Making the Most of Equity Compensation - Adviser Investments

Making the Most of Equity Compensation

March 10, 2021

Episode Description
FEATURING Andrew Busa and  JonPaul McBride

Equity compensation is becoming a bigger part of people’s paychecks in many industries—but deploying this important wealth-building tool can be fraught with complexity. Fortunately, Andrew Busa and JonPaul McBride of our financial planning team are here to break down the ins and outs of equity comp, including:

  • Key terms to understand when it comes to stock options
  • Non-qualified stock options (NSOs) vs. incentive stock options (ISOs)
  • How options are taxed—and how to decide when to exercise them
  • Trading windows and blackout periods

Stay tuned for more podcast content from us on this important topic—and consult our primer on equity compensation to learn more.  Listen now to ensure you’re making the most of the investment opportunity equity compensation gives you.

For informational purposes only. Ideas provided should be discussed in detail with an adviser, accountant or legal counsel prior to implementation.

Episode Transcript

Andrew Busa:

Hi, this is Andrew Busa and I’m a senior financial planner at Adviser Investments. And we’re here with another The Adviser You Can Talk To Podcast. So today I’m joined by my colleague, JonPaul McBride. He’s a member of Adviser’s financial planning team, and he recently acquired a designation as an equity compensation associate, which is perfect because that’s exactly the topic we’re going to be discussing today, equity compensation.

JonPaul McBride:

Hey there, Andrew.

Andrew Busa:

So, we’re diving into equity compensation today. And hey, by the way, congratulations on that designation, I know that took a lot of hard work so-

JonPaul McBride:

Much appreciated.

Andrew Busa:

We’re glad that you did that. So tee us off today.

JonPaul McBride:

Yeah. So we’re going to talk about equity comp, and it’s not often that we get to quote Beyonce, but for this pod, “We are getting paid in equity.” So for many of our clients, it’s an important wealth-building strategy and that’s what we’re going to focus on today.

Andrew Busa:

No, it really is. It’s becoming such a powerful wealth-building tool, getting paid in equity. And we’re seeing this more and more with the financial planning that we’re doing with our clients. It’s becoming a much more common way for companies to pay their employees. So it’s really important to understand how it works because it can get confusing really quickly. So, JP, the world of equity compensation is vast. We could go in a lot of different directions on today’s episode, but you’re the expert, what are you going to focus on today?

JonPaul McBride:

Andrew, it really is vast. And we’re going to revisit and expand on other types of equity comp, such as restricted stock and employee stock purchase plans in future episodes, but today we’re really going to hone in on executive comp in the form of stock options. So, we’ll identify two types of stock options that executives usually get, talk about how they’re taxed and of course, three ways to maximize the impact of those out.

Andrew Busa:

Yeah. I love that. I think that’s perfect structure for today’s episode. And two quick caveats before we dive into the meat. The first is that this episode is only concerned with publicly traded companies. So, when you’re getting into private equity, things like that, that’s a totally different ball game, maybe we’ll cover that in a future episode. And the second thing is we have a companion piece that dives into some of the definitions that you’ll hear today about stock options. So, if you want some extra context for yourself, be sure to check that out, we will link to that written piece in the show notes, but without further ado, let’s dive in.

Andrew Busa:

All right, so let’s start off with the basics so we can have a foundation to build the rest of this episode on. We have to define exactly what an option is and go over some common vocabulary. And really, options aren’t shares of a company, they’re the right to buy shares at a certain price. Is that a good way of going about it, do you think?

JonPaul McBride:

Yeah, that’s right. And just like with a standard stock option, employee stock options are really governed by an agreement between the company and the recipient. So, there are a few key terms to remember here when we’re talking about stock options. The first one is the grant date. That’s when you receive the options from the company. And it’s important to keep that date in mind because it comes into play when we talk about taxation later on in the episode.

Andrew Busa:

Right. I’m thinking back to our old CFP studies here, JP, with a grant date, because when options are granted to you, that’s not a taxable event, right? I can remember the studying in my head, grant date, there’s no taxes, you’re just given the right to buy options at some point in the year.

