The first half 2018 is a reminder that market volatility is always lurking below the surface of a Bull Market. Big market moves similar to the volatility we experienced in 2015 but not yet approaching declines of 2008-09 can rattle even the most experienced holders of stock compensation (and their advisors). In some industries, stock prices, because of recent big declines, may have actually returned to 2008 levels. Employees who are new to the stock grant experience or experienced market participants whose attitude about stock price moves is influenced by memories of quick option riches during the 1990s, can both find that they are less than fully prepared to cope with the emotional toll caused by an uncertain market and its effect on their equity compensation.
You may soon face decisions that affect your financial future and long-term wealth in the midst of this market turmoil. Stockbrokers and financial advisors promote and justify many tempting option exercise and risk mitigation strategies. PROCEED WITH CAUTION. Below are 10 topics I find myself discussing over and over again.
Engage in financial housekeeping. If you have a financial plan with goals for your stock grant gains, stick to it. If not, create it now before the market turns up and provokes you to take risks without thinking. In my experience, investors who have committed to a plan and have stuck to it have experienced better returns than those who tried to time the market. Diversification should be a central part of the plan.
Let’s build a hypothetical example: Let’s say you work at a company and have been receiving grants of nonqualified stock options (NQSOs) each year for the past 10 years. At the suggestion, of your qualified equity compensation planner, you have been systematically exercising and selling NQSOs sometime after the options turn six or seven years old. Let’s look back in time: Your 2008 grants had an exercise price of $18.50. You exercised in 2014, when the company’s stock price was at $33. The exercise price of your 2009 grant was $2.45, close to the bottom, but the market price had recovered by 2015 to $24.50 when you followed the planner’s advice to exercise. Your stock continued to rise in 2016 and 2017, eventually reaching $44. Your planner may have taken a lot of heat from you for “missing the top” at the stock’s all-time high.
Today, let’s say your stock, like many that have pulled back since the beginning of 2018, currently trades at $35. Your newer 2016 grants are just barely in the money but the 2010 grants were at $8.60 and according to the plan, you exercised them in 2016 at $24.50. This year, you’ll exercise the 2012 grants which you received at $19.00. If, along the way, you’d committed to building a diversified balanced portfolio with the stock-sale proceeds (which perhaps exclude the stock of issuers in the same industry as your company) it could have kept pace with the broader market and very likely exhibited significantly less volatility than your company stock. For many executives whose wealth is tied to the performance of their company, this lower volatility is an attractive portfolio trait.
Do not overplay tax changes. It is a good idea to review your plan periodically to see how tax-increases, tax cuts, or changes in your marginal tax bracket may alter your situation. But don’t obsess about the tax consequences of an option exercise or restricted stock vesting. Market volatility can easily take the equivalent of the top 37% marginal tax bracket away from you in a matter of weeks! Just ask the next GE executive you meet.
Accept more options and stock now. While down markets mean the exercise of patience, not options, they are a terrific time to receive new grants. Unlike during past market downturns, you may now be receiving grants of restricted stock, RSUs, or performance shares along with or instead of stock options. These grants continue have value in a down market and therefore can both lessen the pain from underwater stock options and ease “volatility” in the value of your stock grants. Gather as many as you can!
Be realistic. The recent almost decade-long recovery will someday end. Benjamin Disraeli once said: “What we learn from history is…that we do not learn from history.” The next time you hear the words “It’s different this time” or “Earnings don’t matter,” be skeptical. Option holders who embraced a healthy degree of skepticism during previous run-ups in stock prices, and made the decision to take some profits, are usually glad they did. As well, those who continue to diversify out of their company stock when it represents too large a chunk of their net worth are probably glad they have been doing so.
Don’t be stubborn! After option exercises or restricted stock vesting, avoid using tax-deferral strategies beyond the point where the market’s effect on your holdings erases the hoped-for advantage from long-term capital gains rates. For Incentive Stock Options (ISOs) this differential is only 9%, or the difference between an ordinary tax obligation in the top bracket (37%) and the maximum AMT rate (28%). In lower brackets, the difference is even less. Declines in price beyond this limit mean that the advantage of paying long-term capital gains rates on an ISO stock sale at some point in the future (and recovering some portion of the AMT paid in the year of exercise) is erased.
