Jan 22, 2024

How Dependent Is Your Wealth on Your Company’s Stock Value?

Jan 22, 2024
Pat Phillips — CFP®
Wealth Architect
While company stock compensation can yield great payoffs, it’s important not to have all your financial security tied to the success of one company, even if you wholly believe in its mission and longevity. In my 15 plus years as a financial planner and advisor, I’ve observed that employees and founders with equity in their companies often overestimate the liquidity and diversity of their assets. Their stake is often not as accessible as they perceive, even at publicly traded companies.

While company leaders are often knowledgeable about their equity packages and options, I’ve found that non-executive employees are sometimes not as informed. For those seeking more information, below are high-level descriptions of the main stock compensation considerations and best practices that I talk through with clients.

Most common types of employee stock compensation

Stock compensation can take many forms and it’s important to have a strong understanding of the nuances of your particular stock benefits. In recent years, three types have emerged as the most common granted by public companies to their employees.

Restricted Stock Unit (RSU)
With RSU’s, an employee earns shares of stock over time and/or as prescribed performance milestones are achieved. The stock units granted typically vest quarterly for a duration of four years. The units, or shares, are typically taxed as wage compensation when they are released or transferred to the employee. For publicly traded companies, the vest and release dates are usually the same. For pre-IPO, private companies, there may be two conditions required before vesting is complete, such as vesting time (e.g., four years) plus an event (e.g., IPO or acquisition). This two-part requirement is called a double-trigger. Only once both triggers are satisfied can the shares be liquidated. RSU’s are taxed as compensation upon the release date. 

Employee Stock Purchase Plan (ESPP)
ESPP’s are designed to incentivize employees to defer a percentage of their salary now to buy company stock at a discount later. Each company’s plan may differ, but in most cases the stock purchase price is either discounted by a pre-established percentage (5%, 10% or even 15%) or sold at the lowest price recorded over that time period (typically six months). If you participate in your company’s ESPP, note that there are a variety of different tax implications to consider. How long you hold the shares after purchase will determine whether the gain is taxed as ordinary income and/or long-term capital gain. Learn more about ESPP tax treatment here.

Stock Options
If granted stock options, you have the right to purchase shares, once vested, at the fixed price stated in your stock option letter. If the share price grows over time, you can exercise that stock at the original price and gain from the difference. If you leave the company, you are usually required to exercise your vested shares within 90 days after departure. The two most common types of stock options are incentive stock options (ISO’s) and non-qualified stock options (NSO’s or NQSO’s). ISO’s are typically only granted to employees who join very early in the company’s formation. ISO’s offer more potential tax benefits than NSO’s. The tax benefits are too complex and nuanced for a deep dive in this post, but you can learn more here. If you are ever granted ISO’s, we recommend you speak to a financial and tax advisor within 30 days of the ISO’s being granted. NSO’s, on the other hand, are treated just like wages. Upon exercise, the difference between the exercise price is taxed as wage income and, thus, subject to payroll taxes and ordinary income tax rates.

The risk of employee stock compensation? Overexposure

When compensation is subject to a milestone or performance metric, companies sometimes refer to it as an employee’s “target compensation.” If your employer gave you a $500,000 target compensation package for the upcoming year, for instance, it might break down to 50% salary, 15% cash bonus and 35% RSU grants that vest over a period of time. While this might be a generous package, remember that it’s still a target. It’s not guaranteed, even though people sometimes think of it that way. The reality is, it comprises different forms of indefinite income, all of which are reliant on just one company.

You might anticipate a $500,000 year ahead and feel a sense of security in that number, but if the company’s stock price declines, you fall short of performance metrics or you lose your job, then suddenly your bonus is in jeopardy, your salary may be cut and your equity could be worthless if it hasn’t fully vested. If you have substantial savings and/or other streams of income apart from the company you work for, you might be OK. But if the majority of your income and net worth is held in that one company, you might have to brace for significant financial impact.

Context is also key when assessing your risk and financial livelihood in the case of unexpected income loss. Do you live relatively simply? Or does your lifestyle (or plans for the future) include numerous major expenses that could be impacted, like a mortgage or paying for private school for your children? As a company employee and stockholder, the more complex and expensive your lifestyle, the more you might be affected by loss of compensation or a decline in your company’s stock value.

It’s natural to focus on what’s right in front of you – the feeling of wanting to maximize your potential compensation, believing deeply in the company you work for and the work you do within the company – but it’s typically best to avoid having most or all of your liquid assets in one company and one stock. When your finances are dependent on one entity, you are likely “over-concentrated” and in a financially risky position. Over-concentration of your financial capital and human capital (your knowledge plus the time and energy you spend working) can seriously compromise your financial and emotional well-being if things do not go as hoped. Yet, it’s common for people to underestimate this risk. Naturally, we often are (or want to be) optimistic about the future of the company we work for every day.

