Net exercise: Overview, definition, and example
What is net exercise?
Net exercise refers to a method of exercising stock options where the option holder does not need to pay the exercise price out-of-pocket but instead uses a portion of the underlying shares to cover the cost of exercise. In a net exercise, the option holder effectively "net" the difference between the value of the stock and the exercise price, allowing them to receive a reduced number of shares after the transaction. This approach is commonly used to exercise options without requiring immediate cash payment for the exercise price.
For example, if an employee holds stock options with an exercise price of $10 per share, and the stock is worth $20 per share, the employee may exercise their options using the net exercise method to receive shares equivalent to the difference in value without having to pay the $10 per share exercise cost in cash.
Why is net exercise important?
Net exercise is important because it provides an efficient way for option holders to exercise their stock options without having to invest additional cash upfront. This method can be especially useful for employees who may not have the liquidity to pay the exercise price but still want to benefit from their options. It also simplifies the process for companies issuing options, as they don’t need to handle cash payments for the exercise price.
For companies, net exercise allows them to retain a portion of the shares in circulation and minimizes the cash outflow associated with employee stock options. It also ensures that the employee is still able to participate in the upside potential of the stock without having to make a cash investment.
Understanding net exercise through an example
Imagine an employee is granted stock options to purchase 1,000 shares of a company at an exercise price of $10 per share. The company’s stock is currently trading at $30 per share. Using the net exercise method, the employee does not need to pay the $10,000 in cash to exercise the options. Instead, the employee will use the current value of the stock ($30 per share) to cover the exercise price. After subtracting the exercise cost, the employee will receive 666 shares (the 1,000 options minus the 334 shares used to cover the exercise price).
In another scenario, a company might grant stock options to an executive. Instead of paying cash to exercise the options, the executive uses the net exercise method to pay for the exercise price using the value of the shares themselves, reducing the total number of shares they receive.
An example of a net exercise clause
Here’s how a net exercise clause might appear in an employee stock option agreement:
“The Option Holder may exercise the Option in whole or in part by using the Net Exercise method, where the Option Holder shall surrender a number of shares having an aggregate value equal to the exercise price of the Option. Upon such exercise, the Option Holder shall receive the difference between the total number of options exercised and the number of shares used for the exercise price in the form of common stock.”
Conclusion
Net exercise offers a practical and cost-effective way for option holders to exercise their stock options without needing to pay the exercise price in cash. By using the value of the underlying shares, option holders can reduce their out-of-pocket costs while still benefiting from the stock's appreciation. For companies, net exercise simplifies the process and retains capital within the company, making it an attractive method for both employees and employers in stock option agreements.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.