If you work in tech, chances are good that you have stock options. According to the National Opinion Research Center, more than 18% of employees in the computer industry benefit from stock options. And that’s a good thing. Stock options can be incredible wealth builders. Over the past several years, computer industry employees with stock and stock options have seen their wealth increase measurably. And the returns have been even greater for the outliers that work at companies like Facebook, Google and Amazon.
However, there is no guarantee that stock options will create wealth. Far from it in fact, as data compiled by Professor Jay Ritter of the University of Florida reveals that IPOs (from 1980 to 2013) have an average 3 year buy-and-hold return of -18.4% when market-adjusted. The picture becomes a bit rosier if you look at more recent data (2001 to 2013), but an average 3 year buy-and-hold return of 3.4% when market-adjusted isn’t going to wow anyone. The reality is that for every success story (e.g. Facebook, Google, etc.) there are many more failures (Zulily, FitBit, etc.).
Stock options benefit from leverage and preferential tax treatment
For this reason, it’s important to understand how stock options work so that when a wealth building event does occur, you can navigate it as intelligently as possible. In our experience, incentive stock options (ISO) and non-qualified stock options (NQSO) have historically been the biggest wealth builders. This is because of their inherent leverage which allow option holders to purchase (or exercise) shares at potentially discounted prices. Unlike outside investors which must purchase stock at market value to participate in growth, option holders participate without any out-of-pocket expense. This ability to control the opportunity for future growth is unique and advantageous.
However, the story becomes a bit more complicated once an option holder purchases (or exercises) shares. Although, option holders risk less capital than outside investors (their exercise price is less than market value if options are in the money) they must carefully navigate the IRS tax code to mitigate alternative minimum tax (AMT) ramifications and benefit from preferential capital gains treatment. Additionally, option holders must also perform the same risk-reward analysis as outside investors to decide when to diversify. And in our experience, deciding when to sell can be the hardest part for technologists as they’re usually emotionally bonded to their stock.
Restricted stock ain’t too shabby either
Although, restricted stock units (RSU) lack the leverage and preferential tax treatment of stock options they can still build wealth. This is especially true if you work at companies like Facebook and AirBnB which have issued RSUs before going public. In these unique circumstances, option holders are awarded shares on a set vesting schedule that they can exchange for common shares once a liquidity event (IPO or acquisition) occurs. So even though employees aren’t able to purchase shares at a discount, they still fully participate in the company growth via the share exchange. And as was the case at Facebook, this can be quite lucrative.
The downside, is that RSUs are always taxed as income regardless of whether the issuing company is public or private. As such, earlier Facebook employees with stock options probably paid less in taxes even if they were wealthier. And once exchanged for common shares, RSU grantees are left with the same difficult decision as stock option holders – when do they diversify? This decision requires careful consideration for behavioral finance along with the grantee’s unique risk profile and financial goals. For those with lucrative grants it’s potentially the most important financial decision they will make in their lives.
At Schmidt Financial Group we fully appreciate the unique challenges of working in the tech sector – we’ve experienced it ourselves and in working with our tech client base for over 20 years. Having most of your wealth tied to employer stock is complex and requires specialized planning. Come talk to us if you’d like to learn more about how you can successfully mitigate single stock concentration risk in the context of a holistic financial plan.