You may have also read up on stories that detail how a declining stock price wiped out someone’s seemingly meaningful net worth before they could exercise, sell, and realize the value that used to be in their employee stock options.
As a result, you might feel wary about your own equity compensation — especially if you’re more conservative with your investments.
That’s understandable, because owning employee stock options does come with a number of risks that need to be managed.
Considering this, is equity compensation appropriate for a conservative investor? And if so, how does someone go about managing equity compensation and employee stock options in a way that aligns with their conservative nature?
Let’s take a look at 6 steps conservative investors should take when it comes to managing their equity compensation.
1 – Know What Type of Equity Compensation You Have
When it comes to equity compensation, it’s not one size fits all.
Equity compensation comes in many forms. Various types of equity you may receive each comes with its own rules regarding when you can access it, when you pay taxes, how it’s taxed, and what, if anything, you can do to control the timing of these events.
Here are some common types of equity comp that might be sitting in your portfolio right now:
- Long stock – Company stock you own outright, usually purchased on the open market
- Employee Stock Purchase Plan (ESPP) – Stock acquired through an employer-offered option to buy shares with a payroll deduction, often at a discounted price
- Restricted Stock Units (RSUs) – Cash or stock that you acquire over a set vesting period set by your employer.
- Non-Qualified Stock Options – Stock options provide you with the option to buy company stock at an exercise price set by the employer. Prior to exercise you do not own the stock, only the right (or option) to buy it. Post-exercise, you literally own the shares. The option is typically offered for a set period of time, say 10 years.
- Incentive Stock Option – Similar to non-qualified stock options, but more complex from a tax standpoint. However, you may be able to pay preferential tax rates.
- Stock in a 401(k) plan – it is possible to on company stock in a 401(k) plan, something that should be considered as part of the overall percentage in one company stock
One interesting note about the various types of equity compensation is that in some cases you literally own the stock, and in others you own the right to buy the stock (you do not own the stock itself, yet). Both types, however, are impacted by a movement in the stock price.
If you are conservative, a good first step is to evaluate what you have access to and what you may already own. You have to know what you are dealing with (and what you could buy into should you choose to do so).
Once you know what you own, you can begin to develop a plan to retain, manage, or eliminate your risk.
2 – Know When You Can Do What with Your Equity Compensation
Once you know what you have, you need to know what you can do with it — and when.
Long stock, or stock that you probably purchased on the open market, is usually freely transferable at any time. You can immediately sell the shares and transition the proceeds elsewhere.
For a conservative investor who is looking to remove risk, this is an easy option.
If you don’t have long stock, things may get more complicated as you’re more limited on when you can sell. RSUs, for example, are typically issued with a vesting schedule. Until the units vest (and assuming you receive shares, not the equivalent cash value), you cannot sell them.
In theory, you may have thousands (or hundreds of thousands) of dollars tied up in stock that you cannot do anything with.
Similarly, you have been participating in an ESPP plan that allows you to easily accumulate stock, potentially at a discount, via payroll deductions. Some ESPP plans however, may not allow you to sell those shares right away. To know for sure, you can check your plan document for more information around the rules and regulations of your specific ESPP.
Employee stock options may allow for the most planning opportunities. They often follow a vesting schedule like RSUs, but they differ in that you can control when you exercise the option and therefore when you are taxed.
This ability to control the exercise may lead to additional considerations for the conservative investor. In one sense, you didn’t pay anything for the option so you have little to lose. But by not exercising and selling your shares, you are putting whatever value the options currently have at risk — something a conservative investor may not be interested in doing.
3 – Consider Selling Your Restricted Stock Units (RSUs) ASAP
If you have RSUs, you might want to sell them immediately. As touched on above, your ability to sell your restricted stock units may or may not be totally in your control due to vesting schedules — but once you can sell it might make sense for you to choose this option.
Remember, when your employer grants RSUs, they give you a promise of something in the future. You may be given 10,000 RSUs, for example, and those vest in 3 years. Between the time the RSUs are granted and the time they vest, you have no right to them nor are they taxed.
When you reach the 3-year time restriction, however, the RSUs vest and you take ownership of the shares (check your plan document to see if you will receive shares or cash when this happens).