Concentration of financial capital is most commonly defined or calculated as a percentage of an investor’s portfolio and/or net worth, such as assets we actually own and can transact in (i.e., buy or sell). A 10% or greater allocation to any one individual stock is often defined as a concentrated position because, at the exposure, the stock price fluctuations of that company’s stock begin to have a materially significant impact on the overall portfolio results, for better or worse. The exercise of calculating one’s portfolio and/or net worth exposure is relatively straightforward; however, I believe many individuals don’t know this is a calculation they should be making and are, therefore, unaware of just how much of their future financial and human capital they have tied to one company.

The antidote to overexposure? Diversification

Take the example case above: an individual with an annual target compensation of $500,000. Again an extremely attractive compensation package. The compensation is pre-tax, but nonetheless, that represents $1.5 million in total compensation over three years and $2.5 million over 5 years – all tied to the success of the individual and the company. If, for example, the individual combines either of those totals to their net worth, their concentration to that one company is likely to increase dramatically.

So, that begs the question: What assets do you have outside of that $1.5 million or $2.5 million if that income stream were to decline, temporarily stop or go away altogether? Typically, it is not feasible to diversify future compensation, but using this formula, might more employees consider focusing on increasing diversification of their current assets? Or on being more proactive in diversifying company stock in pieces as it vests, rather than sitting on it all long-term, waiting for a major positive event that may or may not happen?

A diversification framework is key for building lasting wealth outside of one’s present employer. Work with a trusted advisor to assess your financial profile and diversify your portfolio to mitigate overexposure. There is an emotional and financial balance to consider here. Most work for a company because they have a deep connection to the work and/or the company’s future prospects. It’s natural to want to concentrate your capital in that company and to perhaps have a singletrack mind focused on the benefits of its massive financial success, if it comes to bear fruit. Yet, it’s important to maintain a healthy appreciation of the risks and be poised for long-term financial success that isn’t contingent on the success of a single company. This can be especially true as we’re deeper into our careers and lives and have extensive financial commitments and responsibilities.

Where do you start? Map out your goals and sell when you can sell

It’s not uncommon for me to work with someone who’s sitting on a substantial amount of vested stock that they could be selling and diversifying. First, I help them build a very detailed plan based on their future wants and needs over the next year, five years, and beyond. This includes their desired and anticipated discretionary and nondiscretionary expenses. The key is to build their decision-making around specific goals, rather than the more nebulous approach of simply wanting to accumulate as much money as possible. In many cases, I then encourage them to take action and start selling their stock quarterly as it vests, so they can diversify more and liquidate their assets as needed to reach those stated goals.

It can be tempting to hold onto your equity well beyond its vesting date in anticipation of the value increasing, but every company has its own life path and the most profitable companies of today won’t necessarily be the most profitable companies of tomorrow. The optimal move is often a consistent approach down the middle. If you cling to all your equity and the stock value declines over time or due to unexpected circumstances, you’ll wish you’d sold it earlier. However, if you sell it earlier in order to achieve one of the major goals outlined in your plan, you are less likely to regret it. 

I ask my clients this: What would have a bigger impact on your life, the stock price doubling or losing half its value? Adjusting to a substantial loss because you waited longer to sell is probably going to affect your quality of life (and your family’s) more tangibly than if it was a 2x gain. In other words, going for a third option – selling as soon as you can at a more modest profit – is often the prudent move, in my opinion. “Nobody ever lost money taking a profit,” as the saying goes.

Sometimes people are hesitant to sell their company stock merely because they don’t know what they want to do with the money. Again, this is where systematically mapping out your future objectives is essential, so you’ll be ready to take the appropriate action steps when it’s time.

Work with a professional advisor to create a diversified plan that can fund your priority investments, both discretionary (think: luxuries) and nondiscretionary (think: necessities). Below are some potentially major investments to contemplate:

Discretionary:

    • Vacations
    • Luxury products (car, jewelry, clothing)
    • Home renovation
    • A second home
    • Summer camp
    • Assisting children with big purchase, such as a wedding or home down-payment

Nondiscretionary:

    • Mortgage
    • Property tax
    • 529 college savings plan
    • Long-term stock investments
    • Taxable brokerage account
    • UTMA account
    • Emergency reserve
    • Retirement

Final thoughts

Being disciplined with your financial plan will reduce the chance of regret you might feel if you sell your stock and the price goes up later. All you can do is operate strategically based on time-proven investment principles and the information available to you. Yes, it’s quite possible that by selling now you miss out on a bigger payout, but if you’re already on a path to achieving the goals you set for yourself, how much does the rest really matter? Sometimes we get distracted by chasing a certain “ideal” net worth, but I believe real wealth isn’t a number; it’s living a fulfilling life with the means to do the things you love.

 

If you would like to speak with a Wealth Architects advisor about how we can help you reach your financial and personal goals, contact us here. We look forward to connecting with you.


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