Rule of thumb for exercising stock options.
How do you set the exercise price of stock options to. stock options or SARs. round preferred stock price.
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So I suggest a different rule of thumb rather than percent of. The income tax consequences of exercising the option depend on whether.
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Things to Know about Stock vs. Options. When you sell the shares you acquired by exercising your options,. very rough rules of thumb:.Many of you will one day receive a significant chunk of your pay as stock options. The following is a good rule of thumb,.
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5 Factors Help You Decide When to Exercise Stock Options.
Your individual circumstances will determine when the time is right.
Some advice articles say you should hold onto your employee stock options as long as possible. Don't exercise them until they're near their expiration dates. In theory, at least, this gives the stock an opportunity for additional price appreciation.
But this may not always be the right advice. Your circumstances, your comfort level with risk, your tax situation, and a few other factors should also be considered.
Here are five factors to weigh as you try to come up with a personalized answer as to the best time to exercise your employee stock options.
Your Financial Needs.
If you're holding the options in the hope that the stock price will climb higher, consider your current needs for cash compared to the potential of additional gains. If you need cash now and your options have value, exercising now is a sure thing. A higher stock price in the future is not certain.
You might want to exercise early because:
You have high interest rate debt that you could pay off. You do not have adequate cash savings and you need a larger rainy day fund or emergency fund. You need funds for a down payment on a house. You have another compelling investment opportunity that you think has more potential than the company stock. You need tuition funds for a child in college.
The Risk/Return Tradeoff.
There's a component to your employee stock options called time value.
When there are many years left until the expiration date, time value is the potential for additional future gains. Along with time value comes the risk that the stock might go down. The gains you would realize by exercising today would disappear.
You might want to take risk off the table and forego potential additional gains if:
A fairly significant amount of your financial wealth—more than 10 percent—is already tied up in company stock. Cash in hand today could provide a significant improvement to your financial situation based on your financial needs. You don't think the prospects for the company stock look attractive.
Tax-Planning Opportunities.
Tax planning involves projecting your expected income and deductions over the upcoming years. Exercising all your options in one year could bump you into a higher tax bracket. There may be tax reasons to exercise some options now and wait until later to exercise others. It might make sense to exercise a portion of your options every year rather than wait until the expiration date to exercise them all.
Market Conditions.
The volatility of your company stock and the volatility of market conditions as a whole should be considered. The sun doesn’t always shine. This point is well made in CNN Money’s article on exercising stock options:
“During the tech stock bubble, for example, at least a few conservative employees took profits in their high-flying companies' shares. Turning paper gains in options into real cash—despite exercising "early" according to conventional wisdom—seems to have been extraordinarily prudent in retrospect.”
Quantity of Options/Investor Sophistication.
If yours is a sophisticated, high-net-worth household, you might pursue more advanced strategies than someone with less sophistication. A good rule to follow is that if you don't understand it, don't do it. John Olagues, author of Getting Started in Employee Stock Options , talks about advanced employee stock option exercise strategies. John is a former Stock Options Market Maker from the Chicago Board Options Exchange and the Pacific Options Exchange in San Francisco.
He says that you can reduce risk and increase potential returns by using advanced strategies that involve selling calls and buying puts on the company stock. John is adamant that when compared to an exercise - and-sell strategy, advanced option strategies are a more efficient way to reduce risk and capture the time value remaining in your options.
We'll guide you through the most critical retirement decisions, from when to start taking Social Security to where to spend your dream retirement.
John outlines his thoughts in 5 Golden Rules for Managing Employee Stock Options . Keep in mind that these advanced strategies are best implemented by those with employee stock options that are potentially worth $500,000 or more.
Don't blindly follow a rule of thumb and hold all options until the end. Consider all factors to make a decision that fits your needs.

How do you set the exercise price of stock options to avoid Section 409A issues?
The following mini-FAQ is somewhat based on a WSGR client alert (note: PDF is slow loading).
Do the 409A regulations provide guidance on the valuation of stock subject to “stock rights”?
Yes. The regulations provide guidance regarding acceptable methods for determining the fair market value of: (a) readily tradable (public company) stock, and (b) stock not readily tradable (private company stock).
These regulations represent a significant change in the process for determining the fair market value of private company stock. In order to comply with Section 409A and thus avoid early optionee income recognition and, potentially, a 20 percent additional tax, prior to option exercise, most private companies will need to significantly revamp their fair market value determination process.
What are the acceptable methods for determining fair market value of public company stock?
The fair market value of public company stock may be based upon:
the last sale before or the first sale after the grant; the closing price on the trading day before or the trading day of the grant; any other reasonable basis using actual transactions in such stock as reported by such market and consistently applied; or the average selling price during a specified period that is within 30 days before or 30 days after the grant if the valuation is consistently applied for similar stock grants.
