What Is a Cashless Exercise?
A cashless exercise, also known as a "same-day sale," is a transaction in which an employee exercises their stock options by using a short-term loan provided by a brokerage firm. The proceeds from exercising the stock options are then used to repay the loan.
In this respect, a cashless exercise is similar to buying shares on margin.
- A cashless exercise transaction involves using a broker to facilitate the sale of stock options by employees.
- It is designed to allow employees to exercise their options even if they do not have the resources to make the upfront purchase of shares.
- Cashless exercises are popular among employees of publicly traded corporations, and can receive favourable tax treatment under some conditions.
Understanding a Cashless Exercise
Cashless exercise transactions are made possible by brokers, who will lend employees money with which to exercise their options. The proceeds from exercising the options are then used to repay the broker.
This practice has become a popular method for exercising options among employees who are eligible to participate in employee stock option plans (ESOPs). It is most common among publicly traded companies, due to their greater liquidity.
Most private companies cannot accommodate a cashless exercise, because they have insufficient liquidity. However, they may be able to achieve similar results by using other mechanisms, such as by issuing promissory notes, which are similar to the loan a broker would provide in a regular cashless exercise.
Real World Example of a Cashless Exercise
Emma works for XYZ Corporation, and over the years she has accumulated a substantial amount of stock options. If she were to exercise all of her options, she could purchase 5,000 shares of XYZ stock at a price of $20 per share. Given that the market price is currently $25 per share, Emma could theoretically obtain a profit of $25,000 by buying the shares for $100,000 and immediately selling them at the current market price for $125,000.
However, she is prevented from doing this by the fact that she does not currently have $100,000 with which to purchase the initial 5,000 shares. Moreover, there are also taxes and brokerage fees that would add to the initial cost of exercising the options, even though it would lead to a profit in the end.
To solve this problem, her employer offers a cashless exercise plan. Under this plan, Emma is given a short-term loan by a brokerage firm, for $100,000. Using this loan, she exercises her options and buys 5,000 worth of stock. She then immediately sells the shares at their market price, receiving $125,000. With this cash in hand, Emma repays the $100,000 loan from the broker, as well as any transaction and tax costs associated with the transaction.
Proceeds from such an exercise would receive favorable tax treatment provided that a few conditions are met, such as whether the employee has held the shares for at least one year from the exercise date and two years from the grant date. If those requirements are not met, the proceeds would then be treated as ordinary income.
In the real world, this transaction would be handled by the broker on behalf of Emma. From Emma's perspective, the money from the sale of the options would only arrive in her account after the loan from the broker and the associated fees have been repaid.