Disclaimer

I am not an accountant and this article should not be considered as financial or tax advice. I am providing analysis and calculations which may be used at your own peril. This article is written to demonstrate basic concepts, and does not account for country-specific tax laws or company-specific share option details. Your individual situation may invalidate some or all of the arguments and/or calculations made in this blog post.

Introduction

In many jurisdictions when share options are exercised, the income from such an exercise is taxed at the normal income tax rate. On the other hand, gains on shares (not options) are generally taxed at the more favourable capital gains rate. One therefore might assume that it is beneficial from a taxation perspective to convert company-issued share options into shares. In this blog we analyse the total profit generated from different strategies related to when and how share options are exercised, and will demonstrate that holding on to share options for as long as possible is likely a better strategy than converting options to shares.

The purpose of this blog is to demonstrate a thought process and methodology that can then be extended to account for country-specific tax rates, and country-specific tax benefits. It does not claim to give a universal answer on whether share options should be exercised to convert into shares.

What is a share option

A share option (aka stock option) is the right to buy shares in a company at a fixed price. For example, if one has been issued 1000 share options with a strike price of $10, this means that at some point in the future one can buy up to 1000 shares for $10 each. If those shares are then trading at $100, then each share option would be worth $90, as determined by the market price at that time minus strike price. Alternatively, think of an option as a discount which allows you to purchase something that is worth $100 by paying only $10 — and therefore this discount (your option) has a value of $90. In our example, the 1000 share options would therefore have a value of $90,000.

Assumptions

In the remainder of this blog there are some simplifying assumptions made:

The value of shares of the company that you have share options for will continue to increase.
Tax is incurred when a share option is exercised.
The rate of taxation on gains from a share exercise is higher than the rate of taxation on capital gains.

Country-specific tax considerations and/or benefits are out of scope of this blog.

What does it mean to exercise a share option

Exercising a share option refers to the act of paying the strike price to convert the share option into a share. Continuing with the previous example, we saw that 1000 options to buy shares for $10 would have a value of $90,00, assuming that the shares are currently worth $100 each. However, if we go ahead and actually exercise the shares, then we have triggered a taxable event of $90,000.

The $90,000 benefit from exercising the share options would generally considered income, and will normally be taxed at one’s standard income tax rate. For example, if one is in the 40% income tax bracket then one would have to pay $36,000 in tax in order to be allowed to hold on to one’s shares. In order to convert these share options into shares, the total cost is the strike price of $10,000 plus the $36,000 of income tax. After paying $46,000 one would have shares worth $100,000. One is therefore $54,000 ahead compared to if one had not been granted the stock options.

In order to avoid having to pay cash out-of-pocket in order to exercise a share, one also has the option of a cashless exercise – this is where the money to pay the tax and the exercise price is paid by exercising and immediately selling a portion of one’s share options to cover the strike price and taxes. In the above example, one would pay $46,000 to cover the exercise price plus tax, which can be paid by selling $46,000/$100=460 shares. In this approach, one would be left with 540 shares worth $100 each. As expected, in this scenario one is also $54,000 ahead than if one had not been granted stock options.

Is it a good idea to exercise share options as soon as possible?

If one expects the share price to continue to rise, then one may be tempted to exercise all share options to convert into shares, to take advantage of the lower tax rate applied to capital gains. In this section, we consider why this is unlikely to be a good strategy.

Let’s imagine a scenario where the share price continues to rise to $1000, and we are still employed by the same company. Would we be farther ahead financially if we had exercised our shares at $100 and later sell the shares at $1000, or just held on to the original share options and finally exercise and sell at $1000? The table below shows the difference between the two scenarios. The original formulas can be seen in the first tab of this spreadsheet.

Assumed income tax rate	40%	<– Assumes that taxes are due on exercise (may be country specific)
Assumed capital gains tax rate	18%	<– Even if zero, in the calculations below, holding options until sale is preferable.
Assumed number of share options	1000

	Cashless exercise and hold	Hold and exercise at time of final sale
Per share exercise price	10	10
Per share value at exercise	100	1,000
Per share value at sale	1,000	1,000

Taxable income at exercise	90,000	990,000
Exercise cost (strike price * number shares)	10,000	10,000
Tax on exercise (income tax rate * taxable income)	36,000	396,000
Cost of cashless exercise (tax + exercise price)	46,000	406,000
Number of shares to sell to pay cost of exercise	460	406
Number of shares owned after exercise	540	594
Capital gain	486,000	0
Tax on capital gain	87,480	0
Pre-tax gain	576,000	990,000
Total tax per share (income tax + capital gain tax)	123,480	396,000
Total profit after tax	452,520	594,000

Notice that holding onto the share options for as long as possible has resulted in a greater profit than exercising the share options earlier and benefitting from a lower capital gains rate. In-fact, even if the capital gains rate is set to zero, in a scenario where the future value of the shares is $1000, it is still more profitable to hold on to share options rather than exercising to convert to shares.

