How to Navigate Your Various Forms of Equity Compensation
A differentiated approach can yield powerful results.
By Michael Yoder, CFP®
People often feel stuck when holding multiple forms of company stock. How do they work together? Which ones should they sell first, and which are best suited for holding longer-term? How can they be smart about taxes along the way?
When a person owns more than one form of equity compensation, it may include the following:
Stock options, which can either be incentive stock options (ISOs) or non-qualified stock options (NQSOs)
Stock grants, which typically come in the form of Restricted Stock Units (RSUs) or Restricted Stock Awards (RSAs)
Employee Stock Purchase Plans (ESPPs), which offer the opportunity to buy the stock at a discount
Each form operates differently and faces unique tax treatment. In addition, when some of those shares are QSBS, it creates an additional layer of complexity. This article will consider the ramifications when all are present.
Equity Compensation Principles
There is danger in allowing too much of your wealth to accumulate in one company, particularly the same one that provides your income and retirement plan. As your company stock grows in value, the need rises to translate your paper gains into a more sustainable store of wealth.
This is easier said than done. Not only can the different forms complicate matters, there can often be an emotional attachment to the stock.
These difficulties can be mitigated through smart planning. If you create a plan that eliminates the majority of downside risk while retaining the majority of upside potential, you’ll find it much easier to follow.
To do so, you must determine which forms of your equity compensation are the most powerful. There are two main criteria to consider:
How are future gains taxed?
Non-qualified stock options, which are taxable as compensation upon exercise, fare worst on this measure. By contrast, QSBS shares rank highest, as future gains can be tax-free up to the $10MM limit. Anything taxable at long-term capital gains rates is in the middle.
Which has the most favorable risk/reward profile?
Before you discard your NQSOs, however, know that they often score highest on this front. Since stock options derive value from the spread between the exercise price and the stock price, a small change in stock price can lead to a huge gain in the option’s value. This concept is known as leverage. For this reason, stock options can often be far more powerful than other forms, including QSBS shares.
Formulating an Exit Strategy
Creating a liquidation plan is easier if you break the task down into three steps, as follows:
Step One: How will new shares be handled?
Step Two: How much should be set aside in a “forever sleeve”?
Step Three: How should existing shares be liquidated?
Limiting new shares can prevent the problem from getting worse. In addition, selling new shares can provide momentum toward overcoming the emotional difficulty of selling long-held positions.
In addition, by setting aside a “forever sleeve”, you don’t have to relinquish your exposure to the company’s upside. If the company really does make it big, this sleeve allows you to still financially participate. QSBS shares are often an ideal position for this sleeve.
With these in place, the final step is to begin reducing your position, starting with your least powerful shares.
Given the endless possibilities, we’ll use a case study to illustrate these concepts in action. Please keep in mind that depending upon your particular situation, the best course of action might be different for you.
Case Study
Meet Bill, a 40-year old at a rapidly growing software company that went public 3 years ago. He enjoys his job, and plans to continue working there indefinitely.
Bill’s equity compensation is worth $4.5MM, spread across RSUs, options and ESPP shares. Of this amount, $2MM qualifies for QSBS treatment.
Although he continues to believe in the company, he never intended the stock to constitute 90% of his investment assets. Given the surge in value over the past three years, he is ready to begin diversifying his wealth.
He would like to start his liquidation plan with the “low hanging fruit” and work up from there, retaining as much upside as possible along the way. Each time he sells shares, the proceeds will be directed into a diversified investment portfolio.
His stock is currently worth $100 per share, as follows:
Bill’s Company Stock Positions
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Bill’s Exit Strategy
To prevent additional shares from accumulating, he will begin selling all RSUs and ESPP shares as soon as he acquires them.
Upon selling his new ESPP shares, the gain will be taxable as compensation. Although he could hold the shares for 18 months to avoid making a disqualifying disposition, Bill feels the added complication is not worth the minor potential tax savings.
Upon selling new RSUs, there’s no material tax consequence. When RSUs vest, the fair market value is taxable as compensation regardless of whether one keeps or sells the shares. Capital gains are only recognized on the difference between the price at vesting and the sale price, which should be minimal if the shares are sold right away.
Meanwhile, Bill designated $1MM of QSBS shares to hold indefinitely in his “forever sleeve”. He chose these shares because, unlike the other forms of stock, the future gains are tax-free (up to the $10MM limit). Also, unlike his stock options, these shares are not subject to an expiration date. He feels this amount will allow him to retain a reasonable amount of long-term participation in his company’s future prospects.
Bill’s Liquidation Schedule
With those in place, Bill established the following order for his liquidation plan:
Sleeve #1: NQSOs with exercise price of $.01
These options are Bill’s least powerful position. As explained below, they have virtually no remaining leverage. They also receive the worst tax treatment of any of his shares, with all gains taxable as compensation upon exercise.
As discussed here (Unwinding a concentrated stock position), staggering the sales can mitigate timing risk. With that, Bill decides to exercise and liquidate 1,250 options per quarter over the next two years.
Sleeve #2: RSUs and ESPP shares
Next in line are the ESPP shares and RSUs (apart from the shares set aside in the forever sleeve), which receive better tax treatment than his NQSOs.
Once the above NQSOs are liquidated, Bill will sell these shares equally in 12 quarterly installments over a three-year period. He will begin with the non-QSBS shares, each time selling the shares with the highest remaining cost basis. The QSBS shares, which enjoy the best tax treatment, will be sold last.
Sleeve #3: NQSOs with exercise price of $70 and $90
Highly leveraged stock options have perhaps the greatest risk/reward profile on the planet. Since you have not yet paid anything for the shares, no out-of-pocket money is at risk. Meanwhile, the upside is not only unlimited, it is amplified by leverage.
To illustrate how leverage works, assume the company stock prices rises from $100 to $110, a 10% increase. Here’s how it would affect the options with the lowest and highest exercise prices:
The value of the 10,000 options with an exercise price of $.01 would grow from $999,900 to $1,099,900, for an increase in value of 10%
The value of the 10,000 options with an exercise price of $90 would grow from $100,000 to $200,000, an increase in value of 100%.
As you can see, the latter grant is far more powerful. A small gain in the stock translates into a huge increase in the value. By contrast, the former has virtually no leverage at all.
These options are his most powerful positions, despite the unfavorable tax treatment. Bill will therefore liquidate these last. After the first two sleeves are sold, he will look to first exercise the shares with a $70 exercise price, followed by those at $90. The actual sale schedule will be determined at that time.
With this sleeve, Bill maintains powerful exposure to the stock’s upside potential, which makes following the earlier steps much easier.
Bottom Line
Bill feels good about having a systematic plan to turn his paper wealth into sustainable wealth. Most importantly, this is a plan he believes he can stick with.
When evaluating your own situation, assuming you’re moderately comfortable with the stock’s prospects, look to identify the shares with the best risk/reward profile. If you start by selling the least powerful shares first and go from there, you might find it much easier to begin exiting your position with conviction.
Nothing in this article shall be construed as tax or legal advice. The content is provided for informational purposes only and, there can be no guarantee of its accuracy. Consult your personal advisors prior to acting on any of the information contained in this article.
About the Author
Michael Yoder, CFP® is principal at Yoder Wealth Management (www.YoderWM.com), which provides high-end financial planning and investment advice for individuals and families. You can find more information here.
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