The two types of employee stock options that are commonly offered as part of an employee’s compensation plan are: Incentive Stock Options (ISOs), also known as qualified stock options, and Non-Qualified stock Options (NQSOs). The major difference between the two is that ISOs are entitled to preferential tax treatment at the time of exercise. However, with either type of option, once they have been acquired, any increase in value after that will be treated as long-term capital gains as long as the shares are held for more than one year. This strategy is known as “exercise and hold.”
The exercise and hold strategy involves great risk since it requires the employee to maintain a concentrated stock position. In many cases, the risks involved in holding a concentrated position often outweigh any potential tax benefit. Unless there are restrictions on the employee’s ability to sell their stock, the most prudent thing to do is reduce the concentrated position and reinvest the proceeds creating a diversified portfolio. The risk of holding a concentrated position can be reduced through hedging techniques by instituting a “collar” (selling a call option and buying a put option) or buying a “protective put.” Borrowing against the concentrated position to raise money to pay for the exercise or to invest in other securities using margin is unduly risky.
Employee stock options require complex and sophisticated strategies to address the tax issues and concentration risks. Financial professionals who are advising clients about employee stock options have a fiduciary duty to recommend and propose diversification and hedging strategies.