How to Diversify Your Company Stock Holdings While Leveraging the Wealth in Your Stock Options & Other Equity Grants

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Diversification has always been a sound practice for building wealth and, especially, for preserving it. While you remain optimistic about your company's prospects and want to tie your gains to those of the company's shareholders, you may feel you have too much of your personal wealth tied up in your company's stock: along with (or instead of) stock options, you may also own company stock straight from prior purchases and from the vesting of restricted stock/RSUs.

Once you have settled on a comfortable company stock ownership percentage for your combined holdings, how do you proceed? This article outlines a basic approach to consider.

 

General Rules

 

You may have company stock in different types of accounts:

  • retirement accounts (e.g., IRAs and 401(k)s)
  • taxable brokerage accounts (includes your vested restricted stock/RSUs)
  • employee stock purchase plan (ESPP) accounts
  • stock options (for this article, the term "stock" includes vested in-the-money options)

When it comes to diversifying across all your holdings, you might want to consider the following sales order:

  • First, sell company stock in taxable accounts that are at a loss position.
  • Next, sell company stock in an IRA or 401(k).
  • Then, sell company stock at gain positions in ESPP and taxable accounts.
  • Last, exercise and sell your vested in-the-money options.

 

Leverage

 

The diversification sales order looks at the amount of cash you get from a sale compared to the value of the stock. This is what I calculate as the amount of "leverage" in your stock, regardless of where you hold it. You generally keep the high leverage holdings and sell the low leverage ones.

Leverage is created when you have a small amount of "your money" controlling a larger amount of company stock. "Your money" is what you have if you sell stock today, or exercise your options and sell the stock. You will have to pay taxes, and then you will have money to reinvest or spend to support your lifestyle. Therefore, "your money" is the after-tax part of the stock price. Leverage, then, is a simple ratio: the value of stock divided by "your money," or:

 

LEVERAGE IN YOUR STOCK = Current market value of stock ÷ After-tax cash from stock sale to reinvest

 

For consistency, the examples that follow assume a total (federal, state, and employment tax for NQSOs) tax rate of 40%. Capital gains are taxed at 20% (federal and state), and sales expenses or commissions are $0.

 

Company Stock In A Retirement Plan Such As A 401(k) Or IRA

 

You have $10,000 of current stock value. You sell all of it and have $10,000 in cash to invest inside the retirement account. There is no current taxation. The leverage factor is 1 ($10,000 ÷ $10,000). One is very low leverage.

Company Stock In A Taxable Brokerage Account At A Gain

You hold $10,000 of stock that you paid $5,000 for two years ago, or hold restricted stock that was worth $5,000 when it vested two years ago. A sale today results in a capital gain of $5,000, and your capital gains taxes are 20% of that, or $1,000. Your after-tax net proceeds are $9,000. Your leverage factor is 1.1 ($10,000 ÷ $9,000).

Company Stock In A Taxable Brokerage Account At A Loss

Company stock in a taxable account that you sell at a loss is the most attractive of all to sell to diversify -- even more attractive than the retirement plan stock! Here the leverage factor is even less than 1. When you determine your after- tax proceeds to reinvest from the stock sale, "your money" consists of more than just the sale proceeds. In addition to getting all the dollars out of the stock, there is also a tax value to harvesting losses.

For example, six months ago you bought company stock for $1,000 in a brokerage account. Today you sell it at $600. After the sale, you have $600 in cash and a realized short-term loss of $400. The loss is worth something to you.

Assume this is the only gain or loss you have this year. You can deduct the $400 loss from your income. This saves you $160 in taxes, as your income is $400 less ($400 x 40% = $160). "Your money" resulting from this sale is $760; that's how much you have to reinvest. The leverage factor is less than 1 ($600 ÷ $760).

Alert: Be careful if you want to repurchase your company's stock soon after selling it, or if you have just bought the stock. The wash sale rules can trip you up when you buy a stock within 30 days before or after your loss sale. When a wash sale occurs, you cannot claim the loss on this sale but must defer it until a later sale. Executives and directors also need to understand the Section 16 rules on short-swing profits, i.e. profits from purchases and sales that occur within six months of each other. Lastly, as always, you must not buy or sell company stock when you know important confidential information about your company, in accordance with the rules against insider trading.

 

Tax-Loss Harvesting

 

The tax value of harvesting losses comes from two sources: You first use losses to offset current gains and then use losses to offset up to $3,000 of income each year. Any losses you can't use now may be carried forward indefinitely to future tax years, where they again first offset gains and then are deducted from income up to $3,000. Aggressive tax-loss harvesting can make a noticeable contribution to your wealth over time.