JonPaul McBride:

Exactly. And nothing happens then, the action happens later on. To that point, the vesting schedule, that’s another key term to remember. The whole point of these options is to reward great behavior and great service to the company. So, you don’t want to give these employees all of these options at one goat because they might leave. So, the company will have those options vest over a time or a period of time, maybe five years or so. And at the end of that five years then you’ll have full access to the options.

Andrew Busa:

Right. Well, that makes a lot of sense. I mean, it’s giving an employee an incentive to stick around, potentially hit certain performance marks to be able to get all the options that they’re owed. We often see… An example of how this might work is that maybe you’re granted 1000 shares in this first tranche and then there’s vesting in equal shares, monthly or annually for a five-year period. So that’s how this might work. You need to stick around for the full five years to get all of the benefit of those options. Does that sound about right to you?

JonPaul McBride:

That’s about right, yeah. And you don’t have to wait for the full five years to not take any of the options, they’ll vest over time. As they vest, you can use them, but to get the full impact, got to wait the whole five years in the scenario.

Andrew Busa:

Okay, good. So that’s a good review of grant and also vesting schedule, really important. Let’s get into a couple of more common terms that again, you’re probably seeing if you have stock options available to you. Let’s talk about exercise price and fair market value.

JonPaul McBride:

Of course. So the exercise price of the option, that’s really vital, really key, that’s how much you have to pay to actually exercise that option. So, the fair market value of the stock might be the actual value when the stock is granted to you, but the exercise price could be vastly different. So you might get a fair market value share of $10, but the exercise price is only one. And that’s going to be really key when we talk about exercising those options later on.

Andrew Busa:

Right. And I want to throw in something else here. When you hear the word “exercise,” just think the word “purchase” in your head, that’s really all exercising means. It means you’re buying the stock. Exercise is just a little bit of a term for it. So, on the other end of this though, when you talk about vesting schedule, that implies that there is also a time when these options are going to expire, which leads us to the whole concept of an expiration date.

JonPaul McBride:

That’s true. And usually it’s about five to 10 years from the grant date. So you have a set amount of time to exercise your options. You can’t do it until the world ends, you have to do it within the next five to 10 years.

Andrew Busa:

Right. So, if I think if there’s one takeaway from this whole section, I would say know when your expiration date is, because again, once those options expire and you haven’t exercised them, again, purchased them, that’s it. You’ve-

JonPaul McBride:

Yeah, you’re left totally bagged.

Andrew Busa:

Yeah, exactly. So know when your expiration date is, that’s super important. Just to sum up this section, we talked about what options are generally, how they work, we talked about grant date, vesting schedule, exercise price, we talked about fair market value and the concept of expiration dates. So that gives us a good foundation to then transition into talking about, again, two specific types of options and how those work. We’re going to hit on incentive stock options and non-qualified stock options. So, JP, let’s kick it off with an NSOs, non-qualified stock options.

JonPaul McBride:

Yeah, NSOs. And these are the more common type of options that you’re going to see. They can be given to anyone, including consultants, you don’t have to be necessarily an employee of the firm to receive an NSO. And they’re a great way to participate in the growth of the company, but they don’t have the preferential tax treatment that we’ll talk about later on with ISOs.

Andrew Busa:

That’s interesting to me, with NSOs is that they can be given to anyone. So that means you don’t need to be an employee of the company to receive NSOs, you could be a consultant, like you mentioned, something like that. And again, these are becoming a much more common way for a company to reward, potentially an outside person to do some work for their company. So, that’s one reason we’re seeing more and more of these out there.

JonPaul McBride:

Yeah.

Andrew Busa:

And you mentioned that the taxation, right? This is important, because of course with taxes, it doesn’t matter how much you get, it only matters how much you keep. So if you don’t know the tax rules with your stock options, you could end up really hurting yourself and get a big surprise come April 15th of the next year. So, let’s talk about how these things are taxed, with the NSOs.

