Financial Planning: Strategies

Market volatility and declines like those of 2011 rattle even the most experienced holders of stock compensation (and their advisors). Moreover, some companies have a stock price today that has not made any real progress since 2004 or 2005. Many employees, especially those who are new to the stock grant experience and remember tales of quick option riches during the 1990s, will find that they are less than fully prepared to cope with the emotional toll caused by an uncertain market and its effect on their equity compensation.

You may soon face decisions that affect your financial future and long-term wealth in the midst of this market turmoil. Brokers and financial advisors promote and justify many tempting option exercise and risk mitigation strategies. PROCEED WITH CAUTION. Below are 10 topics I find myself discussing over and over again with my best clients.

1. Engage in financial housekeeping. Engage in financial housekeeping. If you have a financial plan with goals for your stock grant gains, stick to it. If not, create it now before the market turns up and provokes you to take risks without thinking. Clients of mine who have committed to a plan and have stuck to it have experienced better investment returns than those who tried to time the market.

I work with executives at one company who have been receiving grants of nonqualified stock options (NQSOs) in January of each year for the past 10 years. Many of them, at my suggestion, have been systematically exercising and selling their NQSOs some time after the options turn six or seven years old. Their 2000 grants had an exercise price of $2. They exercised in January 2006, when the company's stock price was at $44. The exercise price of their 200 grants was $18.50, and their market price in January 2008 was $32. I took a lot of heat for "missing the top" at the stock's all-time high of $52 in October of 2007.

But they got out before the recent lows. Their stock currently trades at $15. Their 2004 grants were at $8.60, so we plan to exercise them again in January 2012. During the downturn of 2008, the balanced portfolios I constructed with the stock-sale proceeds (which exclude the stock of issuers in the same industry as their company) performed a little better than the broader market and exhibited significantly less volatility than their company stock.

2. Do not overplay tax changes. It is a good idea to review your plan periodically to see how tax increases, tax cuts, or changes in your marginal tax bracket may alter your situation. (In my article on year-end planning, I discuss my thinking about the potential impact of any tax increases.) But don't obsess about the tax consequences of an option exercise or restricted stock vesting. Market volatility can take the equivalent of the top 35% marginal tax bracket away from you in a matter of days!

	Down markets are a good time to receive new grants. Many companies are undervalued today, so their stock prices may go up significantly in the future.

3. Accept more options and stock now. While down markets mean the exercise of patience, not options, they are a terrific time to receive new grants. Unlike during past market downturns, you may now be receiving grants of restricted stock, RSUs, or performance shares along with or instead of stock options. These grants continue have value in a down market and therefore can both lessen the pain from underwater stock options and ease "volatility" in the value of your stock grants. Many companies are undervalued today, so their stock prices may go up significantly in the future. This is good news for people receiving grants of employee stock options and/or restricted stock from these companies now. Gather as many as you can!

4. Be realistic. Just as it was unreasonable to think the double-digit market gains of the 1990s, or the rapid climb of stock prices between 2003 and 2007, would last forever, it's not likely that stocks will recover to their old highs rapidly. Benjamin Disraeli once said: "What we learn from history is...that we do not learn from history."

The next time you hear the words "It's different this time" or "Earnings don't matter," be skeptical. Optionholders who embraced a healthy degree of skepticism during the run-up in stock prices, and made the decision to take some profits, are glad they did. As well, those who continue to diversify out of their company stock when it represents too large a chunk of their net worth are probably glad they have been doing so.

5. Don't be stubborn! After option exercises or restricted stock vesting, avoid using tax-deferral strategies beyond the point where the market's effect on your holdings erases the hoped-for advantage from long-term capital gains rates. For ISOs this differential is only 7%, or the difference between an ordinary tax obligation in the top bracket (35%) and the maximum AMT rate (28%). Declines in price beyond this limit mean that the advantage of paying long-term capital gains rates on an ISO stock sale at some point in the future (and recovering some portion of the AMT paid in the year of exercise) is erased.

Use stop limit orders to protect against a collapse of your stock's price. On a related topic, covered in Part 2 of this article series, be very careful about using a margin loan to continue the financing of your exercise-and-hold strategy. The leverage advantage that works for you on this type of loan in a rising market quickly turns against you when markets turn down. Many brokerage firms are marketing pledge loans with seductively low interest rates. Using your company stock as the collateral on one of these loans may not be a great idea if it prevents you from reducing your concentration in the company stock. If you use your stock to finance a real asset like your home, you effectively tie the fortunes of your home price to the stock market. You might be better off just selling the stock and paying for your house outright.

