Equity compensation schemes abound in both the startup and corporate worlds. But they are not all equal, and not all recipients find themselves on a path to riches, contrary to popular perception.
As you will see in the experience of three different equity compensation grantees (fictitious) in this post, the extent to which you will benefit from an equity compensation package depends on not just the performance of the stock, but also how well you manage key decisions relating to your equity. In particular, understanding the type of equity you have and the associated tax implications are critical to your success – as is understanding the risk proposition of investing in an individual stock versus a diversified portfolio.
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“Employee equity can be complicated. Solid planning can help capture profits and reduce risk.”
Personal Capital Options Specialist
BOOM TO BUST
For our first example, we’ll travel back to the late 1990s to look at someone who made it through the dotcom boom and bust – barely. While he fell victim to the internet frenzy, he was swift to act when he saw warning signs that might impact his equity compensation.
Our character is Steve Stock, a recent MBA grad who decided to leave his job as a mid-level marketing manager at a major national grocery chain to join the startup Webvan – a company that sought to replace brick-and-mortar grocery stores by creating an online storefront that delivered groceries.
Steve recognized the opportunity of catering to busy consumers who might welcome the chance to save themselves the chore of trudging to the store. Like others at the time, it made sense to him that commerce as it was known was about to change forever. What’s more, as a single man in his early 30’s, taking on some risk in his career didn’t intimidate him – especially as he was offered incentive stock options (“ISO’s”).
You’ll recall from Daily Capital’s equity compensation primer that ISOs are the best options to get given their favorable tax treatment. That’s because they’re treated as equity and you do not report income when you exercise them (NB: you may be subject to alternative minimum tax (“AMT”) at time of exercise, as we’ll see with Steve, but any such taxes paid can be treated as a refundable AMT credit in future years).
Steve was granted 100,000 ISOs when he took his Webvan job in September 1998, with an exercise price of $8 per share. Because he was getting options, Steve was prepared to take a pay cut – going from a $130,000 salary to a $100,000 salary.
By September of the following year, 25 percent of Steve’s options (or 25,000 options) were vested (reflecting a normal vesting period of four years) as Webvan prepared for its November 1999 initial public offering. On the day of the IPO, the stock, offered at $15, rose to as high as $34. Much to his joy, Steve was worth as much as $2.2 million (that is, if he were vested in all of his options and if he could sell it at favorable tax rates). His plans for his windfall included paying off about $100,000 in student loan debt that he still carried from his MBA. Once that was paid off, he envisioned traveling the world and buying a nice new home. And maybe, getting a sports car.
While Steve maintained his high hopes for the stock – it was of course, his employer – he grew wary as the stock exhibited some volatility in the months after trading. Although he knew that he’d be paying more in taxes if he sold quickly (with less than a holding period of a year, he recognizes the spread between buying and selling price as a short-term gain; thus he pays tax at ordinary income levels instead of long-term capital gains rates), he decided to take action on his vested options.
In the days following the IPO, Steve simultaneously exercised the vested 25,000 options, at $8 per share, and sold 10,000 shares, at $20 per share, to cover the $200,000 cost of exercise. (This example assumes the lockup period did not apply to these shares). When tax season came around, that meant he had to borrow around $35,000 from his parents to cover the short-term capital gains tax generated by the sale.
Steve was thus left holding 15,000 shares of Webvan, as well as the rest of his options, which were to vest in the coming months and years.
Source: SF Chronicle Graphic
But that’s not the end of the story. As we all know now, the days before the dotcom heyday were numbered by late 1999. And on top of that, Webvan had made its own strategic missteps – including overestimating its market opportunity. As you can see in the stock price chart above, Webvan’s stock price by 2000 had begun a steep and steady downward course. Much to Steve’s dismay, the share price was flirting with his $8 exercise price in March of 2000, and by April it had dipped below $5.
Not only that, Steve found that he owed the government alternative minimum tax on what it considered the $180,000 in income that he received by exercising the options on the 15,000 Webvan shares he still held, making for an AMT tax liability of around $52,000. As the Daily Capital equity primer notes, that credit is refundable in future years. But for Steve in 2000, it meant more borrowing from his parents to cover that liability.
As talk of the bubble bursting increased in the summer, and the stock began to drop again after showing a brief sign of recovery, Steve decided it was time to bail. He sold the rest of his 15,000 Webvan shares at $4.50, for sales proceeds of $67,500. Given his exercise price of $8 per share, that represented a $52,500 loss (Ouch!).
Happily, there is a cushion to Steve’s fall. The following year, he gets his $35,900 AMT completely credited. Also, he knows about tax loss harvesting and can explore using the loss to offset other capital gains (except given where the market was, he didn’t have any gains that year and ended up being able to deduct $3,000 in losses from his income). When all is said and done, Steve made about $35,000 after gains, losses and taxes.
