Employee stock options are a popular form of compensation among high-earning executives and entrepreneurs as they offer the opportunity to purchase company stock at a discounted price and build wealth over time. Equity compensation can be an enormous windfall to employees of successful companies – with proper planning. But investing in employee stock options can be complex and there are many potential pitfalls that can negatively impact your financial well-being. Use this guide to learn more about the 6 most common mistakes made with equity compensation and what high-earning executives can do to avoid them.
Mistake #1: Failing to Understand the Terms
One of the biggest mistakes made with employee stock options is not fully understanding the terms of the award. Company Stock Grant Agreements can be complicated, and executives need to understand the exercise price, vesting schedule, expiration date, and tax implications in order to avoid making costly mistakes.
For instance, you may receive stock options with a vesting schedule that requires you to continue working at the company for a certain period before the options become exercisable. If you leave the company before the options are vested, you may forfeit the right to exercise the options and miss out on compensation you rightly earned. If you are being recruited to a new company, you should negotiate a new equity compensation agreement with the understanding of the one you are leaving behind.
Before accepting employee stock options or making decisions about when to exercise them, be sure to read the agreement carefully, ask questions, and seek the advice of an experienced wealth advisor if necessary.
Mistake #2: Overconcentration in Company Stock
Another common mistake is overconcentrating your investment portfolio in company stock. As options become exercisable, many executives purchase company stock without taking into account how that affects the rest of their portfolio. From a risk management perspective, this can be risky as it places an inordinate amount of pressure on your company’s stock to perform well. If the business were to experience financial difficulties or market volatility, your entire portfolio could be upended at the same time you are potentially losing your paycheck.
To minimize risk, consider diversifying your portfolio and investing in a range of assets, including stocks, bonds, real estate, or even alternative assets. Trading some of the potential upside for a diversified safety net is worthwhile for when the economic winds change.
Mistake #3: Not Having an Exit Strategy
Employee stock options can be an excellent way to build wealth, but it’s essential to have an exit strategy in place. Many executives make the mistake of holding on to their options for too long or failing to exercise their options before they expire. You may find yourself holding on to your options in hopes that the stock price will increase; but if it declines instead, you could miss out on an opportunity to profit.
It’s crucial to have a plan in place regarding when to exercise your options, how to manage the tax implications, and what to do with the proceeds. A great way to avoid this mistake is to set a target price at which to exercise your options and decide beforehand whether you would like to keep or sell the stock.
Mistake #4: Not Considering Tax Implications
Executives may face significant tax liabilities depending on the type of options and the timing of the exercise, and many fail to consider these implications when making investment decisions.
Non-qualified stock options, for example, will be taxed as ordinary income at the time of exercise, whereas incentive stock options have the potential to be taxed as long-term capital gains if certain conditions are met. Incentive stock options also have alternative minimum tax implications that should be carefully considered.
Before making decisions about your employee stock options, it’s essential to understand the tax implications and develop a strategy to minimize your liability. Don’t be afraid to consult a tax professional if necessary.
Mistake #5: Not Understanding the 83(b) Election
The 83(b) election is a crucial but often overlooked aspect of employee stock options. This election allows individuals to pay taxes on the value of their stock options at the time they are granted, rather than when they are exercised. Failing to understand this election can result in significant tax consequences and missed opportunities to maximize the value of your stock options.
By making an 83(b) election, high-net-worth individuals can potentially reduce their overall tax liability and lock in a lower tax rate on any future gains, but there are downsides to this choice that require careful consideration.
For example, the option holder is required to pay taxes on the stock’s value up front, which can be a significant financial burden. Additionally, if the stock value declines, you may end up paying taxes on a higher value than the stock is ultimately worth, thus resulting in a loss. Working with a wealth advisor can be a great first step in understanding how the 83(b) election would impact your long-term financial well-being.
Mistake #6: Taking Out a Loan to Exercise Your Options
One of the most common mistakes executives make with equity compensation is taking out a loan in order to pay for the exercise. This is a dangerous financial move that could put you in a worse overall position.
While it may seem like a convenient way to access the funds needed to exercise your options, it also adds a significant amount of debt to your financial profile, and if the value of the stock does not increase as expected, you could be left with little to no returns on your investment. Therefore, taking out a loan to exercise your stock options should only be considered if you have a solid financial plan in place and a clear understanding of the potential risks involved. It is essential to evaluate your personal financial situation and seek professional advice before making any decisions.
Are You Making Some of These Mistakes?
Employee stock options can be a valuable form of compensation for high-earning executives, but it’s important to avoid common mistakes that can negatively impact your long-term financial health. At Solidarity Wealth, we have experience helping high-earning executives and entrepreneurs navigate their employee stock options. If you’re ready to see what wealth management can do for you and your business, reach out to us at info@solidaritywealth.com or call 385-374-1665 to schedule a discovery call.
About Jeff
For over a dozen years, Jeff has advised some of the country’s most successful families on all aspects of their wealth. With his background as a former tax and estate planning attorney, Jeff has advised clients through business sales, funding rounds, IPOs, complex tax and wealth planning transactions, private and public market investments, executive compensation packages, and much more. In short, Jeff helps clients navigate the unique challenges of wealth and better predict their financial future.
In addition to co-founding Solidarity Wealth, which serves as a multi-family office for successful families in the Mountain West, Jeff advises single family offices on a broad array of challenges. Jeff also serves as the Managing Partner of Solidarity Capital, an income focused hedge fund.
Prior to co-founding Solidarity Wealth, Jeff was a Wealth Advisor at one of the country’s largest Private Banks where, at the time of his resignation, Jeff was ranked as their top Wealth Advisor in the country. Jeff also worked as a tax and estate planning attorney at a prominent law firm in Houston, Texas.
Jeff holds a bachelor’s degree in accounting from Brigham Young University – Idaho and a Juris Doctor with honors from the University of Texas School of Law. Outside of work, Jeff is married and the father of three amazing children. He is a huge sports fan and enjoys spending time with family, golfing, and skiing. He has also served as past President of the Salt Lake Estate Planning Council and is a frequent speaker on tax and estate planning topics. To learn more about Jeff, connect with him on LinkedIn.
Solidarity Wealth is a registered investment adviser. This material is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Solidarity Wealth and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Solidarity Wealth unless a client service agreement is in place.