What are the acceptable methods for determining fair market value of private company stock?
The fair market value of private company stock must be determined, based on the private company’s own facts and circumstances, by the application of a reasonable valuation method. A method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the private company.
The factors to be considered under a reasonable valuation method include, as applicable:
the value of tangible and intangible assets; the present value of future cash-flows; the readily determinable market value of similar entities engaged in a substantially similar business; and other relevant factors such as control premiums or discounts for lack of marketability.
How often do private companies need to perform fair market valuations?
The continued use of a previously calculated fair market value is not reasonable if:
the initial valuation fails to reflect information available after the initial date of the valuation that materially affects the value of a private company (for example, resolving material litigation or receiving a material patent); or the value was calculated as of a date that is more than 12 months earlier than the date for which the valuation is being used.
As a practical matter, most venture backed private companies obtain a new valuation report every time they complete a preferred stock financing.
Is there a presumption of reasonableness?
Yes. The regulations provide a presumption that the fair market value determination will be considered reasonable in certain circumstances, including: (a) if the valuation is determined by an independent appraisal as of a date no more than 12 months before the transaction date, or (b) if the valuation is of “illiquid stock of a start-up corporation” and is made reasonably, in good faith, evidenced by a written report, and takes into account the relevant valuation factors described above.
This presumption of reasonableness is rebuttable only upon a showing by the IRS that either the valuation method, or the application of such method, was “grossly unreasonable.”
What is an “illiquid start-up corporation”?
Stock will be considered to be issued by an “illiquid start-up corporation” if:
the company has not conducted (directly or indirectly through a predecessor) a trade or business for a period of 10 years or more; the company has no class of securities that are traded on an established securities market; the stock is not subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or other “lapse restriction” such as the right to purchase unvested stock at its original cost); the company is not reasonably expected to undergo a change in control or public offering within 12 months of the date the valuation is used; and the valuation is performed by a person or persons “with significant knowledge and experience or training in performing similar valuations.”
This may result in additional expense and burden for smaller companies (for example, having to hire an appraisal firm). Also, this could be problematic for companies issuing stock options or SARs within a year prior to a change in control or an initial public offering.
Are the typical, historical fair market value determinations made by private company boards of directors permissible under Section 409A?
Generally, no. The regulations have significantly changed the method by which a private company determines the fair market value of its stock. For example, valuation of private company stock solely by reference to a ratio related to the value of preferred stock (the old 10 to 1 ratio) generally will not be reasonable. Specifically, to comply with the proposed regulations, the valuation of “illiquid start-up corporation stock” must be:
evidenced by a written report which takes into account the relevant valuation factors discussed above; and performed by a person or persons with significant knowledge and experience or training in performing such valuations.
Consequently, unless a private company board includes a director, or directors, who would satisfy the “significant knowledge and experience” requirement or a company employee satisfies this requirement, the determination of fair market value most likely will need to be made by an independent appraisal. However, if one of the private company directors is a representative of a venture capital investor, or if the company employs individuals with financial expertise who would satisfy the “significant knowledge and experience” requirements, it may be permissible for the written valuation report to be prepared by such individuals.
Are most companies getting independent appraisals done?
Any company that has completed a preferred stock financing with an institutional venture capital firm typically will get a 409A valuation report from an independent appraisal firm. Most pre-VC financed companies that are not issuing large option grants will not incur the expense of a valuation report.
How much does a valuation report cost?
I have had early stage companies get valuation reports done for as cheaply at $5K. However, these valuation reports may be rejected by the company’s auditors, resulting in the need to have them redone by another firm. Valuation reports done by more reputable firms may cost $10K to $25K, and even higher for later stage companies.
What is the typical fair market value of the common stock in relation to the preferred stock price for an early stage company?
The CEO of a boutique valuation company told me recently that the fair market value of the common stock of a typical early stage technology company is at least around 25% to 30% of the last round preferred stock price. The old rule of thumb that the option exercise price could be 10% of the preferred stock price is not valid.
If a startup company is pre-revenue and pre-VC financing, but has a convertible note seed financing of $800K, can it offer options at an exercise price equal to the common stock par value of $0.01 to staff joining before the VC financing. I get it that after the VC round it will have to equal 25%-30% of the Series A VC preferred price, based on what's above, but what about during the angel-seed-convertible note stage?
Geo – Tough call. Options need to be granted at FMV. If a company is able to raise $800K of financing, it probably means that FMV of the common is greater than nominal. BTW, $0.01 is a meaningless number without more context.