This happens because in many countries, at the moment that one exercises shares, one incurs an immediate tax liability. Additionally, one also has to pay the strike price. In our example of a cashless exercise of 1000 shares at $100, the number of shares left after paying for exercise costs is only 540 – and therefore instead of enjoying growth on 1000 share options, one would instead only enjoy growth on 540 shares. Because of this reduction in the number of shares after a cashless exercise, the amount of growth is dramatically reduced versus the growth that would have been experienced if original options had been held.

On the other hand, the tax has indeed been dramatically reduced by performing a cashless exercise at $100 rather than waiting and exercising at $1000. However, the amount of tax savings does not compensate for the lost growth.

The above may lead one to conclude that they should therefore use cash to exercise their share options. We will investigate this in the next section.

Should share options be exercised with cash

If one has extra cash around, they may believe it would be a good idea to use cash to pay the cost of exercising their share options, rather than executing a cashless exercise and hold. This is likely true, and if the share price continues to rise then it would result in more profit than a cashless exercise and hold.

However, if one believes in their company enough to wish to invest cash, then they should consider if it is best to use that cash to exercise their existing share options to convert them to shares, or if it would instead be better to just buy additional shares on the open market with that cash. We therefore compare these two scenarios in the table below. Original calculations can be seen in the second tab of this spreadsheet.

Assumed income tax rate	40%	<– Assumes that taxes are due on exercise (may be country specific)
Assumed capital gains tax rate	18%	<– Even if zero, in the calculations below, using cash to buy more is better than using it to exercise
Assumed number of share options	1000

	Pay cash to exercise	Wait until sale to exercise, and instead buy more shares
Per share exercise price	10	10
Per share value at exercise	100	1000
Per share value at sale	1000	1000

Taxable income at exercise	90,000	990,000
Exercise cost (strike price * number shares)	10,000	10,000
Tax on exercise (income tax rate * taxable income)	36,000	396,000
Cost of cash exercise (tax + exercise price)	46,000	0
Cash paid (purchase more shares)	0	46,000
Sale value of additional shares (purchased in lieu of cash-exercise)	0	460,000
Capital gain	900,000	414,000
Tax on capital gain	162,000	74,520
Pre-tax gain	990,000	1,404,000
Total tax (income tax + capital gain tax)	198,000	470,520
Total profit after tax	792,000	933,480

Notice that the above calculations demonstrate that it is more beneficial to buy shares on the open market rather than using that same cash to exercise and hold shares. This is true even if the capital gains rate is zero. Again, this is due to the loss of future growth on any amount that has been paid in tax as well as any future growth on the cash that was used to pay the strike price.

Caveats

In pre-IPO companies where it is not possible to allocate cash to buying additional shares, it is likely beneficial from a tax perspective to early exercise such share options to convert them to shares. This is because the alternative of buying additional shares on the open market is not an option.

Share options generally expire if one leaves their employer. Therefore share options should be exercised before they expire and become worthless.

Share options likely expire a certain number of years after their grant, and should be exercised before they expire. The following article provides additional information related to exercising stock options: https://kellblog.com/2019/08/18/avoiding-the-ten-year-stock-option-trap/.

Conclusions

Based on the above calculations, if one wants to maintain their investment in a publicly listed company, and have the expectation that their company stock price will go up, then it would generally be financially beneficial to hold on to stock options as long as possible rather than exercising those options to convert them to stock. If one wishes to invest additional cash, then it is likely better allocated buying additional shares rather than to exercise options. Having said all of that, do not forget to exercise your in-the-money options before their expiry date or when you leave your employer as they will become worthless once they expire!

Disclaimer: this should not be considered as financial or tax advice, and your individual tax circumstances may differ. In the above calculations we disregard any country-specific tax laws that may increase the attractiveness of exercising share options.