How does the vesting of stock options work?

theshortstack

This is probably a silly question, but I just want to clarify how the vesting of stock options work.

Let's say for example that I've been given £100k worth of stock options at work - and 25% of that vests every year for the first four years that I'm with the company.

I'm assuming that once my first year is up (and assuming I want to take advantage of my stock options), I'm going to need to cough up £25k to purchase the initial shares that are made available to me.

Is that correct?

I guess the reason that I'm asking is because I'd ideally like to hold on to the shares for the long term, but £25k is a large amount of cash to cough up each year, even if the stock has gone up and it's therefore a safe investment.

Therefore, it looks like I'm going to be forced to just take the amount that the stocks have increased and dump the actual stocks themselves.

Is that right?

Thanks very much for your help,

masonic

theshortstack wrote: »

This is probably a silly question, but I just want to clarify how the vesting of stock options work.

Let's say for example that I've been given £100k worth of stock options at work - and 25% of that vests every year for the first four years that I'm with the company.

I'm assuming that once my first year is up (and assuming I want to take advantage of my stock options), I'm going to need to cough up £25k to purchase the initial shares that are made available to me.

Is that correct?

Ok up to here. Presumably the options will be exercisable for some time after they vest, so you wouldn't necessarily have to take them up immediately.

I guess the reason that I'm asking is because I'd ideally like to hold on to the shares for the long term, but £25k is a large amount of cash to cough up each year, even if the stock has gone up and it's therefore a safe investment.

Therefore, it looks like I'm going to be forced to just take the amount that the stocks have increased and dump the actual stocks themselves.

Is that right?

Thanks very much for your help,

Well the options will give you the right to buy at a certain price, so if the current market price is higher, then you would still need to stump up the cash, but could immediately sell the shares at market price to realise a capital gain if you wanted and weren't contractually restricted from doing so.

theshortstack

Thanks masonic - appreciate the response.

When the shares become available to purchase, would that £25k have to be paid in a single lump sum or is there a potential schedule of payments that could be set up?

It sounds like I would have to sell the shares then to release the capital gain, unless I have a spare £25k lying around.

bowlhead99

The options themselves have an intrinsic value (e.g. the right, but not the obligation, to buy shares at 80p which are currently trading at 100p, will have a value of 20p or more). So, options - as long as they have already vested and have no further restrictions - can pretty much be sold on their own. Or, they can be executed to buy the shares at 80p that are then instantly sold at 100p and the cash from the sale will be received on the same day as the cash needed for the purchase.

So, you should not need to actually 'front' the £25k, because the broker gets the 100p proceeds for you on the same day he pays the 80p exercise cost for you. £5k just appears out of nowhere, for you - you don't really need to physically pay £25k and get £30k.

What you are getting from the company as a freebie is the option value (hopefully) increasing between when it is granted and when it vests and you can use it. Whether you yourself can 'afford' to own £25k or £50k or whatever of the shares in this one individual company, is not really relevant from the company's point of view - you are not going to be handcuffed to buy and own the shares and keep them after vesting. The company recognises that not everyone has the financial capacity to have £25k tied up in the shares of the company they work for, and like you say, if you don't have £25k lying around that you can risk on the future fortunes of this one company, you should clearly just sell up and cash in the value of the option (without even needing to hand over the £25k).

Shares are bought and sold on the market in real time. So you can't come up with a 'payment plan' to buy them, as such. You either want them at a point in time or you don't. However, what you might consider, if the options have a long period between them vesting and expiry, is just to exercise a few at a time and keep the rest of the 'un-executed' options in your back pocket.

Say for example the options are to buy 25000 shares in the company for 80p and the shares are 'worth' 100p on the open market. The options are worth 20p+ each, so each 5000 share options is worth £1k. You could cash out 25000 options for £5k profit or you could cash out just the first 5000 options for £1k and leave the others unused.
-Then three months later when the share price is 115p, your remaining options which still have an exercise price of 80p, are worth 35p each. So now you could cash in another 5000 options for £1.75k instead of £1k.
-six months later the share price is 150p and the options are worth 70p so you cash in another 5000 options for £3.5k instead of the original £1k.
-A bit further down the line while you waited for the share price to top 200p for a monster gain in your option value, the share price crashes to 70p. The option value to buy shares at 80p when they're only worth 70p is pretty much nothing so you get no value out of the last 10,000 options.

So, in some sense, yes if you don't have the money to front £25k and keep the actual shares, you can still benefit from the increase in the company's value over time (at least until the options expire - don't let that happen...) But if you are doing it with options rather than actual owned shares, the value change is very highly geared to the company's fortunes (in the example above, share price going up 10% from 100p to 115p, just a 15% rise, caused the value of the unused options to increase 75%). So, it is a risky strategy as the value can be lost overnight if the cash is not actually in your hand.

Very often, people receiving share options will just cash them in instantly. The growth from them being granted to you and them vesting is a great risk-free growth curve, because if they are worthless it didn't 'cost' you anything while if the company performs as well as expected there will be a nice value. But once they have vested, the risk is on you. The risk/reward mix changes for the worse, because now you can be worse off than if you cash out that day. You can keep them as options, with potential of large further gains but an erratic value, or you can pay out cold hard cash and own actual shares with a less volatile value, but one that can still crash hard.

If you think of all the companies out there in the world that you could invest £25k in, or all the really well-diversified investment funds that you could invest in as part of a broad portfolio of shares in hundreds of companies, it is not necessarily wise to hold a £25k investment in the one company you work for. If it falls on hard times you get a double whammy of losing your job or promotion prospects at the same time as your £25k turning to ashes.

So if you have options over 100000 shares vesting over a long period of time, the sound thing to do when the first 25000 vest is to cash them in and spend the money on something else, because you still have 75000 options giving you growth aligned to your company's prospects but you don't need your personal wealth to be actually tied up in those assets in order to get it.

theshortstack

You're a legend bowlhead - thanks very much for taking the time to type all that. It's massively appreciated and the whole thing makes a whole lot more sense now.

Just one more question though, so that I'm totally clear on this. Am I right in assuming that any profit I make on the vesting of my stock options will be subject to tax at my normal rate or does this get classified under my tax free Capital Gains limit of £10k a year?

Thanks,

somethingcorporate

My understanding is it would be subject to CGT not your normal/prevailing income tax rate.

bowlhead99

You are right that you have (actually £11k and a bit) of capital gains allowance each tax year.

Whether any of the value of the options you receive at date of grant, or the value at vesting, is subject to income tax or NI is something you can clarify with your employer, as they will presumably have clarified this with their legal or accounting advisors. And if your firm is large enough to be listed then presumably you are not the only person ever to receive share options. It would be unusual for them to not bother to produce any standard documentation and instead expect you to go and look at a web forum to get advice from strangers on the impact of their scheme on you the employee.