6. Focus on face value. Don't become fixated with complicated option-valuation models. The tools that use these methods can be helpful, but they are all based on past performances and trading ranges for your company's stock. While there are no other data on which to rely, predictions of future performance based on past performance will probably prove to be inaccurate. The tools on this website allow you to see the net after-tax value of your options, restricted stock, and SARs in various price-increase scenarios that you choose. Use them to help construct realistic "what if?" scenarios. Doing this will give you some financial goals and perhaps the perspective necessary to sell when the price rises at some point in the future.

7. Exercise and hold with caution. My clients with incentive stock options (ISOs) have asked: "Should I exercise and hold now that the market price is down?" Their question really is: "Should I exercise now, avoid or pay very little AMT, and hold for a long-term capital gain?" My answer is: "Buying now with the price close to, or at, the strike price is no different (or very little different) than buying in the open market. Buy-and-hold investing is a choice available to everyone."

When you consider open-market purchases, you should ask yourself: "Are there reasonable, fundamental reasons to believe the stock will rise and that I do not already hold a substantial amount of company stock?" If the answer is yes, then you may want to buy (exercise) and hold. If the answer is no, then you do not want to buy (exercise) and hold, do you? Whether you have ISOs or NQSOs, when you exercise and hold you need to consider the alternative-investment returns on the same cash you are putting into your stock, the diversification of your portfolio, your risk tolerance, and your needs for cash, as if you were buying any stock.

One of the advantages of stock options (when the market is rising) is the leverage they afford. If you own options to purchase stock at $2 when the market price of the stock is $10, you have at your control a lot of profitable stock with no cash committed. When the market price declines, the leverage declines with it. Because the tax advantages may never materialize, be ready to abandon a tax-minimization strategy as your stock price falls.

8. Diversify. Ask yourself: "Am I an entrepreneur or an employee?" Entrepreneurs take risks, have big chunks of their net worth in their company stock, and have a vision of and direct impact on the long-term prospects for the company. Employees earn a paycheck, with stock options or restricted stock as a nice benefit and a long-term supplement to it.

Entrepreneurs risk (and sometimes lose) it all. Employees seek the stability of a paycheck. How does your stock plan fit into your vision of what you are? Evaluate your company stock holdings over all the employer stock plans you participate in: stock options, an employee stock purchase plan, restricted stock, performance shares, and/or a 401(k) plan.

Make sure you aren't overloaded with your company's stock. Diversify the rest of your portfolio away from your company and its industry, consistent with the vision you have of where you fall on the entrepreneur/employee continuum. (For more ideas about diversification, see my article on this topic.)

9. Know hedging basics and limits. Many brokerage firms and banks are marketing various strategies to protect large, concentrated stock positions. If you have at least $1 million in one stock, a hedging strategy that shelters your gains and lets you take out some cash may be worth considering, as opposed to a straight sale of some of your holdings.

Protective puts, equity collars, and prepaid forward contracts, described in detail elsewhere on this website, may be available to provide partial protection against price declines, or to generate cash, in exchange for certain conditions. However, hedging arrangements involve complicated taxation and securities laws, and many companies ban them. Moreover, by hedging you may be giving up too much of the future appreciation on your stock.

Each strategy also has costs. When stock markets bottom out, speculative excess and overvaluations get wrung out of the market, and many stocks are oversold for a while. These conditions reduce the need for certain price protections. You also may want to set up a program of selling your company stock at pre-determined prices in a Rule 10b5-1 plan, which, when structured properly, can provide an affirmative defense (not a shield) against charges of insider trading.

10. Act fast when terminated. If you change or lose your job while the market is down, exercise your in-the-money options and sell the stock as soon as you conveniently can. The rationale of being a "good corporate citizen" and maintaining a concentrated portfolio in your company stock no longer applies. As with any stock you can buy, don't be tempted to hold after option exercise or restricted stock vesting unless you view this as a good investment decision. The broader market or a mutual fund may hold less risk than this single stock.

W.E.B. Bantling is the pen-name of a broker and financial advisor whose real name must, like his advice, remain a secret. This article was published solely for its content and quality. Neither the author nor his firm compensated us in exchange for its publication.