For Webvan, the rest is history. After November 2000, the Webvan stock started trading for pennies and the company eventually filed for bankruptcy in July 2001. Other dotcom option grantees did even worse than Steve and some even had to file for bankruptcy themselves to deal with their AMT liabilities.
Luckily for Steve, he acted quickly and was able to get out with some benefit and eventually left Webvan on good terms – all the wiser for his experience.
Our next example jumps ahead to the year 2012 to show how less stormy markets might impact someone’s compensation package, as well see how equity compensation packages have changed since then. Our next character is Rina Rich, a senior-level Facebook software programmer who was granted restricted stock units (“RSU’s”) in the company in its pre-IPO days.
Back in the dotcom days, ISOs were more common since companies didn’t have to treat them as a compensation expense. As such, they effectively inflated company incomes. Changes in accounting laws have closed that “loophole,” and subsequently RSUs has also become more common with newer technology companies, such as Facebook. Another advantage that Facebook saw in RSUs is that they don’t have to be counted as stock until they are actually vested. Further, the company included a performance condition among its RSU terms that delayed vesting until six months after the IPO. Thus, growth of the company’s shareholders (from the SEC’s perspective) was limited, and the company didn’t have to make public disclosure of its financials until it was ready to do so.
Rina, in her late-30s and married with two young children, saw potential in Facebook’s fast growth and joined the company in early 2008. Facebook lured her from a major engineering company with a compensation package that included 100,000 RSUs, even though her new $120,000 salary was significantly lower than the $150,000 she had been making. She was prepared to take the risk considering that her husband, a lawyer, worked for a stable company.
Rina, and other Facebook employees, watched with great anticipation as the company made its fully priced $38 per share IPO debut in May 2012. The IPO launched to a lot of bad publicity – and it seemed that the stock was on a steady downward descent after that. However, Rina was powerless to do anything with her equity; while she had worked at Facebook for four years (and thus had fulfilled the time restrictions), there was still the performance restriction that delayed vesting until six months after IPO.
Six months later, Facebook’s stock price had fallen to $23. On paper, Rina’s shares were worth $1.265 million (That’s after the company deducted state and federal taxes at 45 percent; assuming she was paid in net shares, she got 55,000 of her original 100,000 grant).
With her payoff, Rina hoped to put aside money for her children’s college education, and also trade in the family’s starter home for a nicer house in the competitive Silicon Valley market. Furthermore, she knew that keeping such a big chunk of net worth in an individual company was a risky proposition. With a family to take care of, she was eager to get to a point where she could diversify. As some other Facebook employees flooded the market with their newly granted stock, Rina wondered: how long should she hold onto her stock?
Ultimately, Rina decided to hedge by selling some and keeping some. Thus, she balanced her near-term liquidity needs (and prudent desire to diversify) with her faith in the company’s prospects. Soon after her shares vested, Rina sold 30,000 of her 55,000 shares in December 2012 at $27, making an after-tax gain of about $750,000 (she had to pay short-term capital gains tax on the $4 price increase since vesting).
Rina decided to hold the rest of her shares only until she’d be paying capital gains rates. So the day that she had held the shares for a year, November 14, 2013, she sold her remaining 25,000 shares at $49, for gross proceeds of $1.2 million. Given that Congress raised long-term capital gains rates during the year she waited to sell, she paid end up paying 20percent instead of 15percent, for an after-tax gain of $1,100,000.
While we can see in the stock price graph that Rina may have made more by waiting more, with a total net gain of $1.9 million, we can see she did quite well. With her proceeds, she was able to meet some of her near-term goals and invest in an asset allocation appropriate for her family and their long-term financial goals.
In our last example, we’ll take a look at a longer timeframe (that encompasses both good and bad market conditions) and focus in on a more established company. After all, Silicon Valley is not the only place where equity ownership in a company can become a significant factor in a person’s wealth: among companies that have stock outstanding, 36percent of the workforce has equity ownership.
Our last character is Steady Eddie, a mid-level finance manager with Procter & Gamble in Cincinnati, Ohio Eddie was granted 50,000 incentive stock options in December 2004. Eddie, a late-40s married man with a homemaker wife, had resisted the urge to move to greener pastures presented by the dotcom boom.
Dotcom companies had then courted him with offers of as much as 100,000 in stock options. Considering that the offers also came with a reduced annual salary of $100,000, compared to the $150,000 he was then making at P&G, Eddie had decided to stay put.
