31 Aug Making the Most of Company Stock
If you receive most of your compensation in the form of company stock, you have both a golden opportunity, and one that’s easy to squander. If managed thoughtfully and responsibly, however, concentrated, company stock can place you on a clear pathway to financial independence.
Major Pitfalls to Avoid:
- Inertia – This is the most common problem. Stock compensation is complex. Those who have it lead very busy lives so the default decision is usually to do nothing.
- Irrational exuberance – The term coined by former Federal Reserve Chairman Alan Greenspan often applies to those with stock in their company. They are so emotionally vested that logic can take a back seat.
- Lack of clarity – Many executives haven’t explored their lifetime goals and lack context for making decisions. They don’t know if they are in wealth creation or preservation mode or somewhere in between.
- Relativism – People get hung up on the performance of peers. If you sell stock, or don’t, and that results in your colleague making more money, it might drive you crazy. You have to let go of this.
- Fear of politics – Selling shares, especially if you are a key executive, sends a negative message to shareholders, employees, and customers. However, if your financial independence is on the line, don’t fret the politics. Your life is more important than what people might say.
- Mistaken beliefs – Don’t make decisions about your stock based on what anyone thinks the stock will do. No one knows what the stock is going to do. Really.
- Increasing lifestyle expenses – Don’t do this before you have divested a good portion of your stock. I saw the trouble and pain this can cause during the 2000 tech bubble and the 2008-2009 Great Recession.
What Should You Do?
Consider your goals through these three lenses: personal, professional, and financial. All decisions should flow from here. For example, if you are in the wealth creation time of your life and are building your professional brand, it may make sense to stay ridiculously concentrated – the stock is your wealth creation ticket. However, if you are at the other end and could achieve financial independence by selling, why aren’t you? Most people I work with fall somewhere in-between these two extremes, but having a clear understanding of desired outcomes is a starting point.
Common Forms of Ownership
- ISO (Incentive Stock Options) – Huge leveraged upside with tax benefits that could result in saving almost 20% in taxes if you exercise and hold for a year. The problem is when you exercise, you trigger something called AMT income, which means you might end up paying a phantom tax if not carefully planned. There are strategies to optimize gains, such as managing the “AMT crossover point” and exercising early in the year.
- NQSO (Non Qualified Stock Options) – These offer the same upside as ISOs, but without the tax benefits. Gains are recorded as ordinary income at exercise. Exercising and holding these can result in major losses if the stock declines, so it’s generally best to exercise and sell at the same time.
- RSU (Restricted Stock Units) – These shares are granted and vest over time. They don’t offer the leveraged upside of options but can still create significant wealth. They are taxable as they vest, so it is usually best to sell the shares upon vesting, or at least enough to pay the taxes.
Other Key Things to Know
- 83 (b) election – This must be done within 30 days of being granted equity. This avoids receiving phantom income at each vesting period, which can get costly if the company is growing and you don’t have the cash to pay the taxes. The drawback is you have to pay tax in the year of the grant based on what the stock was worth when it was granted to you (even though it hasn’t vested yet). However, if you’re a founder of a new company and the company doesn’t have any significant value yet, the tax is going to be very small.
- Qualified Small Business Stock (QSBS) – For founders, venture capitalists, or executives of start-ups, these stocks can mean huge tax savings for those who hold for five years or longer.
- 10b5-1 Plans – Most executives are limited to trading company stock in open windows, and some need permission. 10b5-1 plans set the process on auto-pilot, eliminating the need to receive permission, plan for trading windows, or worry about inside information.
Maximize Your Impact
Nobel-Prize winning Indian economist Amartya Sen once suggested that “We should think about wealth not in terms of what we have, but in terms of what we can do.” Those with stock compensation have interesting opportunities to make an impact by donating part of it to charity. However, this must be planned carefully, as itemized deduction phase-out rules can eliminate much of the tax benefit. The good news is there are ways to minimize these traps while maximizing impact, so be sure to incorporate a good CPA into your planning.
Some strategies involve giving large, lump sums (every five years or so) rather than yearly, allowing you to maximize the tax benefit and diversify in the same year. Donor advised funds, private foundations, and charitable trusts can be effective tools. These vehicles can make annual grants so charities don’t miss any funding that you wish to continue.
You Only Get One Shot
Recognize that if you have accumulated significant company stock over the years, it is likely your only shot at making life changing wealth. Some repeat the feat, but it’s rare. Most of the people I know that “made it” tell me their wealth came from the confluence of luck, skill, and opportunity. Treat concentrated stock very carefully, take time to think through your goals, and be sure to bring in experts to help you with it.