Company Stock In ESPPs

Analysis for your ESPP shares is similar to that described above, because an ESPP account is also a taxable account, differing only in the details of the tax computation (note- the tax calculation can get particularly tricky, depending on whether you have met the special holding period rules that apply).

Alert: Executives and directors also need to understand the Section 16 short-swing profit rule that matches sales and purchases that occur within six months of each other. All employees must not buy or sell when they know material nonpublic information.

Company Stock In Options

You have very high leverage with your stock options. This makes vested in-the-money options often your last choice to exercise and sell for diversification.

For example, you are vested in 1,000 nonqualified stock options (NQSOs) at a $9 per share exercise price, the options expire in seven years, and the market price is now $10.

You effectively own $10,000 of stock through the options. You exercise the 1,000 options and immediately sell the shares in a cashless exercise, realizing $1,000 in income ($1 per share). Your income tax is $400 at a 40% rate, leaving $600 in after-tax proceeds available to reinvest. The $600 is truly "your money" in the option now. Your leverage factor formula is the same: The dollar value of the stock you are exposed to, divided by the after-tax cash available to reinvest: $10,000 ÷ $600 = 16.6. This represents very high leverage.

 

More Option Spread, Less Leverage

 

Leverage gives us insight into how our after-tax wealth changes as the stock price changes. Using the example above, assume your stock now goes up 100%, to $20 from $10 a share. If you exercise options and sell the 1,000 shares, your taxable income is $11,000 ($11 spread on 1,000 shares). You owe $4,400 in taxes ($11,000 x 40%), and your after-tax proceeds available to reinvest are $6,600.

This $6,600 of "your money" is 1,000% larger than the $600 you had when your stock was at $10. Your stock price went up 100%, but "your money" increased 1,000%! You can also say the wealth in your pocket went up 1,000% for a 100% gain in the stock price. That's the positive value of high leverage and why you want to keep the high leverage holdings until you realize these sizeable gains. After the stock price reaches $20, the leverage ratio drops: $20,000 ÷ $6,600 = 3.0.

This leverage analysis is another way to illustrate why you do not want to exercise and sell as soon as the options are vested, unless you believe your stock price has peaked. The spread between your fixed exercise price and the  market price grows tax-free until you exercise. This makes it difficult for any comparable alternative investment to produce better returns than waiting to exercise your options until later in their term.

Below is a table that shows your gains and leverage factors as the stock price continues to double. The percentages are the increases from one stock price to the next.

 

 

Exercise price

 

Stock price

Total value (1,000 options)

 

Post-tax net: your money

Leverage ratio

$9

$10

$10,000

$600

16.7

$9

$20 (+100%)

$20,000

$6,600 (+1,000%)

3

$9

$40 (+100%)

$40,000

$18,600 (+182%)

2.2

$9

$80 (+100%)

$80,000

$42,600 (+129%)

1.9

$9

$160 (+100%)

$160,000

$90,600 (+113%)

1.8

$9

$320 (+100%)

$320,000

$186,600 (+106%)

1.7

 

Which Options To Exercise

 

Options generally have the most leverage of any of the ways you will invest in company stock. This is because you don't have to put up any of your money until you exercise an option. As the table above shows, when the company stock price is just a bit above the grant price, you have very high leverage. As the company stock price grows higher and higher above the grant price, the leverage shrinks lower and lower. As the grant price becomes a smaller and smaller portion of the total stock price (i.e., very big spread), the declining leverage in the option nears the leverage of holding the stock outright.

If you have two options that expire at the same time, you will want to exercise the one with the lowest leverage first. This is the one with the lowest grant price/biggest spread compared to the current market price. When options are similar in grant price and thus their spread, you want to exercise the oldest ones first. For options that are quite different both in the grant price and the time to expiration, the leverage analysis is not very helpful. You then might want to turn to financial advisors experienced with other option valuation methods, such as Black-Scholes or a Monte Carlo simulation of expected option outcomes.

 

No "Rule Of Thumb" Approach For Everyone

 

The rules of thumb described in this article work well when you have developed a financial plan with a commitment to diversifying some of your company stock holdings. The leverage analysis provides insights about the relative value of your various company stock holdings to your long-term wealth-building. Your personal situation can lead to different conclusions. When you understand the leverage in your company stock ownership, it becomes a more valuable employee benefit.

 

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