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Financial Life Advisor
What to do with Stock Options?
Having worked for a successful startup company over the past 7 years, I’ve lucked into some non-qualified stock options that have now vested and make up a large majority of my personal “savings”. Is there a standard process I should follow in terms of redistributing my savings into other investment portfolios so that I am no longer exposed to volatile swings of a single stock? E.g. should I redistribute past a certain threshold of my personal savings or based on a certain return of the vested option?
J.M. from London, England J, it sounds like you picked the right company for which to work. Highly appreciated stock options were made famous by Microsoft and have been great for the early employees of other tech companies like Dell and Google. For each success story, there are many companies whose stock options ended up worthless. As with all investments and compensation, you should make sure to look at them in the context of your personal financial plan and the risk and reward they represent.
Someone in your situation often has a “large majority” of their net worth tied up in those highly appreciated stock options. When looking at cashing in those stock options you must look at the two most important factors - tax implications and your risk. Understanding the tax situation is much easier than the risk, so let us start there.
Cashing those options can cause a large tax burden. Non-Qualified Stock Options (NQSO) generally do not have any tax consequences until they are vested and exercised. Usually, when issued, the options have an exercise price equal to or greater than the current market price (thus giving them no current value). If the underlying stock price increases, the value of the options also increase in value. When those options are exercised, the difference between the option strike price and the purchase (market) price of the stock is considered compensation. That compensation is ordinary income taxed at your marginal personal tax bracket, and subject to FICA withholding. To illustrate, on a large exercise (say $200,000 income), you could reasonably expect to have to pay between 30% and 35% in tax on the gain, resulting in about $60,000 to $70,000 of additional federal tax on that transaction. State taxes, if applicable, would be another addition.
Now, once you have exercised those options and own the underlying stock, you have all the ownership rights of owning the stock. With options, you do not receive dividends and have no voting rights. Once you own the stock, you get both dividends and voting rights. If the stock continues to appreciate in value and you have owned it over one year, any subsequent gain would be taxed as long-term capital gains at much more favorable tax rates.
On the other side, if you own the stock and it declines in value, you could lose money. The worst case would occur if you exercised your options, realized a large income, and paid the tax, only to have the stock become worthless. If you had kept the options, you would not have realized the income, and although they are worthless, you would not have paid tax on something that is now worthless. You limit your downside risk when you keep the options instead of exercising them.
Now comes the harder part of the equation: quantifying the risk of holding a “large majority” of your net worth based on one company’s stock price. It is human nature to think the good times which led to your current situation will continue to roll. You have an inside track to what is going on at your company and have seen it grow quickly. You see nothing but opportunity ahead and want to build as much as possible because the tax burden it too much to “cash out,” and this investment is doing better than just about any available “diversified” investment. After all, some of the wealthiest people in the world made their vast fortunes owning a significant share of their own very successful companies. It is easy to understand why many employees are reluctant to cash in their highly appreciated stock options.
One thing that I have not mentioned yet, but is a very common, is still being employed by the company in which you have the NQSOs. If your employer goes under you would not only lose a “large majority” of your personal net worth, but you would be jobless. This happened to the employees of Worldcom, Enron, and others. I propose that you take some risk off the table. If your company continues to be successful, you should continue to get promotions, raises, and possibly more options and/or stock. If the company does not work out, you can walk away with a significant portfolio. Trading the potential for making extraordinary wealth for current security, should the train go off the rails, removes possible catastrophic financial failure.
Here is a psychological exercise to help demonstrate this point. Imagine you have $500,000 cash in a bank account. That $500,000 represents everything you have in this world. Would you go out and purchase $400,000 in your own company stock? While this ignores taxes, which are a big concern, it demonstrates your likely situation. Most financial experts advise that you should have no more than 20% of your total net worth in one company. If that company is also your current employer, you should have no more than 10%. That being said, I am not sure I would exercise almost all of my stock options if I was in your situation. I would reduce the exposure of my total net worth to at least 50%. Use that as a guideline going forward to gauge if I should divest more on an annual basis. I am still young and have a high risk tolerance, so 50% would be my comfort zone. If I were older, had more assets or had a lower risk tolerance, I would regard that 50% as too risky.
If you are set on keeping all of your stock options, you could purchase put options on your company stock. With a put option, you own the right to sell shares of stock at a certain price, so if the company stock tanked, you could sell “put” shares of stock for a higher than current market price. Even though your NQSO’s lost value, you would have placed a floor on those losses through put options. Those put options can be a pricey way to hedge a position like this. You must pay a premium on the option, which comes right out of your bottom line. If the stock price rises or stays flat, then your put options will expire worthless. Overall, this is not a strategy I would recommend.
After deciding how much of a concentrated position you want, a general rule of thumb used when dealing with NQSOs is that you should hold them until right before expiration. This will allow you to participate in most of the upside while delaying the tax consequences. If the stock options decline in value or expire worthless, you have not lost the higher tax payment upon exercise. There are exceptions in certain tax situations, but generally this is the best strategy. After exercise of the options, I usually recommend selling the stock and reinvesting the proceeds in a diversified portfolio. After the option exercise, you are, effectively, the person with the money sitting in the bank, wondering how to invest it. Diving back into a single stock does not make sense.
It is great you work for such a successful company. It is easy to think about the upside, but do not overlook the downside. Recent events have taught us that some of the companies which everyone thought were so strong can come to their knees, virtually overnight. Make sure to consult a tax professional and financial planner when looking at developing a specific divesting strategy for your options. Your strategy for lowering your risk exposure should be coordinated with the tax consequences. Recommended actions for this type of situation will depend highly on your specific circumstances. Keep up the good work.
Posted by Ben Gurwitz on 6th November, 2009 | Comments | Trackbacks
Tags: Financial Planning, Tax Planning, Investments, Nov 09
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