You are also taxed on the value of the shares that day. Specifically, you are taxed on the following:
Number of Units Vested * Share Price = Taxable Income
Typically, the amount of tax due is paid through a cashless exercise, but you likely have the option of covering the tax bill with cash if you are inclined.
Because you already paid tax and because RSUs are no longer subject to risk of loss, they very much resemble long only stock as discussed above. Following the logic of selling long only stock, it also makes sense for conservative investors who want to diversify their equity compensation to liquidate vested RSUs.
4 – Consider Selling ESPP Shares ASAP, As Well
An employee stock purchase plan allows for a convenient way to purchase company stock through payroll deductions. Some companies even offer a discount of up to 15% of the stock price to participate in an ESPP.
Typically, participation in an ESPP means that you defer a set dollar (or percentage) per pay period into the plan. For a set period of time (often 6 months) the money is collected. At the end of the collection period, the collected dollars are used to purchase shares on your behalf.
An ESPP can provide a convenient, profitable, and low-risk way to participate in the growth company stock. But as a conservative investor, you may want to consider liquidating your plan shares immediately after they are purchased for you. If you get to buy the stock at a discount, immediately selling means locking in a minimum profit equal to that discount.
Much like RSUs, ESPP shares resemble long only stock once they are purchased through the plan. Therefore, as a conservative investor, it may make sense to sell them right away.
5 – Make a Plan for Employee Stock Options
Employee stock options present the biggest planning challenge for conservative investors, and deserve a well-thought out strategy for properly managing them according to your goals and risk tolerance.
You may have considerable wealth tied up in your stock options, which is an opportunity — but mismanagement can cost you, and no matter what, you’ll need to pay taxes on any exercises you do.
Let’s assume that you were granted 10,000 options with an exercise price of $1 per share and a current share price of $50 per share. There are a few things to note in this scenario:
- Until you exercise your shares, you didn’t have to pay anything for them. One could argue that you have “found money” to the tune of $490,000.
- If you do exercise, you will pay tax. The type of tax depends on the type of options. Using a simple hypothetical tax rate of 33%, we can suggest that you may incur a tax bill of $161,700.
- If you do not exercise, your $490,000 is subject to the fluctuations of the market and the prevailing share price. This can equate to significant positive or negative swings in the value of the shares.
An exercise and sell at all tax cost may be the best strategy if your goal is to maximize diversification.
But if you have a severe aversion to paying tax, you might need to explore a plan that allows you to take advantage of tax deferral. That means not exercising your shares, which likely equates to both more risk of loss and a bigger opportunity to create more wealth over time.
6 – Determine How Much Money You Have Elsewhere
After all of this is said and done, none of it may even matter if you have only a small percentage of your overall net worth tied up in employer equity. One rule of thumb in the industry suggests no more than 10-15% of your net worth should be tied up in company stock.
If you fall below this percentage, even if you are a conservative investor, you might want to consider staying invested in company shares (while keeping an eye on your equity comp to be sure it remains an acceptable portion of your net worth).
If, for example, your total net worth was $1,000,000 and you held $100,000 worth of company equity, then only 10% of your wealth is tied up in your company. This may be an acceptable figure for most conservative investors.
Be mindful, however, of how the other $900,000 of your wealth is invested. If all $900,000 is invested in a US equity fund, your overall allocation is likely too aggressive considering your appetite for risk and willingness to expose yourself to volatility.
Putting the rest of your net worth into something like a more conservative mix of fixed income and equity types investments might be a more appropriate way to meet your stated conservative intentions.
What You Should Consider Next as a Conservative Investor
If you’re a conservative investor with equity compensation, you may want to keep things simple and liquidate your entire company stock position as soon as possible.
This strategy pays no regard to tax or timing. It simply turns equity into cash as soon possible, removing the risk associate with a single stock position
However, this simple strategy (while it may be appropriate for some) may sometimes be an oversimplification of the process. Even a conservative investor may benefit by holding some company stock for the short and long term, especially if the holding is well maintained in a tracked, suitable, and reasonable financial plan.
Ultimately, conservative may mean a lot of different things. Determining what is means to you and how the impacts your financial plan will be determined by a confluence of your age, income, assets, and other personal needs.
Once you determine what conservative means, you can build a plan that addresses your needs for conservative investing.
The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment. Diversification does not guarantee a profit or protect against a loss. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Tax services are not offered through, or supervised by, The Lincoln Investment Companies.