The P&G options, with an exercise price of $55, would fully vest after three years. Eddie had plans of saving for retirement and paying off the mortgage on his family’s home. At the time the options began to vest in December 2007, the P&G stock was up to $74 (giving him a paper net worth of around $800,000 if he were to receive favorable tax treatment).
Steady Eddie waited the three years for vesting. After three years of watching the P&G share price increase steadily, by the time he could exercise, the markets had begun to soften. Eddie was eager to get his wealth into a more prudent portfolio to meet his retirement goals, so he decided to exercise 18,000 of his vested options.
Eddie paid the whopping $990,000 price by selling down the portion of his shares (he sold roughly 13,400 shares to get sales proceeds equivalent to the $990,000 price he paid). He had paper gains of $155,000 on that sale, but come tax time, he knew he’d have todip into his savings to pay the $100,000 in tax that he’d owe on those short-term capital gains. When the time came around to pay, he was able to reduce that bill by selling other securities at a loss (read more about this concept, called tax loss harvesting, it in Personal Capital’s Ultimate Tax Guide to Maximize Investment Returns).
Why didn’t Eddie sell the full amount right away? Because he wanted better tax treatment at sale and he was confident that P&Gcould weather any impending market correction, and he could realize more value over time. When 2007 drew to a close, Eddie owned 4,600 shares and 32,000 unexercised options
As we know, the broader markets did not improve. The subprime crisis accelerated through the Lehman Brothers bankruptcy and ultimately into the financial crisis. Eddie held on to his P&G shares until December 2008. At that point, he sold his remaining 4,600 for $61 each for gross proceeds of $280,000. After taking into account the exercise price and a 15 percent long-term capital gains tax, he was ahead by $23,000. Adding up those paper gains, he was up $180,000.
As the crisis deepened and evolved into the great recession, Eddie steadfastly held on to his options – he was wary of the cash outlay he’d need to exercise them. He didn’t need the money in a hurry and his options were valid for 10 years from the time of vesting. Besides, the P&G share price dipped below his $55 exercise price and didn’t increase above that until September, 2009. As the stock market started recovering, the P&G stock too gradually rallied. Eddie’s paper wealth climbed.
By January 2013, the P&G stock seemed to be stabilize at around $70. He decided to exercise another 5,000 options, paying $275,000. His plan is replicate the last transaction by selling a portion to cover the costs while holding the remainder for long-term capital gains tax treatment, and to continue to repeat that course of action over time to capture the share price appreciation in a tax-efficient way.
Today, Eddie’s remaining equity is worth $600,000 on paper (assuming he pays ordinary income tax on part and long-term on part). That’s in addition to the $180,000 that he’s already got in the bank from his equity, for a total of $780,000. We know from his experience that it takes time to get there, but that staying the course has been beneficial.
As we can see from the tales of Steve, Rina and Eddie, not all stock option stories are happy. What’s more, no equity compensation schemes are simple. And as you can see, luck and what was happening in the markets had a lot to do with results.
So what can an individual do?
It emerges that the most important aspects that are within your control are:
- First, doing the due diligence on the company that you are interested in.
- Second, negotiating a package that is favorable to you (stay tuned for a subsequent Daily Capital post on that topic).
- Third, understanding how taxation works and identifying key decision points.
- Fourth, understanding the risk proposition of a single stock versus a diversified portfolio.
A big part of Rina Rich’s success is that she benefited from her RSU package – an outright grant that didn’t have an exercise price. She also worked at a company with a proven value proposition. While the markets helped a lot, she navigated the tax decisions well and sold down as soon as she could, eventually coming away with $1.9 million. She could use that to help attain her short-term goals and get in a sound long-term portfolio.
Steve on the other hand, was a little too risk-loving. While leaving a company that eventually went bankrupt, with $35,000 in the bank is not such a bad outcome (NB: taking into account his $30,000 salary deduction, he’s down $25,000 after two years), he would have done better if he decided to diversify earlier. And fundamentally, Webvan itself was a risky proposition.
Finally, Steady Eddie’s steady course paid off. When the story ends, he has $180,000 already in the bank and $600,000 in potential gains. He may eventually realize $780,000 – if the stock price stays constant.
But even Eddie could have done better. Relative to the other characters, Eddie’s terms were not great – three-year vesting and a high strike price. He also had some tough market timing, with the right time to sell from a vesting / tax angle being exactly at the market nadir. It might also have been prudent to exercise more so he can sell sooner. It seems that with some guidance, he may have negotiated a better package or executed a better sell-down strategy.
The bulk of the story is: it’s complicated. Don’t be afraid to reach out to someone for advice. That’s why Personal Capital has individual financial advisors – to deal with unique issues that come up with everyone’s unique financial lives.
Image credit: Mathias Erhart