What to Do with Expiring Non-Qualified Stock Options (NSOs)
Deadlines cause stress, but they also force decisions to be made. If you have Non-qualified Stock Options (NSOs) that are about to expire, odds are good that you’ve been sitting on them for a while and will soon have to make a decision about what to do with them (whether you like it or not).
It’s easy to make mistakes under pressure so in this article we’ll share our thoughts and tips on what to do with your expiring nonqualified stock options (NSOs).
Here’s an outline of what we’ll cover in this article:
Table of Contents ▼
This list may seem ambitious, but we’ll do our best to address these as straightforwardly as possible.
What Are Expiring Non-Qualified Stock Options (NSOs)?
Non-qualified stock options (NSOs) are a type of employee stock option that allows you to purchase company shares of stock for a set price for a specific period of time.
The typical time frame for NSOs is 10 years before expiration but can vary based on the company and how long you work there.
Whatever the set time frame is, your NSOs will expire and become unexercisable at the end of the set term.
We define Expiring NSOs as any NSOs that will be expiring over the next 12 months.
12 months may seem like a long time, but it’s really not if you’re trying to make strategic decisions on (1) what to do with your NSOs, (2) determine their impact, and (3) estimate their taxes.
The last thing you want is to be a week or two away from your NSOs expiring and not have a solid plan in place.
Differences Between Public and Private NSOs
Nonqualified Stock Options (NSOs) are granted both by public companies and private companies.
All that public vs private means is that public companies are traded on the stock market and private companies are not (or at least not yet).
If you’re at a public company, you’re able to see your company’s value at any point by looking up its ticker symbol.
If you work at Palantir, you can type PLTR into Yahoo Finance and you’ll see what the current stock price is and the frequency at which it’s being traded.
If you’re at a private company, your company will have two different values that affect your NSOs. The first is the 409a valuation, the second is the fair market value.
The 409a valuation is what matters at exercise and is what taxes will be based on, the fair market value (FMV) likely isn’t known since there’s not a public market.
When managing NSOs at a public vs private company, it’s important to realize that your exercise strategy will likely vary significantly.
If you exercise NSOs at a public company, there’s a good likelihood that you can turn around and sell the shares on the stock market immediately.
If you exercise NSOs at a private company, there’s unlikely an immediate market for you to be able to sell your shares, which means that you’ll need to make sure you have a way to pay potential taxes.
Understand Your Exact NSO Expiration Timeline
If you’ve worked at a company for several years, it’s possible that you’ve received multiple grants of NSOs over the years.
It’s great to receive equity every year, but keeping tabs on all your grants can be a little cumbersome.
Whether you have one big batch of NSOs that might be expiring soon, or you have a collection of annual NSO grants that will be expiring every year for several years, it’s crucial to understand exactly what you’re working with so you can make a plan for the future.
When we work with clients we like to build a shared Google Sheet in addition to tracking equity grants in our financial planning software.
Determine Level of NSO Impact
Once you have a clear understanding of your existing Non-Qualified Stock Options (NSOs) and those nearing expiration, you’ll want to assess their potential impact.
To evaluate this, you’ll need to calculate three key totals:
#1 - Total NSO Value
This is calculated by multiplying the number of NSOs you own by the current share price of your company.
#2 - Total Exercise Costs
This is the total number of NSOs you plan to exercise multiplied by your NSO exercise cost.
#3 - Total Bargain Element (or Spread)
This is calculated by subtracting Total Exercise Costs from Total NSO Value.
Example of Bargain Element Calculation
If your NSOs are valued at $30 each and your exercise price is $10, the bargain element (or spread) is $20 per NSO. Multiply this number by the total NSOs you own to find your total NSO bargain element.
After calculating these figures, you can gauge the significance of your expiring NSOs. Consider these questions to guide your decision-making:
How much bargain element will exercising your expiring NSOs generate? Is it substantial (in the millions) or minimal (a few thousand)?
Do you plan to sell your shares immediately after exercising?
How will you fund the exercise costs? Will you use cash or opt for a cashless exercise?
