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Company Incentive Stock Option

by retirebyforty on December 8, 2010 · 23 comments

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This post is the extension of the Stock Participation Plan post. Company incentive stock option was a widely used incentive in the tech. industry during the 90s and early 2000s. These options are less prevalent now because many big tech. stocks went side way in the last 10 years and many options are worthless. I’m only covering ISO (Incentive Stock Option) because that’s what I have.

So what are company stock options? It is the right to buy (“exercise”) a certain amount of company stock at a set price (“strike price.”) Let’s go through an example and pretend I work for Microsoft.

MSFT example

1/1/2000 – Happy new millennium! I was an awesome worker bee and MSFT decided to reward me 10,000 stock option. This is hypothetical, in real life a rank and file employee usually gets minimal options. I have received anywhere between 300 to 5,000 options during my tech. career, mostly near 300. The executives receive many many more options of course. These stock options has some conditions and they are different for every company, but my options are as follows.

  • Exercise price – MSFT stock was $56 on 1/1/2000 and I can buy MSFT at this price when the vesting period.
  • vesting – The options are vested in 5 years. This is when I can exercise the options.
  • expiration date – The options expire in 10 years if I don’t use it.

If the stock keeps going up, and on 1/1/2005 MSFT stock is $100/share. Then I can make a lot of money. I would buy the 10,000 shares of MSFT at $56 and sell them at $100. In effect, I would have made 10,000 * ($100 – $56) = $440,000 pre-tax.

Unfortunately the real world was a different story, on 1/1/2005 MSFT stock was $27 and the stock options are worthless. The options expire on 1/1/2010 and during this 5 years period, MSFT has not gone anywhere near $56. In fact, if I work for MSFT since 2000 and receive stock options every year, I would not have made much money from them. See the price graph below.

MSFT price from 2000 to 2010

I do not work for Microsoft, but many large tech. companies has similar chart during the last 10 years. Of course, there are exception such as Google, but they are a new dominant force. Apple also did quite well this past 10 years, but there are many more companies that went side way such as Microsoft, Dell, Cisco, Sun, and Oracle.

Pitfall – If you have stock options. Do not exercise and hold the stocks. During the dot com run up, some coworkers wanted more company stocks because the price kept rising. Let’s look at MSFT again, but go back 5 more years. In 1995, MSFT cost $4 and Joe programmer was awarded 1,000 options. His options became exercisable on Jan. 2000 and the price is $56. He wants more shares so he can let it ride and save on tax. You pay tax when you sell the shares, not when you exercise (ISO.)

Exercise on 1/1/2000 – He paid the company broker $4,000 and received 1,000 shares of MSFT.

At that point, the market started to turn down and by April 2000, MSFT dropped to $30/share.

Joe programmer sold at $30 and still made $26,000.  1,000 shares * ($30-$4). However if he just sold it on Jan. 1st, he would have made $52,000 then he could have used this money to invest in different companies. More importantly, that $4,000 out of his pocket should have been invested elsewhere. That’s the opportunity cost of exercise and holding.

retireby40′s strategy on stock options

  • Never exercise and hold the shares. This is putting too many eggs in one basket. The company already provides pay check, bonus, benefit, SPP, and more. I try to keep company holding to 5% of my portfolio or less.
  • Exercise at the highest price between the vesting date and expiration date. Easy to say but, practically impossible to do. Sell the shares on the same day and then use the profit to diversify.
  • This is free money so you can gamble with it a bit. If you think the stock can go up, just hold it until it hits your price point. Even if it drops, you won’t loose any of your own money.

Then again, I haven’t made much money from company stock option. If you have better strategies, please share them.

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{ 20 comments… read them below or add one }

Jim December 8, 2010 at 4:31 am

They also started becoming less popular when accountants made companies expense their value through the p&l. During the tech boom a start up with no cash could give options to their employees and not count them as an expense. This was clearly wrong so from about 2003 companies had to expense the day 1 value over the vesting period. Thus if your option was worth $10 on day 1 with a 3 year vesting it would add $3 per year to your expense. This gets expensive if you issue lots of options.

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retirebyforty December 8, 2010 at 9:51 am

It was around 2003-2005 that I stopped getting ISO. There was the controversy about Apple back dating their options too. I think that dampens enthusiasm for ISO as well.

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Moneycone December 8, 2010 at 4:44 am

Good detailed post! I like your 5% rule! No matter how well the company is doing, always diversify!

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retirebyforty December 8, 2010 at 9:52 am

I’ll need to rebalance soon, my allocation is a bit of a mess. I’m a bit over 5% today actually.

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Kellen December 8, 2010 at 7:54 am

I learned about diversification in finance class, and try to diversify as much as possible. However, I’ve noticed it’s something that non-business majors who try to invest seem to have a problem understanding.

You make a really good point that you should only exercise when you plan to sell the stocks. Why bother exercising and actually putting your own money in if the price is not right for you to sell? The nicest thing about stock options is that you *know* whether they’ll make you money or not when you are deciding whether to invest your own money in it.

