IMAGE Alicephoto / 123rf.com
By Bill Dillhoefer
- In real estate, it’s “location, location, location.” In equity compensation, the word is “diversify, diversify, diversify.” The number one reason people don’t diversify is that they believe their company’s stock will continue to rise. This assumption is shaky to say the least. Volatility is a certainty. What if you need to sell while the stock is (temporarily) down? What if the stock drops and doesn’t come back? Diversification helps reduce risk.
- Doing nothing with your company stock and options has BIG risks. Employee stock options are not like owning the stock outright. Typically, options come with a 10 year window of opportunity, after which they disappear if not exercised. Additionally, if you wait too long to exercise, your flexibility drops as the expiration deadline approaches. This can result in an underwater option at expiration or an unexpected tax bill.
- Having an equity compensation advisor can help. A financial advisor that specializes in working with clients that receive company stock and options can help with both the big stuff and also the details. Like the carpenter you hire to build your addition, they have the knowledge and own the right tools to make the job easier. A competent equity compensation advisor can track your company holdings and analyze risk and reward. They can also model and compare diversification strategies to help minimize taxes.
- Having access to your company stock records online is not enough. Although your company may provide you with online access to your stock and options positions, this is not the same thing as guidance. Analyzing your holdings includes looking at different types of valuations and issues like leverage and concentration. The equity compensation analysis and planning processes will help you to thoroughly understand your holdings, set priorities, discover your comfort with risk, and bring a useful coherence to your financial picture.
- Building wealth is different than just saving for retirement. If you contribute to an individual retirement account (IRA) or 401(k) program through your employer, you are on the road to a comfortable retirement and probably way ahead of many of your peers. However, building significant wealth over the long term requires more than just saving. It often takes participation in company stock and option programs which provide significant growth and leverage. If you are fortunate enough to receive grants of company stock shares or employee stock options, you also need to manage these holdings to maximize their wealth building potential. Be aware that small increases or decreases in stock price can cause large increases or decreases in the value of your employee stock options because they have leverage. Consequently, stock option recipients need to make timely exercise and sell decisions to build wealth.
- Taxes are inevitable but their impact can be managed. The taxation of company stock and options is complicated. Gains are sometimes classed as ordinary income, sometimes as capital gains and sometimes they can trigger Alternative Minimum Tax (AMT). Taxes on equity compensation can’t be avoided entirely, but their impact can be managed. Keep in mind that ordinary income taxes on non-qualified options (NQSOs) and the AMT on incentive stock options (ISOs) can be significantly minimized with proper timing and smart planning. This is one of the areas where the help of a knowledgeable advisor who can model the tax effects of exercise and sell strategies can be very valuable.
- Any plan is better than no plan, but an “optimized” plan is best. Equity compensation diversification plans can be developed with simple “cookie-cutter” rules. For example, exercise and sell 1,000 shares when the stock price reaches $50. However, an “optimized” plan is designed to fit your situation. It takes into consideration your goals, cash flow requirements and risk tolerance. The creation of an optimized equity compensation diversification plan is an iterative process that should be revisited on a regular basis to incorporate changes in your situation, your current and long-term needs, and your revised or refined goals. The best plans are always a work in progress.
- Your family is counting on your equity compensation; who are you counting on? Financial security is a heavy responsibility even when shared by a couple. A financial advisor that specializes in equity compensation can not only help with managing and diversifying your company holdings. They will also represent a perspective outside the family pressures that can sometimes be useful in bringing different opinions into alignment.
- Don’t leave your company stock and option wealth to chance! Too many people leave money on the table because they don’t have a well-planned diversification strategy. Take the following next steps with your equity compensation holdings:
FIRST, engage a professional that can provide you with a personalized analysis of your company stock and option holdings.
SECOND, get quarterly updates and consultations regarding your equity compensation analysis to understand valuation (i.e. intrinsic, after tax, time and forfeit values), the role your stock and options play in achieving your financial goal, your concentration level and key diversification metrics.
THIRD, when you are ready to take action have your advisor model and compare diversification strategies based on after-tax cash flow requirements, diversification percentage and tax optimization.
Bill Dillhoefer has helped financial advisors and individuals for the past 18 years to maximize the value of the company stock and options via informed decisions. Connect with him on LinkedIn or follow him @StockOpter.