JonPaul McBride:

Yeah. So, remember that we were talking about the exercise price/purchase price when we were talking about options and also the fair market value. So with NSOs, the difference between those two, the exercise price and the fair market value are actually taxable to you as ordinary income. So that’s spread between those two. So in the example before, I said, $1 exercise price, $10 fair market value per share. That $9 is ordinary income to the person who’s exercising that option. So you’ll see it on your W2, they withhold taxes on it, they withhold BIK on it, and it really just comes to you basically as part of your paycheck.

Andrew Busa:

Got it. So there’s no taxable event then until you make the decision to exercise these things. And then at that point you just own a share of stock. It’s pretty simple, at that point, you’re just now subject to holding period requirements for a short-term or long-term capital gain.

JonPaul McBride:

That’s exactly right.

Andrew Busa:

Right. So there’s nothing really special you can do with NSOs to get more favorable tax treatment in other words. So, keep in mind too, once you exercise and buy the stock, there’s still going to be movement in that stock price once that happens. So, the takeaway there is, keep in mind, you don’t have a gain or loss until you decide to ultimately sell that stock, right?

JonPaul McBride:

Exactly. And you know what? We’ve seen the downside of this, right?

Andrew Busa:

Mm-hmm (affirmative).

JonPaul McBride:

We’ve seen folks who have exercised an option maybe at $10 and it falls to eight, but you locked in that tax treatment on the $10 fair market value at the time that you exercise. So definitely there’s risk there. It doesn’t come completely scot-free, but it’s still a great option, a great way to add to your net worth.

Andrew Busa:

Right. Well, and that’s where I think it’s important to include your adviser in this sort of conversation because let’s face it, it can be very difficult to know, “Okay, I’ve purchased a stock, now what do I do with it? How does it fit in with my net worth picture? You know, when should I sell it?” Those are the kinds of questions you should be asking your adviser, your tax preparer to understand not only the tax implications, but also the investment implications of that decision, they’re really tied together.

Andrew Busa:

So again, just to sum up NSOs, when you exercise, you should be thinking about ordinary income. That’s the same thing as W2 income, compensation income, you can call it any of those things, but with NSOs, you’re concerned with ordinary income, which from a tax perspective is less favorable, it’s taxed at a higher rate than long-term capital gain rates. So if you hold that for over a year after you exercise it, and then you sell it, you get that preferential long-term capital gain treatment, rather than if you sell it before a year, then you’re subject to short-term capital gain or loss, depending on the [crosstalk 00:11:32].

JonPaul McBride:

Exactly. Yeah. And that’s a little bit of double taxation too, Andrew. So, you’re paying taxes on that first exercising trigger date, and then you might have ordinary income from there on, so you could just sell it right away, it’ll be ordinary income at short-term rates, or as you’re saying, hold it for a long-term capital gain for a year, but whatever do, you’re probably going to pay some additional taxes on it if you’re holding it.

Andrew Busa:

Right. Well, that’s a really good segue into incentive stock options, because you mentioned the idea of double taxation. With ISOs, you have the potential to avoid that double taxation if things go correctly for you. So take us through this one.

JonPaul McBride:

Yeah. Incentive stock options. So these are for employees only because they really do have, as you just mentioned, favorable tax treatment. Much less common, I don’t see these as much for the general population, they’re really more for the C-suite of executives in a company. And as you mentioned, they’re taxed differently. So they have, qualifying dispositions is what they’re called, so two years from the grant and one year from exercise, if you sell the ISOs at that point, it actually qualifies for long-term capital gains on the difference between the grant date price, fair market value and that sale price. So it really, a great deal for folks who are making these incentive stock options.

Andrew Busa:

So with incentive stock options then, when you exercise, you make the decision to purchase, you’re not subject to ordinary income the way you are with NSOs, but there’s something else we have to watch out for?

