When dealing with employee stock options, the conversation usually centers around issues of income tax and investment risk.
We talk about taxes because the amount of tax you pay has an impact on how much money you actually receive when you finally sell your shares. The issue of how much tax you owe depends on the type of stock option you have, when you exercise it, and when you sell it.
We also focus on investment risk because owning many stock options means you own a large position in one company. That likely increases your level of risk and exposure to market volatility, which may cause wild swings in the value of your options — and we need to properly manage that for the sake of your portfolio.
As you might expect, determining how much income tax you’ll pay (and when you’ll pay it) and how to effectively diversify (or not diversify) your assets involves detailed, technical analysis and a lot of number-crunching.
But detailed number-crunching and endless Excel spreadsheets are only one piece of the employee stock option puzzle. What you might not expect is the fact that some of the first questions I ask my clients have nothing to do with the above-mentioned analysis.
In my opinion, understanding the non-technical concerns around your employee stock options is critical to determining which direction all the detailed analysis should take you.
COMPARISON GUIDE
Not All Stock Offers are the Same! Here's a helpful comparison between two of the most common employee stock options.
If you find yourself on the receiving end of a large chunk of employee stock options, you may first want to start by asking yourself the following 4 questions.
Are You Willing to Sell Any of Your Employee Stock Option Shares?
The first question I tend to ask is, “Are you willing to sell any of your shares?”
That’s not rhetorical. Think about this and answer honestly. Are you willing to sell at all?
This question doesn’t consider investment risk. It doesn’t consider taxes. It doesn’t consider retirement. It’s intended to start an honest dialogue about what you are willing to do — and perhaps more importantly, what you’re not willing to do.
The reason many people say, no, they’re not willing to sell, is because they feel they should be a team player. They don’t want to feel as though they sold out when “everyone else” kept their shares.
Others don’t want to sell their shares because they’ve had them for a long time. These clients have seen the shares grow, and they believe their company has given them so much — so it would be disloyal to sell.
These thoughts lead people to feeling obligated to ride the ship as long as it sails. But it’s important not to succumb to peer pressure or even emotions around loyalty or commitment to the company. If you are not willing to sell, you limit your options. Options that may lead to better decisions regarding tax, investments, and financial planning.
Why you do not want to sell your shares helps me understand your relationship with the stock. From your relationship with the stock, we can begin to plan with that relationship in mind.
At What Price Would You Be Willing to Sell All Your Employee Stock Options?
Ever considered what it would be like to have employee stock options worth a lot of money — say five million dollars? What about ten million dollars?
If you believe in the power of the company, you might feel the upside is limitless. You just need to hang onto your shares long enough to cash in on the potential.
But you need to be able to answer this question: At what point would you say, “enough is enough, and I’m ready to sell all of my shares”?
Having five or ten million dollars on paper is completely different than exercising and selling all your shares and receiving a big check — a big check that can fund whatever it is that you want to fund: retirement, a beach house, college for the grandkids, charitable donations, a legacy for your family or cause you care about, and so on.
This question helps paint a clear picture about what matters most to you. Is it retirement, leaving wealth for heirs, or charity? Something else?
That’s the non-technical side, but there’s an important numbers-base element here too: the question also establishes a data point for a conversation in the future.
On day one, this conversation might be unreasonable or unrealistic, as the value of your stock options may be minimal. But what if your employee stock options are suddenly worth $1 million, or $5 million, or $15 million dollars one day in the future?
Say the first day you could exercise your options, they’re worth $1,000. Considering what you’d do if their value reached $1,000,000 might sound far-fetched, you say you’ll sell everything if you reach that $1,000,000 mark.
But if your company continues to grow and you actually hit $1,000,000 of value, your thoughts may change. It’s not uncommon for employees to reset their target to be to be $2,000,000, or $3,000,000, or more. Too often, people create moving goalposts to hit.
Unfortunately, that habit could leave you with nothing if the stock price never gets there — or worse, if it goes down in value.
Setting a reasonable target on day one is a good reminder of where you started and how far you’ve come. The target can be a friendly reminder of how good things may have been, and how greed can get in the way.
What Are You Most Concerned About with Your Employee Stock Options?
Employee stock options can be complicated — extremely complicated.
If you combine the complex nature of stock options with potentially considerable wealth, it’s reasonable for you to be concerned about making mistakes. But don’t let that concern paralyze you.
Fear-based inaction often causes employees to defer making any decision with their employee stock options until they’re forced to do something (like when their options are about to expire).
Waiting until you have no choice but to take action isn’t a good strategy. Being proactive and creating a strategy allows you to evaluate how to best fit your options into your existing personal financial and investment plan.
This is why it is so important to understand what your biggest fear is regarding your stock options. The fears I hear most often are things like:
- I am afraid of paying tax
- I am afraid of market volatility
- I am afraid of missing out
All these are reasonable concerns with regards to employee stock options. And all of them can be identified, addressed, and managed accordingly. But only if they are discussed in the scope of a sound plan.
What Will You Do If The Stock Drops By 50%, Or More?
It’s possible that the price of your stock options increases to a point where you have the opportunity to create serious wealth. That’s the ideal outcome, but many people never experience it.
The reality is, it’s possible that your employee stock options go down in value. A down market scenario is a scenario that should be explored and analyzed by everyone who holds employee stock options.
I always ask my clients what they’d do if their stock price fell by 50%.
The answers to this question tend to vary based on the stage of life each client is in. A retiree who has all their assets in the falling stock of one company may not have many desirable options and may feel stuck.
For them, option one could be the adjust their retirement expectation downward. Another option could be to go back to work.
While not ideal, you want to think through Plans B through Z because you don’t want to be caught unprepared. Crossing your fingers and hoping the stock price goes back up is not a good plan.
On the other side, if you’re younger and gainfully employed, you may have time for the stock price to recover (but you should consider that it may not recover too). If you’re not depending on a stock price recovery, you may have time to implement a more traditional retirement plan: save more!
The question is to see how well you have considered the unfortunate scenario of a declining stock price. And if it does, how well prepared are you to actually handle it without it wrecking your financial plan.
Working with the Non-Technical Side of Employee Stock Options
The softer side of financial planning goes well beyond Excel, spreadsheets, and projections. It makes space to consider how you may be impacted when things go well, when they don’t, and when they change quickly — and how you can respond to each scenario.
These softer questions serve as a primer into a dialog about real issues that you may face with your wealth. Some questions are fun to discuss, like imaging what retirement could look like with $10 million in the bank.
Other questions, like what if all that wealth is wiped out overnight are very much not fun — but also very important to consider so you’re prepared for that possibility should it occur.
Each of these questions provides a jumping-off point for important considerations that should be coupled with the technical analysis to determine how comfortable you are with the stock, how prepared you are to hold it, and how you should plan for retaining and/or selling some or all of your employee stock options.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.
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