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 that you begin to receive every year something called Long Term Incentive Awards. These can come in the form of stock options, performance unites, 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 executive who receive this type of compensation do an awful job of construction a smart strategy and game plan on what kinds of options to take if they are offered a choices and how to most effectively build an exit plan from having 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. Here is a little debrief on each of these kinds of plans, and then I will talk strategy about exercising them.
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 within 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 the employee has the right over the next year no matter how high the stock prices goes to purchase 1,000 shares of Coke stock at $65. So, if Coke's stock goes to $95, then the option is worth $30 per share or $30,000 to the employee of gross income if 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.
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. However, you must be very careful and talk with your CPA our accountant 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. However, 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 versus paying ordinary income tax which is a sizable difference of tax. 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.
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.
However, each of these plans comes with a hook which is called a vesting period. Typically, these plans will either vest over three years 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 to pay 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 elect to pay tax on the stock when you get the grant or 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 3 to 4 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 so they can get the most out of their option plan. However, each year you get closer to the expiration date provides most risk to you the employee of 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, you need to think smarter about your overall strategy about when to trigger your options.
It's easy to play Monday morning quarterback with stock options. I'm confident that you will personally have a hard time exercising these on your own and doing it well because you 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 personally 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. No matter if the stock is booming or treading water, if the stock hits this price you are out of that set of options. The truth is that if you continue to keep working for the same company you will continue to get more options from them. However, by doing it this way you have an automatic game plan no matter what happens day to day in the stock market.
Another route you can go 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 401k, 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 doing phenomenal. If your company stock is growing like a week, your emotional side will tell you to gather up as much of the stock as you can in your portfolio. Ask the employees of companies like Enron and dotcom's gone bust how that went for them.
As you can see from this article, navigating the sale of stock options from your company can be a challenging task. I highly recommend that you get with a financial advisor, CPA, or a team of people who can help create a quality game plan so you can make the most of your hard work. More companies are limited the cash compensation to 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!
Written by:
Ted Jenkin, CFP®, AAMS®, AWMA®, CRPC®, CMFC®, CRPS®
Co-CEO and Founder oXYGen Financial, Inc
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