Use stop limit orders to protect against a collapse of your stock’s price. Be very careful about using a margin loan to continue the financing of your exercise-and-hold strategy. The leverage advantage that works for you on this type of loan in a rising market quickly turns against you when markets turn down. Many brokerage firms are marketing pledge loans with seductively low interest rates. Using your company stock as the collateral on one of these loans may not be a great idea if it prevents you from reducing your concentration in the company stock. If you use your stock to finance a real asset like your home, you effectively tie the fortunes of your home price to the stock market. You might be better off just selling the stock and paying for your house outright.
Focus on face value. Don’t become fixated with complicated option-valuation calculations. The tools that use these methods can be helpful, but they are all based on past performances and trading ranges for your company’s stock. While there are no other data on which to rely, predictions of future performance based on past performance will probably prove to be imprecise.
Exercise and hold with caution. Executives with incentive stock options (ISOs) have asked me, “Should I exercise and hold now that the market price is down?” Leaving aside the fact that some executives are asked by their company to own some minimum amount of stock, their question really is: “Should I exercise now, avoid or pay very little AMT, and hold for a long-term capital gain?” My answer is: “Buying now with the price close to, or at, the strike price is no different (or very little different) than buying in the open market. Buy-and-hold investing is a choice available to everyone!”
When you consider open-market purchases, you should ask yourself: “Are there reasonable, fundamental reasons (besides those company ownership guidelines) to believe the stock will rise and that I do not already hold a substantial amount of company stock?” If the answer is yes, then you may want to buy (exercise) and hold. If the answer is no, then you do not want to buy (exercise) and hold, do you? Whether you have ISOs or NQSOs, when you exercise and hold you need to consider the alternative-investment returns on the same cash you are putting into your stock, the diversification of your portfolio, your risk tolerance, and your needs for cash, as if you were buying any stock. One of the advantages of stock options (when the market is rising) is the leverage they afford. If you own options to purchase stock at $2 when the market price of the stock is $10, you have at your control a lot of profitable stock with no cash committed. When the market price declines, the leverage declines with it. Because the tax advantages may never materialize, be ready to abandon a tax-minimization strategy as your stock price falls.
Diversify. Ask yourself: “Am I an entrepreneur or an employee?” Again, company ownership guidelines may adjust your planning but they also add risk. Entrepreneurs take risks, have big chunks of their net worth in their company stock, and have a vision of and direct impact on the long-term prospects for the company. Employees, on the other hand, earn a paycheck, with stock options or restricted stock as a nice benefit and a long-term supplement to it. Entrepreneurs risk (and sometimes lose) it all. Employees seek the stability of a paycheck. How does your stock plan fit into your vision of which you are? Evaluate your company stock holdings over all the employer stock plans you participate in: stock options, an employee stock purchase plan, restricted stock, performance shares, and/or a 401(k) plan and diversify accordingly.
Make sure you aren’t overloaded with your company’s stock. Diversify the rest of your portfolio away from your company and its industry, consistent with the vision you have of where you fall on the entrepreneur/employee continuum.
Know hedging basics and limits. Many brokerage firms and banks market various strategies to protect large, concentrated stock positions. If you have at least $1 million in one stock, a hedging strategy that shelters your gains and lets you take out some cash may be worth considering, as opposed to a straight sale of some of your holdings.
Protective puts, equity collars, and prepaid forward contracts, which are beyond the scope of this post, may be available to provide partial protection against price declines, or to generate cash, in exchange for certain conditions. However, hedging arrangements involve complicated taxation and securities laws, and many companies ban them. Moreover, by hedging you may be giving up too much of the future appreciation on your stock. Each strategy also has costs. When stock markets bottom out, speculative excess and overvaluations get wrung out of the market, and many stocks are oversold for a while. These conditions reduce the need for certain price protections.
For some executives, selling, even for all the right reasons is difficult because of the job they do. If you have a role at your company that regularly makes it difficult to sell stock because you have access to non-public, inside information, consider setting up a program of selling your company stock at pre-determined prices in a Rule 10b5-1 plan, which, when structured properly, disciplines your diversification and can provide an affirmative defense (not a shield) against charges of insider trading.
Finally, act fast when terminated. The worst kind of volatility is the kind that causes you to lose your job. For your own sanity, if you change or lose your job, exercise your in-the-money options and sell the stock as soon as you conveniently can. The rationale of being a “good corporate citizen” and maintaining a concentrated portfolio in your company stock no longer applies. As with any stock you can buy, don’t be tempted to hold after option exercise or restricted stock vesting unless you view this as a good investment decision. The broader market a mutual fund and certainly cash likely holds less risk than this single stock.