JonPaul McBride:

There is, it’s the dreaded AMT, alternative minimum tax. It’s a completely separate tax return, completely separate set of rules. And that spread amount that I just talked about between the grant date price and the potential fair market value price when those options become exercisable is actually a preference item for AMT. So that’s really a great reason to get your tax preparer involved, get your financial planner involved, because you could be subject to that AMT and you’d definitely want to watch out for that.

Andrew Busa:

Right. This is something where again, you don’t want to be hit with a big surprise come April 15th. Maybe you’ve never even heard of alternative minimum tax, and all of a sudden you’re subject to it. So, just make sure that you’re again, involving your tax preparer, your adviser in your decision, and they can help give you some guidance on that because it can get confusing. So that’s a good description of a qualifying disposition, right? Again, if you do this right, you don’t pay ordinary income when you exercise, you’re only subject to long-term capital gains rates when you ultimately decide to sell that share of stock. But what if you mess up, what if you don’t comply with the timeline that you went over before, what happens then?

JonPaul McBride:

Then it’s gone. No, if you mess up, then it just becomes an NSO. So you’re subject to that non-qualified treatment, the compensation income on the difference between the grant date and the fair market value when you exercise.

Andrew Busa:

Okay. And I think the reason why this is an important point is that if you’re being given incentive stock options, it’s probably pretty likely that you’re in the higher-income tax brackets, meaning your ordinary income, your W2 income is being taxed at a pretty high rate, whereas if you can do this correctly with a qualifying disposition, you can sidestep ordinary income and instead subject yourself to that lower long-term capital gain rate. So again, this is a tactical strategy where you’re doing some tax optimization on a year-to-year basis. These are the things that really help you build even more wealth over time. So any other caveats to know about before we leave ISOs?

JonPaul McBride:

Yeah. One other rule, if there weren’t already enough for ISOs, is that there’s a 100K limit on how many options you can exercise in a year. When you’re granted these ISOs, you need to keep that grant date in mind and you need to keep that fair market value on that grant in mind, because the shares that you’re going to exercise, or as they become exercisable in the future, you’re subject to a 100K limit. And over that limit, those options are actually NSOs. So let’s say that if you were granted 100,000 shares at fair market value of $1 a share, and they start vesting 25,000 a piece over time, you’re all set, but in that same scenario, if you have a $100,000 grant, they’re vesting over maybe two years, and the fair market value is 250, then some whatever’s over that $100,000 limit will actually be an NSO.

Andrew Busa:

That’s interesting. So, I’m glad that you got this Equity Compensation Associate designation, because someone has to know about this stuff. So I’m glad that you can school us up on how this all works.

JonPaul McBride:

I live for this.

Andrew Busa:

Yeah. This is your ball game now. So to sum up the section before we move on to the next one, we talked about the general difference between NSOs and ISOs. And keep in mind that things can get a little thorny when you’re talking about the timing of when to exercise, when to sell, you have to be careful and make sure you know what you’re doing and know what the implications are of these decisions. So we are here to help you with that. So definitely give us a call if you want to talk anything over. So let’s move on to the final section of today’s episode, and that’s going to be leaving you with three ways to maximize your employee stock options, really three simple, actionable things that we think everyone can do if you’re receiving stock options. So, where do you start with this?

JonPaul McBride:

Well, you start with reviewing your stock plan and your stock option agreements, those are going to be your Bible when it comes to exercising these options, knowing when the grant date is, how often they’re going to vest, how you can exercise the options, that’s a really important thing too, that we haven’t talked about yet. Can you sell some of the options after you exercise them to cover the price of the taxes and the exercise price? Or are they going to automatically do it for you and then withhold it on the company’s side? So knowing that is really important to your plan in maximizing the impact of these options. So definitely, that’s the first step.

Andrew Busa:

Yeah. Again, knowing your plan documents, it’s the basic thing, but these are the important items to make sure you at least know what you own, that’s what that comes down to. And again, looping back to the beginning of this episode, when we talked about the basic vocabulary, the grant date, vesting schedule, you said it already. So I think number two, piggybacking on that, I’ve heard you talk about really paying attention to deadlines.