Geo – Tough call. Options need to be granted at FMV. If a company is able to raise $800K of financing, it probably means that FMV of the common is greater than nominal. BTW, $0.01 is a meaningless number without more context.
What if the start-up company has not gone through a round of financing, is pre-revenue, does not currently own any assets, but is having engineers research and develop a proof-of-concept for an idea that the company's owner has for a new product. If the start-up wants to offer the engineers options such that, if the engineers are successful in developing the proof-of-concept (thereby allowing the company to actually patent the idea), the engineers can enjoy the upside potential of their efforts, can the company set the exercise price at or near zero (since the company currently doesn't own anything, has no cash flow, and has had no financing), or does it have to assume future cash flows based on a possible product, and then add an extra layer of discount to reflect the probability (as opposed to the the certainty) of developing the product successfully and receiving cash flows from it at a later date? Thanks!
Yokum, what is the latest thinking on how to price common stock options for an early stage company? I saw that in 2009, a valuation firm said 25-30% of the preferred stock price. Is that the current thinking?

Rule of thumb for exercising stock options

This page sets out some typical rules which are employed in the early exercise of an option. However this is not to be construed as advice in any specific case, and you should seek your own independent advice before making any decisions.
The following table sets out the rule of thumb for when an American call option is likely to be exercised ahead of expiry, before the stock goes ex-dividend.
Where a call option is deep-in-the-money, with little chance of the stock falling below the strike price before expiry, the option is a candidate for early exercise.
This generally occurs where the dividend the investor would receive, if they were to exercise the call, is greater than the interest expense incurred in buying the shares which are the subject of the option ahead of the expiry date. Generally this only occurs on the day before the ex-dividend date.
For in-the-money calls where the corresponding put still has some value, the rule used by most of the market is that if the value of the dividend is more than the value of the corresponding put plus interest, then the call should generally be exercised for the dividend.
Writers of call options who want to avoid assignment (being exercised against) may need to either buy back or roll that short call position to another strike in another expiry, being mindful again that the option they roll to is not also a candidate for early exercise.
National Australia Bank.
Ex-Div 7th June 2004.
Dividend 83 cents.
Share Price $30.31 on last cum dividend date.
Corresponding put is worthless Interest = 6.4 cents (Strike Price $26.00 X Interest Rate 5.25%) / 365 days X 17 days till expiry 83 cents > 6.4 cents.
Therefore the June 2600 call will generally be exercised.
Corresponding put is 68 cents Interest = 7.3 cents 83 cents > 75.3.
Therefore the June 3000 call will generally be exercised.
Therefore the June 3050 call will generally not be exercised because the dividend isn't large enough.
Early exercise of American puts for interest.
The following table sets out the rule of thumb for when an in-the-money American put option is likely to be exercised ahead of expiry.
When put options are deep-in-the-money they become candidates for early exercise.
Consider an example where an investor owns both stock and a put option over the same stock, and the put is trading at intrinsic value (as is often the case when the option is deep in the money). By exercising early, the holder of the put sells their shares at the exercise price of the option and earns interest on the proceeds earlier than if they were to wait until expiry to exercise. This usually occurs after the stock has gone ex-dividend, so that the dividend is retained by the shareholder.
Another way of looking at whether the put should be exercised early is to compare the value of the corresponding call option with the cost of carrying the underlying stock to expiry. The importance of this relationship is due to the fact that stock ownership plus a long put is an equivalent position to holding a call option with the same strike price and expiry. The two strategies are said to be synthetically equivalent.
Both positions, stock and long put (S+P), and the long call (+C), profit if the stock goes up and limit losses if it falls. Therefore, if one can in effect exchange the synthetic position (S+P) for its equivalent (+C), and the cost of doing so (ie. the cost of the call) is less than the interest earned on the funds received from selling the stock, the early exercise of the put is worthwhile.
This simple arbitrage relationship is known as put/call parity, and is the fundamental relationship of option pricing. It is also the reason that mispricing between call and put options with the same strike and expiry is rarely found. Such mispricing offers the opportunity for arbitrage, where pricing differences are exploited at little or no risk to the trader, in the process forcing prices back to put/call parity.
National Australia Bank.
Share Price $28.00.
Interest Rate 5.25%
7 days till expiry.
Corresponding call is worthless Interest = 3.42 cents (Strike Price $34.00 X Interest Rate 5.25%) / 365 days X 7 days till expiry 3.42 cents > 0.
Therefore the 3400 put will generally be exercised early.
Corresponding call is 5 cents Interest = 3.02 cents 3.02 cents < 5 cents.
Therefore the 3000 put will generally not be exercised early.
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