After reading this article, test your knowledge with a fun, interactive quiz on stock options
Your stock options are valuable, so you so may be nervous about avoiding the mistakes that many people made during past market booms and busts. This series of articles points out common mishaps with stock options that can cost you money.
Major Events To Watch Out For
Many employees squander the potential of their stock options because they lack foresight with them and do not form a financial plan around their grants. Instead, they merely react to unanticipated circumstances and have to scramble to salvage their option awards at the last moment. Most of the common mistakes with stock options arise from the following types of situations.
- Change of control: The company announces a merger with a competitor.
- Termination: You decide to quit your job.
- Expiration: Your options are about to expire.
- Concentration: More than 10% of your net worth is in employee stock options.
- Disability: A whitewater-rafting mishap puts you in a body cast.
- Division of marital assets: You and your spouse have decided to divorce.
- Death: You go to the great company in the sky.
- Market timing: You try to guess whether the stock price will be up or down when you exercise your options and sell the stock.
- Taxes: You misunderstand the tax consequences of your equity pay.
With proper education and planning, you can improve your chances of preventing the financial losses that may otherwise occur when you must react to unanticipated circumstances.
Study Your Plan Document And Share It With Your Advisors
Ideally, you will understand how your company's stock option plan document addresses each of these scenarios, and you will devise a strategy to address each possibility. The plan document, together with your grant agreement, will govern the rules and timelines associated with each circumstance. Request a copy of the plan, read it, and share it with your advisory team and a reliable family member.
Change Of Control
Accept the fact that virtually any company may be bought by, or may join forces with, its nearest competitor in a merger or acquisition (M&A).
Plan As If It's Inevitable
Your company's plan document should spell out what will happen to your stock options in a merger, acquisition, or asset sale. The plan document may allow the acceleration of vesting in a change of control: this may give you an opportunity to exercise 100% of your options immediately instead of having to wait for the length of time that your grant agreement specifies.
Accelerated vesting is appealing because it allows you to realize the benefit of your stock compensation earlier, but it has some significant tax consequences because you can't stretch the taxation over several years. This opportunity is limited: you may have fewer than 30 days to exercise your options before they expire.
Other Choices
In an M&A situation, you must make other investment and cash-management decisions that depend on the structure of the deal:
- Will the shares you buy in your current company convert to shares in the new, merged company? (See a related FAQ.)
- Is the potential for appreciation in that new stock worth holding for long-term capital gains, or are you better off with exercising and selling simultaneously?
- Will you receive stock options in the buyer in exchange for your current options and/or as part of your compensation package with the new company? (See a related FAQ.)
- Could this merger result in the loss of your job? If so, what happens to your stock options?
- Will you need cash from this exercise to support yourself until you find another job?
- Will the company withhold enough money from your exercise to meet your tax obligation, or do you need to reserve cash for that purpose?
In some situations, your company's plan document may state that there is no acceleration of vesting, and you are faced with planning decisions related only to your vested options.
For more information on stock options in mergers and acquisitions, see the section M&A on this website.
Termination
If your relationship with your company ends for any reason other than retirement, disability, or death, your plan document will specify the treatment of your stock options. Make sure you understand its terminology. If you do not, costly mistakes may occur.
Example: Your official termination date was September 19, but you received a severance package through December 31. The plan document allows you to exercise your vested stock options for 90 days after termination (i.e., until December 19). Don't confuse the length of your severance package with your post-termination exercise window.
The standard "window" for exercising after termination is 90 days (or three months), but read your company's plan carefully for exceptions. For more, see the section Job Events: Termination.
Expiration
By granting stock options, your employer has, in effect, given you a "use it or lose it" compensation coupon. You've earned the right to purchase a particular number of company shares, at a certain price, within a specific period.
There is a tendency, particularly with NQSOs, to delay any exercise activity until the last moment. That approach is not necessarily aligned with your financial goals and your company's stock performance.
Pay Attention
Revisit the timing and pricing targets associated with your equity compensation at least twice a year. Exercising a combination of in-the-money grants concurrently, in an effort to minimize taxes and maximize what you put in your pocket, is not uncommon. Market conditions, strike prices, number of vested options, and your overall financial objectives should have more influence on the timing of your exercise strategy than the fact that one particular grant is scheduled to expire in the near future. For details, see the articles and FAQs in Financial Planning: Strategies.
Concentration
For many employees, stock options carry emotional issues, not financial ones: you are loyal to your company and want to believe in a bright future for it and its stock price. Emotions can overtake dispassionate good sense to the detriment of family financial goals. This leads to some of the most costly mistakes.
Conventional wisdom advises against having too much of your portfolio invested in a single company stock. But it's not unusual to find employees with 60% to 90% of their net worth in their company's stock through a variety of programs: stock options and/or restricted stock, employee stock purchase plans, and company stock purchased or given as a match to salary deferrals through the 401(k) plan.
Financial advisors typically warn clients against having more than 10% to 15% of their investment assets in a single company's stock or a specific sector of the economy. Read more about how to diversify, and why, in Financial Planning: Diversification.
Enrons And Lehmans Happen: Be Prepared
When Enron filed for bankruptcy, its employees lost over $1 billion in retirement savings as a direct result of investing in its stock. Many had 50% or more of their retirement savings in company shares. The Enron implosion was not a freak mishap. During the subsequent decade, over the course of two major market downturns, employees at other respected companies, such as Lehman Brothers, experienced similar devastating declines in their net worth because of rapidly falling share prices.
Market crashes and corporate downfalls are not exceptions. They are an ineluctable part of the business cycle and should be regarded as intermittent realities of capital markets. What are you doing to prepare yourself?
Ask The Tough Questions
Stock options quickly concentrate net worth. Optionholders must pay attention to the risks that increase with each additional grant. How do you know whether your wealth is too concentrated in your company's stock? Answer a few simple questions developed by Dr. Donald Moine, an industrial psychologist who specializes in compensation:
- How much is your home worth?
- How much are your cars worth?
- How much are your stock options worth, plus any company stock you already own (in a 401(k) plan, through ESPPs, in an outside investment account, etc.)?
If the answer to question 3 is more than 1 or more than 1 + 2, your wealth is heavily concentrated, and you are at risk of suffering a serious financial setback if your company's stock price plummets.
The next question Dr. Moine asks is: "Would you like free insurance to protect the value of your stock options and your company stock?" Who wouldn't? You're already insuring your house and cars because the cost of replacing them could be devastating. Why wouldn't you be interested in free (or nearly free) risk-management strategies to protect another sizeable contributor to your net worth? For high-net-worth optionholders, these types of hedging strategies exist (e.g. zero-premium collar, pre-paid forwards), as explained in the section Financial Planning: High Net Worth.
Many diversification and liquidity tactics exist. Seek help from skilled advisors in managing your concentrated position. Let someone who is not emotionally attached to your company's stock price evaluate the merits of your equity compensation according to investment criteria, tax consequences, your risk tolerance as established for your personal investment-policy statement, and the role your company's stock should play in your overall wealth-building strategy.
Next Article
Part 2 of this article series covers the impact that major life events, market risk, and taxes can have on option gains. Another article by a different author looks at mistakes that affect your stock option financial planning and personal wealth: How To Avoid Mistakes And Create Wealth With Your Stock Options, by Paul Palazzo.