JonPaul McBride:

Yeah. So deadlines are important not just because of the expiration dates that we’ve already mentioned a couple of times, but also because there are blackout periods, if it’s public company, right? They want to avoid insider trading or the appearance of insider trading. So they’ll have a blackout periods or open trading windows where you can actually sell your shares. So, you don’t want to earmark April 30th as a date when you want to exercise to sell your options, and that’s during a blackout period. You want to know when you can sell, that’s almost as important as knowing when they’re going to expire or when you can exercise.

Andrew Busa:

And one clarifying point to this, episode has been focused on talking about a publicly traded stock, right? So private valuation, private companies, that’s a whole different can of worms that-

JonPaul McBride:

Whole different ball game.

Andrew Busa:

… maybe we’ll get into. Yeah, maybe we’ll get into on a different episode. Today’s episode, we’ve been focusing on publicly traded companies. So again, like you said, pay attention to those deadlines, blackout periods, they pop up within the stock plan, so knowing when those are, you don’t want to be surprised by that if you want to sell your stock and you find out you’re not able to do so.

JonPaul McBride:

Exactly. Often we’ll tell clients to mark a blackout date on their calendar and set a reminder, because it’s a great way to know, even if you’re not going to exercise options during that period, just knowing that that’s coming up, it gives you that flexibility.

Andrew Busa:

Yep, exactly. And what’s the third point to maximize your stock options here?

JonPaul McBride:

Well, the third way is to diversify. There’s an inherent risk in holding too much of one security, always, but especially when your wages are tied to that security in question. So, a really good rule of thumb is 5% of your portfolio. If you have about 5% in your company’s stock, that’s a pretty good cap on your exposure to them.

Andrew Busa:

Right? And that’s a little bit of art and science, it’s not a hard and fast until you get past 5%, and all of a sudden it’s time to make some decisions, but it is a good number to keep in mind. And you can be surprised how quickly you can blow right past that 5% if you’re getting options granted to you pretty frequently, these are vesting every month or every year. If you don’t go into this with a plan and a strategy, all of a sudden your portfolio could be very concentrated in one stock. And that’s a risk that we want to help you diversify away from ultimately, right?

JonPaul McBride:

Exactly. And then there’s inherent risk and you might think it’s going to the moon, and if you had Tesla over the past year, you’d be right, right? So we have to deliver this advice with a grain of salt, it could go up, but it could also go down.

Andrew Busa:

Yeah, absolutely. So before we wrap up, anything else to leave the listeners with, JP?

JonPaul McBride:

We talked about options, and as you mentioned, it’s a vast ocean. So we’ll hit restricted stock and employee stock purchase plans in the future. So watch out for that.

Andrew Busa:

Yeah. I love it. We’ll have a sequel.

JonPaul McBride:

Yeah, exactly.

Andrew Busa:

Well, this is great. This has been Andrew Busa and JonPaul McBride from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. Be on the lookout for our next conversation, like JP said, about future stock option episodes. We’ll talk about restricted stock, other forms of equity compensation. If you did enjoy this conversation, please subscribe, please review our show, that really helps us out. And you can always check us out at www.adviserinvestments.com/podcasts. Now your feedback is always welcome. If you have questions, if you have topics that you’d like us to explore in a future episode, please email us at info@adviserinvestments.com. Thank you.

Podcast released on March 10, 2021. This podcast is for informational purposes only. It is not intended as financial, legal, tax or insurance advice even though these topics may be discussed. Information and events addressed in this podcast, as well as the job titles, job functions and employment of the podcast’s participants with respect to Adviser Investments, LLC may have changed since this podcast was released. For more information on each individual featured in this podcast, see the Our People section of our website.

The Adviser You Can Talk To Podcast is a trademark of Adviser Investments, LLC.

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If you don’t know the tax rules with your stock options, you can end up really hurting yourself.


Andrew Busa, CFP®

Senior Financial Planner

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