One of the greatest wealth creators is concentrated exposure and ownership in the success of a single company, which flies in the face of traditional notions of diversification. If you are a business owner or are compensated with stock options, this is a MUST read.

In recent years I’ve come across more and more key employees (not necessarily founders) who are partially compensated with employee stock options. This compensation technique is popular among many high growth and startup companies and can be a tremendous benefit to employees. I cannot stress enough the importance of understanding the different types of stock options, their vesting periods, how to exercise them, and the tax implications. Let’s cover the basics, so even if you’re new to stock options, you’ll be more prepared to make informed decisions.

Real-Life Example:

My client was an early employee of a tech company. When he first joined, they granted him over 30,000 shares of incentive stock options at an extremely low valuation. When the company IPO’d his options went from pennies to hundreds per share – my client had suddenly become a multi-millionaire almost instantaneously! He faced some major challenges as his new wealth came with vesting and exercising periods that needed to be understood and tax planning to avoid tax issues.

But the bigger issue was not having the right information at hand, which leads to random and rushed decisions that can cost a lot of money. After careful consideration and planning, we were able capitalize on this high growth company and reduce my client’s risk by reallocating some of portfolio to align with his short and intermediate term objectives. Now he’s not so worried about the day-to-day fluctuations of his stock options and has a complete wealth building plan to help him secure his financial future.
Real-life example: How Four Points Wealth Management helped a client effectively manage his stock options.

What is an Employee Stock Option?

Employee Stock Options (ESO) are a common way for companies (many publicly traded) and startups to incentivize employees through owning a portion of the company they work for. ESOs are a form of equity compensation granted by companies to their employees. ESOs give employees the right to purchase a certain number of shares of the company’s stock at a fixed price (the “strike price”) for a certain period of time. The main types of stock options are incentive stock options (ISOs), non-qualified stock options (NQSOs) and restricted stock units (RSUs), but can also come in other forms too. NQSOs are more common and offer more flexibility than ISOs, but ISOs have some tax advantages. Let’s dig deeper into that.

Each stock option has its own set of potentials risks and rewards, including but not limited to:

(Incentive stock options)
(Non-qualified stock options)
(Restricted stock units)
An ISO gives you the chance as a holder to buy (exercise the options) and pay tax at capital gains rate when disposing off shares due to exercising your option but only when certain conditions are met.Think of NQSOs as employee bonuses. They don’t activate certain capital gain benefits but can help regular income when large numbers of employees purchase their items.The units are “restricted” in the sense that they cannot be immediately liquidated and must remain issued with the company until certain goals set out by both parties have been met.
These offer a great potential for long-term gains but accompany a host of regulations that must be carefully observed to stay on the good side of the IRS.These typically offer fewer restrictions and therefore simpler processes, though they also provide you with smaller potential tax benefits.There are taxes on traditional stocks that aren’t applicable to RSUs until vested.
Employee Stock Options (ESO) types, risks and rewards.

Typically, most employee stock options carry vesting periods related to the underlying asset and the company itself. It’s important to remember that stock options aren’t actual shares of stock—they’re the right to buy a set number of company shares at a fixed price, usually called a grant price, strike price, or exercise price.

What are Stock Option Vesting Periods?

When an employer grants an employee stock option, they typically come with a vesting schedule. This is essentially a timeline of when the employee is entitled to certain elements of the plan, from exclusivity and ownership timing, to key benefits and payment possibilities. Vesting terms can range from immediate vesting to seven-year vesting schedules. For example, if an employee is granted 1,000 stock options with a four-year vesting schedule, they would only be able to exercise 25% (or 250 options) after the first year of employment. The remaining options would likely vest on a monthly, quarterly, or annual basis over the next three years.

Pre-determining such a schedule is an essential element of issuing employee equity since it offers visibility into their liquidity and access over time. It allows employees to understand not just their upfront compensation but also their long-term awards as well. This schedule establishes key metrics and triggering events, allowing for both workers and companies to keep track of equity and lay out when it is coming due.

Once the options have vested, the employee can exercise them by buying the stock at the predetermined price. If the stock’s market price is higher than the exercise price, the employee can sell the stock for a profit. If the market price is lower, the employee can choose not to exercise the options and let them expire.

How to Exercise Stock Options

Learning how and when to exercise your stock options can make the difference between gains and losses. Namely, to exercise means that the employee opts to purchase a specific quantity of shares at a predetermined price on or after a particular date in order to start the clock on owning the stock (important for long or short-term capital gains).

So how do you go about doing so? There are three main strategies to do it effectively.

  1. Cash for Stock – the simplest method which involves purchasing your option shares with cash and later holding onto them as a long-term investment.
  2. Cashless Exercise and Sell – still exercising your stocks but then immediately selling them upon purchasing in order to gain gains before setbacks (reduce exposure).
  3. Exercise and Sell to Cover – you fully cover the related cost of exercising the options. This will help reduce current tax liability but is rarely recommended because of the inherent financial risks that come along with it if you require various amounts beyond what’s available in your brokerage account.

