I worked for a Fortune 100 company for over 15 years. When you rise through the ranks of management at a large company, they generally stop talking to you about salary and instead use the word Total Economic Package (or Total Compensation Package). The reason they do this is because every year you start receiving something called Long Term Incentive Awards. These can come in the form of stock options, performance units, restricted stock, or incentive type stock options—essentially, all types of compensation linked to the hopeful future growth price of the stock of the company you work for every day. Unfortunately, most executives who receive this type of compensation do an awful job of constructing a smart strategy on what kinds of options to take if they are offered choices; they also struggle with how to most effectively build an exit plan if they have too much money in their company stock.
Types Of Stock Options
The three main types of stock options I run into most are Non-Qualified Stock Options, Restricted Stock Plans, and Incentive Stock Options. Before we talk strategy on exercising these options, here is a short debrief on each of these plans.
1.) Non-Qualified Stock Options
A non-qualified stock option is one methodology for a company to compensate key employees or others in an organization without having to actually pay them cash. They work best for employees at a company with a rising stock price.
The company will grant the employee an option to purchase shares of stock at a fixed price. For example, Coke grants an employee 1,000 options at $65, which are good for 10 years. This means that over the next year the employee has the right to purchase 1,000 shares of Coke stock at $65 no matter how high the stock prices go; if Coke’s stock goes to $95, then the option is worth $30 per share or $30,000 to the employee if gross income is exercised. All of these types of options will be taxed at ordinary income rates, which is a consideration that needs to be made at the time of exercising the option. When the stock isn’t publicly traded, the company determines the value of a share of stock on the date the option is granted. The options typically lapse on a certain date which is predominately 10 years from the grant date.
The incentive to the employee or service provider is to participate in the potential increase in value of the stock without having to risk a cash investment. The company receives a tax deduction for this ordinary income element reported by the employee or service provider.
The reason these options are called “non-qualified” is they do not qualify for special treatment of another type of option called “incentive stock options” within the IRS tax code.
2.) Incentive Stock Options
Incentive stock options are only available for employees and other restrictions apply for them. For regular tax purposes, incentive stock options have the advantage that no income is reported when the option is exercised and, if certain requirements are met, the entire gain when the stock is sold is taxed as long-term capital gains. You must be very careful and talk with your CPA or accountant, however, as you could be subject to alternative minimum tax offset, etc. if you do not plan all of this strategy cohesively at one time.
The incentive stock options look and feel a lot like the non-qualified stock options, but the difference is that at the time of exercising the option they won’t be immediately treated as ordinary income. You could decide to hold on to the company stock, and if you meet the special holding period you could be subject to capital gains tax on the money instead of paying ordinary income tax, which is a sizable difference. I did mention above that it can be very tricky with alternative minimum tax, so you should be certain to plan your tax strategy wisely.
3.) Restricted Stock Plans
Restricted stock plans are essentially grants of stock in the company stock. For example, Coke grants you 1,000 shares of restricted stock in your next round of performance reviews. If the stock is trading at $65 a share, they have really given you an additional $65,000 of compensation.
It is important to note that each of these plans comes with a hook which is called a vesting period. Typically, these plans will either vest over three or four years depending on the company. This means that although you got the grant from the company, you don’t actually own the stock or percentages of the stock until your vesting period hits. If the vesting period is three years, then you’ll receive one third of the stock each year for the next three years.
Taxation can be a little funky when it comes to restricted stock plans. Although you don’t technically own the stock, you will be responsible for paying the tax on any dividends earned on the stock plans. In addition, you have a special election called IRS code 83(b) which actually gives you the choice to either elect to pay tax on the stock when you get the grant, or to pay tax when you are actually in constructive receipt of the stock. There can be pros and cons to both of these depending on where you think the stock price will head over the three to four year period.
When To Trigger?
For most people who receive these types of option plans, they generally come to me with the idea to wait as long as possible in order to get the most out of their option plan. This can be a chancy strategy for employees, however, because with every year you wait and you get closer to the plans expiration date, you risk experiencing a sharp downturn in the stock or some other event that could essentially make your options worthless. Since the stock market has seen massive declines in 2000 and 2008, it is worthwhile to think smarter about your overall strategy for triggering your options.
It’s easy to play Monday morning quarterback with stock options. Oftentimes, individuals will have a hard time exercising these on their own and doing it well because they are emotionally vested. For example, if you set $70 a share as the price where you will trigger the options, then the day that stock hits $70 you will move the price to $80 a share. I’ve done it myself and have seen many executives who create this logic in their head because they are inside of the company every day.
One smart strategy to define is simply having a set price on each option plan as the trigger price. Regardless if the stock is booming or treading water, when the stock hits this price you are out of that set of options. To some, this may not seem too consequential because if you maintain employment at the same company you will continue receiving options from them; the advantage to this strategy, however, is that it gives you an automatic game plan no matter what happens in the stock market on a day-to-day basis.
Another route you can take is to create a holistic diversification plan. This means that you set a certain percentage of your overall portfolio to be in your company stock. Between your employee stock purchase plans, stock in your 401(k), stock options, and restricted stock, you will diversify out any money that is above that overall percentage you set within your financial plan. This provides for a great deal of discipline, especially if your company stock is performing exceptionally well. If your company stock is experiencing significant, accelerated increase in value, your emotional side will tell you to gather up as much of that stock as you can in your portfolio. But don’t be too hasty in your purchases, for this approach does not always end well; just ask the employees of companies like Enron and dotcom’s gone bust.
As you can see, navigating the sale of stock options from your company can be a challenging task. To make the most of your hard work, consider meeting with a financial advisor, a CPA, or a team of people who can help create a quality game plan for you. More companies are limiting the cash compensation for their executives and tying their performance into the performance of the stock prices. Make the right smart money moves and don’t get caught in a shootout at the OK Corral!
This article was reposted with permission from Your Smart Money Moves.
All investments carry some level of risk, and may not be suitable for all investors. Before deciding on any investment, you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. Seek advice from an independent financial advisor if you have any questions or doubts.