The exercise of an option is when you make a purchase of shares. When this happens, there may be tax consequences, which depend on whether you have an incentive stock option or a nonqualified option.
A company will usually provide a form to fill out when you make an exercise. And of course, you will need to abide by certain rules. For example, there will likely be a minimum number of shares for an exercise (often this is 100 shares) or that you will be prohibited from making an exercise during a blackout period (this is when there is major corporate event, say an earnings release).
Three Main Types of Methods for Exercising an Option
Cash: This is the simplest approach. Yes, you write a check to make the purchase. Or, in some cases, you can do a salary reduction.
Cashless Exercise (this is only for publicly traded companies): If you do not have the cash to make the exercise, then you can use a cashless exercise. This is when a brokerage firm will make a temporary loan to purchase the shares and then immediately sell a certain number to pay for the exercise price, the withholding taxes and any fees. The net amount goes to you. The process usually happens within minutes.
Example: Suppose you want to exercise 1,000 shares at $20 each. The current stock price is $40.
However, you do not have $20,000 to make the transaction.
So with a cashless exercise, a broker will purchase the shares and then immediately sell them for $40,000 ($40 times 1,000). From this amount, the broker will get $20,000 for its loan and $7,000 will go to taxes. There will also be a fee of $500. Thus, you will get a check for $12,500.
Once the transaction is done, you can move the money to any account.
Sell-To-Cover Exercise: This is similar to a cashless exercise. But the main difference is that you sell just enough shares to pay for the exercise of the option as well as the withholding taxes and any fees. You will then keep the rest of the shares.
Example: You decide to exercise 2,000 shares of XYZ Corp. The exercise price is $10 and the current stock value is $20. In other words, you will need to come up with $20,000 to exercise the option (2,000 shares X $10).
With a sell-to-cover exercise, you will sell the number of shares that will equal the $20,000 plus the withholding taxes of $7,000 and the fees of $500. This will be 1,375 shares ($27,500 divided by $20 per share). The remaining 625 shares will remain in your account.