Equity compensation squeeze - how to get the most juice
What is equity compensation?
Yes, you receive company stock as part of your pay, but how do you actually use it in reality - what are the benefits to you and your family?
Keep reading to learn the basic functions of each type of equity comp as well as how to get the most “juice” (net of taxes) from the fruits of your labor (company stock).
First, an enlightening story…
Back in the late 90s, there were countless examples of lower level employees unknowingly becoming millionaires through stock they received from their respective employers - in many cases, a tech company. What happened in these instances was the perfect storm. The employee worked for a fast growing firm, didn’t realize they received the stock, and therefore did not take any action. The stock increased in value and on paper the holder became a millionaire. At that point, the employee was aware of their good fortune and did not want to sell due to the belief the stock price would continue going up as it had previously (also known as recency bias). Unfortunately, what quickly followed was the tech bubble bursting in 2001. As a result, almost all of these stocks lost value and the employee was left with close to nothing. Of course, they may have been lucky (a second time) not to sell the stock at a low price and part of a financial miracle to work for a company like Apple that recovered and continued growing for decades to come. In this once in a lifetime sequence of events, the employee would be a multimillionaire today.
In lieu of depending on sheer luck, the goal is to manage your equity comp efficiently to mitigate the roller coaster effect (risk) above and get more out of your employer stock positions today, all while being tax efficient.
Fundamentals of each type of equity compensation
Restricted Stock Units (RSUs) - you receive company stock directly. There is only one decision point - keep it or sell it. Most of the time, you want to sell the stock as it periodically vests (monthly, quarterly, annually). There are a few justifications for this action.
You reduce risk
By selling the stock, you are avoiding a concentration in one company. You already have a lot riding on your employer - income to cover your fixed expenses, health insurance, 401k match, the list goes on. We do not want to put any more weight here.
You still have exposure to a higher stock price in the future
Even if you sell, you will continue receiving stock in the future (through future vesting and/or additional grants). If the stock price goes up, you naturally participate in this. In other words, the number of shares you receive is fixed by your employer - though, the stock price is not. If the price goes up, the dollar value you receive increases too.
Your capture value immediately on taxes paid now
Each time stock vests, you pay income tax on the gross number of shares whether you hold it or sell it - you do not have the ability to opt out of this. If you sell right away, you actualize the value on the taxes you are paying regardless.
Stock Options (ISOs and NSOs) - you have the ‘option’ to buy the company stock at a predetermined price. Two decision points exist here:
Whether or not to buy the stock - this is also called exercising your option.
Once you own stock, you can keep it or sell it.
Let’s dive further into each type of option…
Incentive Stock Options (ISOs) - typically, these are granted to employees of a private company positioned to go public at some point in the future.
In most cases, the best initial course of action is to exercise the options as they vest then hold the private stock until the company goes public. This is due to a “hidden” tax benefit. More specifically, if the stock is held for 2 years from the time it is granted and 1 year from exercise, the entire gain can be taxed at a preferred, lower capital gains rate (as opposed to a higher income tax rate).
One thing to be careful of is triggering AMT (Alternative Minimum Tax) when exercising, which is dictated by the amount of bargain element you realize and your household income. Here, it is important to partner with a Financial Planner and/or Accountant to confirm your limits.
Note - this same tax is the justification for not waiting until the company goes public to exercise all of your shares at once. In this latter case, you would likely pay more tax than the former example above - both in terms of AMT and income taxes.
Non-Qualified Stock Options (NSOs) - contrastingly to ISOs, NSOs do not contain a hidden tax benefit. As a result, these are best held in their option state (not exercised to buy the company stock) until you are ready to sell. This way, you have more exposure (gross of taxes) to the stock price, which hopefully goes up by the time you liquidate.
Conclusion - drink your juice today
Equity compensation is another form of recurring pay - think of it as a bonus. Our objective is to squeeze the juice of the stock so there is a higher yield, net of taxes. At the same time, we want to mitigate risk and avoid losing our crop to a potential drought (economic recession). The approaches highlighted above allow us to balance these two factors and use the proceeds right now to accumulate true wealth.
Please note - the definitions and strategies outlined in this blog are intentionally light to provide a high level idea of how equity compensation works. To craft a detailed, tailored plan that connects all components of your life, it is advised to partner with a Financial Planner and Accountant.