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retirebyforty December 8, 2010 at 9:55 am

I had a hard time when I first started investing. At one point, I think 50% of my portfolio was in company stock. Terrible move! Luckily, I got away relatively unscathed and I try to limit my company holding to less than 5% now.
Many people don’t understand the opportunity cost of putting your own money to exercise options. It took me over an hour to explain this to my buddy. :)

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everyday tips December 8, 2010 at 2:02 pm

My husband was offered a job with Microsoft in the early 90s, along with a bunch of stock options. This post brought it all back! (We did not go because it would require a reloc, and we had too much family to leave behind.)

I agree with your views on the stock options. We are waiting for ours to go above water, so no decisions for us to make at the moment!

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retirebyforty December 8, 2010 at 2:07 pm

Oh darn it!
A few of my options are above water, but it’s still not much money.
Tech. stocks need to man up and lead the charge to economic recovery. ;)

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Andrew @ 101 Centavos December 8, 2010 at 5:18 pm

I’ve always worked for private companies, so no stock options. Holding too many options goes against the old adage of don’t mess where you sleep.

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Aloysa December 8, 2010 at 8:31 pm

My brother in law has some stock options with his company. He was ready to retire in his late 40s until the market went down. Good strategies. I need to refer him to this post. :-)

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retirebyforty December 8, 2010 at 9:15 pm

Ouch! That’s gotta hurt. Stock options are just paper money, you know what I mean? During the dot com bubble everyone was so exited to have a bunch of paper money, but they couldn’t exercise. Once the vesting period was over it was too late, the stocks came way down. :(

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The Passive Income Earner December 9, 2010 at 8:56 pm

I still get stock options but rarely. Now they give Restricted Stock Unit. About 1/3 of what they would have given for options with 1 to 3 year vesting period for us. (I don’t work for MSFT by the way.)

I got burned with my options just before the meltdown … I had no rules :( I learned the lesson the hard way. The fortunate thing is that since everyone got burn, there was approval to convert options to RSU so there was a silver lining. Good timing since I cashed it in today! Those life lesson can be pricey at times …

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retirebyforty December 9, 2010 at 9:08 pm

I also get RSU now. I like that a lot better because I think our company has gotten too large and there are no more explosive growth left. Even before the dip, my options were worth very little because price went side way for so long.
Wow, options converted to RSU! I would love that. Our worthless options got converted to …. wait for it …. more options that needs to be vested again … Thanks a lot Corporate.
Stock options are only good if you get a huge amount like the executives do.

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Buck December 11, 2010 at 7:45 am

Great detailed post. Currently no stock options in a private company :( but in the past my stock options went from IPO to a 3 bagger. Before I got more educated, I thought it would continue to the moon. Company lost a major client, eventually got bought out. Made some change, but nothing close to the 3 bagger. Your point about selling at the highest point before expiration, easier said than done is so true. :)

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Ken @ Spruce Up Your Finances December 11, 2010 at 11:15 pm

I do remember this as one of the popular incentive recruiting tool back in the tech boom. However, a lot of companies stock have been on a downward spiral so most of the employees may not be able to exercise these options.
It is still good to have if one is working to those companies who offer it for as long as they hold on the stock and exercise it when the stock market goes back up

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retirebyforty December 12, 2010 at 5:09 pm

I work for a big tech. and I don’t think the stock will go up too much from now on. I think the company is just too big to gain a lot, but I could be wrong. I hope the stock goes up. :)

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Tommy December 14, 2010 at 5:13 am

There is one other thing that could happen. I work for MSFT and there was a special sale of underwater option in the mid-2000′s. I remember that one of the big investment banks (JPMorgan maybe?) bought our underwater options to cash us out of the situation. I took the deal in a heartbeat while some of my coworkers held on to theirs hoping the stock would hit 40 or so again sometime soon. Anyway, there’s a lesson for you there: if your company offers a buyout of underwater options, it usually means they’re giving you a way out since they believe the stock price won’t ever hit the strike price by the time they vest–take the offer and be happy you got something out of the deal

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retirebyforty December 14, 2010 at 8:50 am

I don’t work for MSFT. Can you give a bit more detail on the buy out? Was it just cash for underwater options? How much was the offer? It couldn’t have been that much since it was underwater.
Thanks for stopping by.

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Prasun Choudhury June 6, 2013 at 6:13 pm

Most companies I know of (either worked or got job offers or have friends working) nowadays give Restricted Stock Units (RSU) which gets vested anywhere from 3 year – 5 year time frame. Some companies give RSU’s in terms of actual shares, e.g. they are giving you 300 RSU’s that will be vested in 3 years and some companies give it in terms of dollars, e.g. you will get $10,000 worth MSFT stocks that will be vested in 5 years. For volatile stcks like AAPL, RSU’s in terms of dollars might be a safer bet as the value of RSU’s in terms of stocks might change significantly in 3 – 5 years time frame.

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retirebyforty June 7, 2013 at 9:10 am

For mature companies, RSU definitely is a better deal. Stock options hasn’t gone anywhere since the early 90s for Intel and Microsoft.

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