It may seem as though the bargain element is the sole factor to consider; however, that’s not the case. For instance, if you need to invest $100,000 to achieve a bargain element benefit of only $10,000, you are committing a significant amount of capital for a minor gain. This is why doing a cashless exercise can be so beneficial if you’re at a public company.
That said, the bargain element is still a big factor, probably the biggest factor to consider. This is because for every dollar of bargain element you generate from NSO exercises, you create a dollar of taxable income. (More on this soon.)
Build an NSO Exercise Strategy
You’ve read this far, now it’s time to finally make a plan to exercise. Whatever strategy you end up going with, your strategy should (at minimum) have all of the following elements:
Know how you’ll be paying the NSO exercise costs.
Know how tax withholdings will be covered.
Decide on how many shares to sell or not sell following exercise.
Have a plan to best use the cash generated from selling exercised NSOs.
Have a method for calculating/estimating what you’re going to owe in taxes.
If you have time to decide what to do with your expiring NSOs, it’s not uncommon to break your NSO exercise strategy between multiple tax years to help manage your tax bracket a little bit.
That said, stock prices can fluctuate so much that any tax benefit gained from exercising over a couple of years could be wiped out in a single day.
Your NSO exit strategy should be informed by your personal situation, your own personal goals, and what’s best for you personally.
Estimate Taxes From NSO Exercises
NSOs generate taxable income at exercise and if you don’t take time to estimate them you’ll likely be caught off guard.
Similar to how RSUs often result in employees being under-withheld come tax time, the same issue arises with NSOs.
NSOs are required to withhold taxes at statutory rates whenever options are exercised.
The statutory rates (i.e. required rates employers have to withhold at) are 22% for income under $1M and 37% for income over $1M.
If you need help estimating your taxes, that’s something we’re happy to help with. We’re also connected with lots of CPAs who can help with filing your actual tax returns.
Example NSO Exercise Strategies
This section warrants an entirely separate article (which we’ll link here once it’s written). For now, here are some common exercise strategies we help clients execute.
Exercise & Sell Everything All at Once
This strategy involves exercising all expiring NSOs and selling shares immediately. It’s primarily an option for NSOs at public companies, but it’s ideal for those needing immediate liquidity and/or want to diversify away from the company. It results in a single tax event that can push you into a higher tax bracket, but tax optimization isn’t the deciding factor.
Exercise & Sell Some Now and Then Repeat Next Year
By spreading out your exercises, you can potentially save some money in taxes, but this is not guaranteed as your company’s stock price can fluctuate significantly.
Exercise & Sell to Cover Taxes
This “exercise-and-sell-to-cover” method involves selling only enough shares to cover exercise costs and tax liability, allowing you to retain some shares as an investment. This is typically only done if you’re:
(1) very confident that the stock price will go up in the future
(2) there’s minimal tax liability owed from exercising. (This is common if your company is still private.)
(3) Holding a concentrated position fits your overall investment objectives
Pure Exercise & Hold
If you’re extremely confident that the company’s stock price will increase in the future, you may be tempted to pay cash to cover the exercise costs and pay cash again to cover any tax liability. This is probably the most aggressive approach and it’s not very common if exercising results in any sort of significant tax liability.
Execute Your Expiring NSO Strategy
After thinking long and hard about what you actually want to do with your expiring NSOs, it’s time to put your strategy into action.
If your company is publicly traded, it’s possible that you might not be able to exercise and sell due to trading windows. If that’s the case, please make sure that you’re aware of when trading windows are expected to take place!
The fact the NSOs are expiring means you’re going to be forced to make a decision, but staying on top of things will allow you to be proactive about the situation.
Final Thoughts & Tips for Expiring NSOs
Crafting a strategy for expiring NSOs doesn’t have to be overwhelming, especially if you’ve taken the time to analyze your situation and have a solid plan in place to help you achieve the desired outcomes.
We’ve helped many clients save significantly by crafting strategies that address both tax implications and long-term goals.
Saving taxes can be great, but knowing that you’ve taken the time to truly build an exercise plan that’s custom to your unique situation is what the entire focus should be.
This is something we love helping clients through and you’re welcome to review our services page to get a sense of how we might be able to accomplish this.
Thanks for reading!