You work so hard to drive company performance, and your success and accomplishments provide additional compensation through your company’s equity-based compensation plan. Unfortunately, this method of compensation adds complexity that needs to be fully appreciated, not only by you, the employee, but also by your spouse or others with whom you share your life. Our careers offer an opportunity to live an amazing life of significance, and equity-based compensation is a powerful part of the way executives are rewarded. Importantly, you will need to be prepared for the many decisions that come along with grants of company stock and options.
Our firm offers equity compensation guidance to our corporate-executive clients who have substantial – and usually concentrated – stock and options holdings in their companies. While these clients benefit from our comprehensive financial planning services, we also analyze and advise on ways to maximize the value of stock and options compensation, while seeking to mitigate the investment risks inherent in these concentrated equity positions. There is risk and reward associated with grants of shares and options, and an insightful discussion of the why, how, and when of diversifying concentrated equity can lead to a better wealth-creation outcome. In short, the goal of stock and options monetization is our clients’ maximization of after-tax value and reduction of risk.
We discuss strategies for not only when to best sell company stock or to exercise options, but also the associated potential tax ramifications and complexities. We work with your accountant or tax attorney to provide guidance on the use of tax-advantaged strategies that are sometimes available to the recipients of corporate stock and options grants. As a corporate executive shares with us their grant summary statement and vesting schedule, information about company shares already owned, tax status, and an understanding of other personal assets and liabilities, we produce a comprehensive Personal Equity Compensation Profile report that offers key insights concerning an individual’s company stock and options.
There are five sections in the equity compensation report:
- Stock Option Valuation: Includes In-The-Money Values, Cash-Out Values, Full Option Values, and Option Forfeit Value®
- Company Stock Holdings: Values Restricted/Performance Stock Grants, Owned Shares, and Total Forfeit Value®
- Investment Risk/Reward: Illustrates upside and downside leverage in one’s holdings
- Personal Risk/Reward: Contains financial goal, concentration, and Value at Risk (VaR) analyses
- Decision Framework: Identifies considerations for making informed diversification decisions regarding vested options and owned shares
The upshot concerning equity compensation is that there are five important items a corporate executive should know, and which the customized report will lay out in detail – Forfeit Value®, Leverage, Insight Ratios, Concentration, and Financial Goal Attainment.
Equity Compensation Fundamentals
While equity compensation comes in various guises, equity awards are generally of two flavors: grants of shares and grants of options.
Grants of shares are often called restricted stock units or performance shares, and these are also subject to a vesting schedule. Vesting can occur over a number of years, and/or shares can vest based upon company performance. When restricted stock or performance shares vest, they are taxed as ordinary income, and then subsequent growth is given long-term capital gains tax treatment, if the shares are held for a year or more.
Employee stock options give the employee the right – but not the obligation — to buy stock in the company at a predetermined price (that price is often called the strike price, grant price, or exercise price). The vesting schedule for the options generally runs over 3 or 4 years, and the right to purchase generally expires in 7 to 10 years. Tax ramifications will depend on the type of option – whether incentive stock options (ISOs) or non-qualified stock options (NQSOs), which you can learn more about here.
Tax issues clearly come into play in the cases of both stock and options grants. Due to stock vesting and/or exercise of options grants, income can be concentrated into a tax year, which leads to the need for tax-related planning (e.g., even including tax-planning issues like when/how to structure charitable gifts to optimize deductions over a multi-year period), and some clients will also need to plan their cash flow carefully to pay additional taxes caused by their equity-based income.
5 Things Every Executive Should Know About Their Employer Stock and Options
- Forfeit Value®: The Forfeit Value® is the equity value the employee will lose by leaving the company before retirement. This amount includes all stock-based awards. Another way to look at Forfeit Value® is the opportunity cost incurred by leaving the company. A component of Forfeit Value® that we include is the difficult-to-calculate “time value” of company options. We make this calculation using a Black-Scholes-Merton options pricing calculator. The Forfeit Value® of options is an estimate of what would be left behind if the executive were to leave the company. This value excludes the in-the-money value of vested options because one would be able exercise these before departing. However, by exercising vested options, one gives up the remaining time value of the options. Furthermore, full option value of unvested options – intrinsic value plus time value – is forfeited upon leaving, as is the value of any restricted or performance stock. In short, Total Forfeit Value® includes the time value of vested options, full options value of unvested options, and the full value of the employee’s restricted and performance stock grants.
- Leverage: Our comprehensive report will outline upside and downside equity values at various hypothetical price increments. To fully explain and appreciate an executive’s equity compensation, we make the important distinction between the leverage inherent in stock options versus the lack of leverage in owned shares and restricted or performance stock grants. The leverage effect means that (based upon the details of the options) a given percentage change in the company’s stock price can mean a significantly higher percentage gain or loss in one’s option portfolio. Our report also presents this idea with helpful graphics. In contrast, the incremental change in the value of stock always remains the same as the incremental change in the price of the company stock.
- Insight Ratios: This ratio helps the executive decide when to exercise employee stock options and sell the shares. The Insight Ratio also helps with the decision of which tranche of vested options to sell. Again, we utilize the Black-Scholes Merton options pricing calculator, as the Insight Ratio is the time value of the option divided by the full option value for each vested option. In short, the Insight Ratio is the percentage of time value compared to the intrinsic (in-the-money) value in each grant. As options approach expiration, or the options go deeper in-the-money, the time value of the option will decrease and will thus lower the Insight Ratio. If an option has a low Insight Ratio, it means that most of its value is in-the-money value. For example, a ratio of 7% means that 93% of the option’s full value is in-the-money value, which is at risk by continuing to hold the option. Typically, options with low Insight Ratios are the best and first candidates for exercise and sale.
- Concentration: The wealth associated with corporate stock and options awards is often a crucial component in achieving one’s financial goals, but there are risks associated with concentrated positions in company stock and options. In our equity compensation report, we show overall asset allocation that includes the value of one’s diversified portfolio (assets that are separate from company stock and options), as well as the gross (pre-tax) values of any owned company shares, vested and unvested stock options, and restricted/performance stock awards. The relationship between the gross values of company stock and options and the value of the diversified portfolio represents the degree to which wealth is concentrated. With a highly concentrated position, declines in the executive’s company’s stock price can have a devastating impact on total wealth.
- Financial Goal Attainment: Our report includes a section designed to provide context about the role that company stock and options play in achieving personal and family financial goals. An important financial goal is achieved when a low-risk investment portfolio is established, a portfolio that contains the amount of money required to meet personal needs and that of the family. The question of financial goal attainment plays into the risks that one can take with company stock and options. For example, if financial goals are already achieved, one can afford to take more risk with options, perhaps holding them to expiration. Conversely, if your goals are not yet secured, it may be important to exercise options to lock in the in-the-money value of options.
Expert equity compensation guidance should focus on ways to maximize the value of stock and options compensation while at the same time mitigating investment risks inherent in such concentrated equity positions. We offer this guidance in an effort to bring clarity and understanding, so the executive can make informed decisions in light of any tax opportunities and complexities.
Contact a member of the Wealthspire team to learn how we can work with you to provide customized planning and advice around your equity compensation, and to receive the one-page summary, “5 Things You Should Know About Your Employer Stock and Options.”