Each of these strategies come with pros and cons, and it’s important to understand how your decision aligns with your goals and objections. Analyzing current trends in market value as well as projections for industries or sectors may provide clues on future performance when deciding whether to cash out of a current position.

Paying Taxes on Stock Options

When an employee exercises their stock options, they may be subject to taxes. The tax treatment of stock options depends on the type of option and when they’re exercised. NQSOs are subject to ordinary income tax on the difference between the exercise price and the fair market value of the stock when they’re exercised. ISOs, on the other hand, may be subject to alternative minimum tax (AMT) if they’re exercised and sold in the same tax year.

Gains on employee stock option trades may be subject to short or long-term capital gains taxes, depending on how long they were held prior to sale. These rates could differ according to income and filing status as determined by the IRS. Generally, short-term capital gains are added to your income, so gains (if they occur) would be subject to ordinary income tax treatment. On the other hand, long-term capital gains are taxed at 0%, 15%, or 20%, depending on your income.

This is generally much more tax efficient than short-term gains. Additional considerations may include if any federal withholding tax is withheld before paying out proceeds from sales among other scenarios. Trading smartly entails taking all this information into graceful consideration as part of the financial planning strategy moving forward.

Other Types of Employee Stock Options

In addition to the ESO plans discussed above, there are a few other stock option plans that I’ve seen clients and business owners deploy in the past:

  • Stock Appreciate Rights (SARs): SARs provide the right to an increase in the value of a designated number of shares, typically paid out in cash. These are great for employees because they don’t have to pay the exercise price but still get to participate in the growth of the company. Most often a company will use a SAR plan along with an ESO plan to help an employee pay for exercising their options and pay for the taxes due.
  • Phantom Stock: Phantom stock is a funny type of plan. These plans allow a company to pay an employee a future cash bonus equal to the value of a defined number of shares; no legal transfer of share ownership usually takes place, although the phantom stock may be convertible to actual shares if defined trigger events occur. I see this type of plan used for smaller businesses that don’t have the funds to pay the administrative costs of the other, more formal plans.
  • Employee Stock Purchase Plans (ESPP): An ESPP plan gives employees the right to purchase company shares, usually at a discount. Most often, an employee sets aside a set percentage of their pay each month and those funds go into an escrow account. Then two times per year the company will purchase, on the employees’ behalf, equivalent shares to the dollars accrued in their ESPP account. The typical discount rate is 15% of the market value on the day the shares are purchased.

Beware of Concentration and Other Issues

When an employee’s wealth is attached to one company, they can easily run into what’s known in wealth management as a “concentration problem.” This means that there is minimal diversification or safety net of wealth in other businesses or investments.

This reliance on a single source opens individuals to fluctuations in the performance of their employer or economic forces, amongst other threats, which can lead to potentially damaging financial losses if the company should fail in any way. This places immense pressure upon employees as any dips or changes in the company stock prices have direct implications for them personally.

Real-Life Example

Silicon Valley Bank shut down after its investments decreased in value and its account holders withdrew large amounts of money, among other factors. The FDIC insurance that protects depositors against loss is unable to do the same for stockholders or investors in unsecured debt. This means those who invested in SVB Financial Group may not be expecting a return on their funds.

They were the 16th largest bank in the United States and many of their customers were in the technology industry.
Real-life example: Silicon Valley Bank investor’s concentration problem

Another issue to consider is capital structure and the possibility of your company going bankrupt or out of business for other reasons. In situations like this, the debt that is collateralized by banks generally takes priority before stocks and shareholders. In other words, you may be holding an equity position but if something unforeseen were to occur, those at the top of the funnel would be the first ones to receive any money from the company; conversely, stock owners would get the smallest chunk (if any).

P.S. After what happened with Silicon Valley Bank, I fully expect we’ll see continued declines and potential bankruptcies and failures from smaller banking and technology institutions over the next year.

Knowledge is Power

When it comes to investment decisions, if you have a handle on all the details up front, you’ll have a much better chance at successful returns in the future.

Stock options can be a valuable employee benefit, they can provide your portfolio with diversity, long-term returns, and — with options — some potential tax benefits but it’s essential to understand the different types of options, their vesting periods, how to exercise them, and the tax implications. As a financial advisor, I highly recommend seeking professional guidance to ensure that you make informed decisions about your stock options.

How Can Four Points Wealth Management Help with Stock Options?

From initial type selection to investment strategy – understanding taxation implications to time frames in exercising – me and my team at Four Points Wealth Management can help you make sure your finances reach new heights. Combining proficiency and personalization, we recognize what matters most to you as well as the intricacies involved in employee stock options, amplifying your decision making and helping you generate greater returns.

If you’re ready to come closer to creating a strategy that maximizes the benefits of your stock options while minimizing risks, please feel free to contact me.

Taylor Leary, Certified Financial Planner in Denver, Colorado.


Advisory services are offered through CS Planning, Corp., an SEC registered investment adviser
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