from a tax perspective.
When your NSOs are granted and vested, you pay $0 in ordinary income tax. However, when you exercise your NSOs, you pay the ordinary income tax rate on the difference between your original exercise price and the stock’s current fair market value.
NSOs vs. ISOs
As an aside, there are key tax differences between NSOs and ISOs. When you exercise ISOs, you pay $0 in ordinary income tax on the difference between your exercise price and the fair market value. You may incur AMT and/or capital gains taxes, depending on how you proceed with your ISOs, but the point is, it’s critical to understand which type of stock options you own.
Let’s go back to our previous example to understand how NSO taxes work. Remember, you received a grant of 10,000 NSOs with an exercise price of $1.00 per option, vesting over 4 years. Again, we’ll assume you vest 25%, or 2,500 NSOs after one year, and the stock has a fair market value of $100 per share. If you exercise your 2,500 NSOs at $1.00 per option, you’ll pay an exercise cost of $2,500 for stock with a fair market value of $250,000.
So, what does that mean for your taxes? You’ll need to pay the ordinary income tax rate on its intrinsic value of $247,500. That’s the difference between your $2,500 exercise price and the stock’s fair market value of $250,000:
$250,000 FMV – $2,500 exercise price = $247,500 intrinsic value
The taxes on that difference are calculated the same as if this income were part of your salary, although such a big bump in income is likely to move some of your income into a higher tax bracket, paid at higher rates.
Bottom line, since your NSO’s intrinsic value is taxed at ordinary income tax rates as soon as you exercise your options, you may not want to exercise them until you’ve completed some careful tax planning, before you are ready to sell.
What is the time value of your NSOs and why is it important?
It’s also critical to understand that your NSO’s value comes from two primary sources:
- Intrinsic Value – An NSO’s intrinsic value is the difference between its exercise price and its fair market value, as illustrated above. This value is relatively easy to see and understand.
- Time Value – An NSO’s time value is a little harder to pin down, but it’s important to your decision on when to execute your options. You can think of the time value as the future potential value left in the option before it expires, which is typically after 10 years (as long as you are still working at the same company). The more time you have left on an option before it expires, the more time there is for the stock’s value to increase. After your NSOs expire, you can’t exercise them at all, because they’re gone.
The easiest way to illustrate the time value of an NSO is to ask yourself: Would you rather have NSOs that expire tomorrow or 10 years from today? Most people would prefer NSOs that expire 10 years from today because they’re more likely to increase in intrinsic value over the next 10 years than when compared to options that expire tomorrow. That potential represents the time value of your options.
Let’s go back to our previous example, in which the intrinsic value of your vested options would be $247,500 if you exercised them tomorrow.
$250,000 FMV – $2,500 exercise price = $247,500 intrinsic value
But now, let’s factor in your NSOs’ 10-year expiration period. Since they were granted to you only a year ago, they have nine years left before they expire. Since the chances of the stock price going up dramatically over the next nine years is likely higher than the chances of it going up dramatically by tomorrow, your NSOs have a much higher time value today than they will in eight or nine years.
NSO Expiration Date | Time Value (Opportunity for More Growth) |
---|---|
10 years away | High time value |
1-2 years away | Low time value |
1 day away | Essentially no time value |
After Expiration | Worthless |
When should you exercise your NSOs?
Now, let’s tie together tax planning with an NSO’s intrinsic and time values.
We now know you have to pay the ordinary income tax rate on the exercised stock’s intrinsic value as soon as you exercise your NSOs. Generally, this argues for immediately selling your options once you exercise them, since you’re incurring the taxes either way.
We also know your NSOs have more time value, or opportunity for additional growth, when their expiration date is years away. As such, it’s often reasonable to hold your NSOs as long as you can, to capture as much of the time value as you reasonably can.
So, for instance, one strategy I use to help my clients manage their NSOs is to set up a schedule to exercise and immediately sell once their NSOs are less than two years away from their expiration date:
- If you exercise too far out from your expiration date, you may leave too much time value on the table.
- If you exercise too close in to the expiration date, you may be forced to sell at a relatively low price, or risk having your NSOs expire worthless.
- By exercising and immediately selling when you’re within the sweet spot of a year or two from expiration date, you’ll make good use of your NSOs’ time value, while also having flexibility on when to sell.
Again, this will depend on your specific tax situation, which means you should talk to your tax professional or financial planner about the right way to manage taxes.
What are valid reasons for exercising and selling your NSOs earlier?
There also are valid reasons for exercising and selling NSOs earlier, including near-term cash needs and/or to reduce high concentration.
Cash flow: Could the cash from an earlier exercise and sell be used for higher priority purposes today? For example, if you need cash to set up an emergency fund, or to fund a down payment on a house, it might be reasonable to exercise and sell NSOs earlier instead of waiting. After all, until you exercise your NSOs, you don’t know they’ll actually be worth anything in the future.
Concentration risk: If you are highly concentrated with your NSOs (more than 20% in company stock, as described above), that may also be a valid reason for exercising and selling them earlier, to reduce your concentration by diversifying out of your NSOs and other vested employee equity.
Are you ready to decide when to exercise your NSOs?
This post has helped you learn what NSOs are, how much concentration you have with your NSOs, how your NSOs are taxed, and how to consider both their intrinsic and time value. We hope this provides you with a framework for deciding when to exercise your NSOs.
You can make the decision on your own if you enjoy this type of work. Or, if you prefer spending your time and energy elsewhere, we specialize in helping tech professionals like you make the most of your NSOs. Know that you can get help from a financial with deep experience with NSOs.
If you have questions about your specific circumstances, or want to talk further about how to make the most of your NSOs, please schedule a free virtual consultation. We welcome the opportunity to speak to you.
After 20 years working for companies including eBay, Yahoo!, Intuit, and startups, I made a career change into the financial world as a fee-only financial planner 9 years ago. I earned my CFP®, spent a few years at a boutique fee-only firm in San Jose, worked 2 1/2 years at a leading wealth management firm in San Francisco, and then left to build the firm I wish had existed when I was working as a tech professional.
My mission is to help other Silicon Valley professionals make the most of their employee equity to help them reach their financial goals.