Dealing with Company Stock February 2012 Vol. No. 1 Bedrock Newsletter My Company Made Me Rich! Now What? How do you deal with a windfall from your company stock? You have stock options or additional forms of company stock and other compensation benefits that have increased dramatically in value and you find yourself with a significant amount of new-found wealth. Sure, these sound like great problems, but how you handle these events can have profound impact on both you and your family s financial future. Do you buy that Maserati, make a down payment on a new house or set up a 529 College Saving Plan for the kids? The first thing you must do is take a step back and assess your current financial situation, your long-term goals and vision for the future. This is not a simple task. You need the counsel of someone you trust and can give you objective advice. Then you need to ask the right questions. How much of my company stock should I own? How do I determine the risk of these holdings? What are my stock options really worth and when is the right time to sell them? What are the tax consequences if I exercise stock options, receive restricted stock or buy or sell my company stock? Are there tax strategies that can reduce my tax liability on these transactions? Can I hedge my bet in case the value of my stock drops to protect some of my wealth? By getting accurate answers to these questions, proactively managing your positions and employing the correct tools as part of a long-term plan you can make informed decisions on protecting and increasing your wealth. Consider working with a financial professional that has experience in dealing with your circumstances as part of your unique wealth management plan. Some of the following articles should help. But you should probably not "try this at home". Bedrock Captial Management, Inc. Joel Shaps, CFP, CIMA President joel@bedrockcapital.com 650-964-7024 bedrockcapital.com Bedrock Capital Management has been managing our clients wealth for over 25 years. Our comprehensive wealth management approach coordinates our client s financial universe to develop a plan to achieve their vision and goals. The components we address with our clients include investments, tax strategies, financial independence and retirement planning, estate planning and wealth transfer issues, cash flow and spending plans, asset protection and insurance analysis, survivor income needs, employee benefits and stock options and education funding. The clients that are the best fit for our firm want an approach that orchestrates all of the parts of their financial world to make their aspirations a reality. The Bedrock organization includes five CERTIFIED FINANCIAL PLANNER practitioners, two are Chartered Financial Analyst charterholders and another that is also a CIMA designee. Each has completed the examination, experience, ethics commitment and education required to provide sound, professional advice.
Bedrock Capital Management. Inc, Bedrock Newsletter February 2012 2 How Exposed Are You to Your Company Stock? By Tony Blagrove CFA, CFP The financial exposure you have to your company may be far more than you think. Not only are your stock options, Restricted Stock Units (RSUs), and Employee Stock Purchase Plan (ESPP) shares directly exposed to the on-going financial success of your employer, but your salary and your bonus are also at risk. The chart illustrates how much of your net worth is linked with your employer. The columns in yellow depict how much of your wealth is directly exposed to your company and the blue columns are not. The yellow areas are exposed to what we call Employer Risk The risk your company s health has on your financial well-being. Risk so you are taking the appropriate amount of risk. Each form of stock compensation has unique features that must be considered in your decision to reduce the amount of company stock you own. In the following articles we will look at each form of stock compensation to better understand them. In one of the following sections of this newsletter we will review the steps you can take to help reduce your exposure to your company. Tony Blagrove CFA, CFP is Bedrock s Portfolio Manager and a member of the firm s investment committee. Investment diversification is not only for your stock investments; diversifying the risk of your employer is important as well. Enron, Lehman Brothers, and WorldCom are all infamous for their spectacular blow-ups and subsequent bankruptcies. Employees of these companies not only lost their jobs and their salary, but everything that was tied to the value of their company (employer stock in 401(k) accounts, ESPP shares, stock options, etc.). Take Lehman Brothers for instance, known today as the largest bankruptcy in US history, Lehman Brothers stock was flying high at $200 a share at the start of 2008. Fast forward nine months and the stock was worthless and Lehman Brothers employees were packing up their personal belongings and saying goodbye to each other. Residents of Silicon Valley have experienced this as well. We have all seen many large and seemingly rock solid technology companies stumble and see their stock prices plunge. By recognizing your Employer Risk and taking appropriate action, you can save yourself plenty of heartache. Properly managing your Employer Risk takes into account various factors like your total employer stock exposure, tax implications, when you can sell, and what to sell first. By carefully analyzing your situation you can manage your Employer
Bedrock Capital Management. Inc, Bedrock Newsletter February 2012 3 Stock Options By Eric Lewis CFA, CFP and Tony Blagrove CFA, CFP What Are They? A stock option gives you the right, but not the obligation, to buy stock at a set price (known as the strike price or exercise price), at any time up until its expiration date. The value of an option is primarily based on its intrinsic value, which is the difference between the current stock price and the stock option exercise price. Let s say you own an option that gives you the right to buy one share of XYZ stock at $100 and the current price of XYZ is $110. The difference between the two is $10. This is the intrinsic value of the option and the option is referred to as in the money because the intrinsic value is positive. If the stock price falls below the exercise price of $100 the option is out of the money and has no intrinsic value. You would not exercise this option because it is silly to pay $100 for a share that s selling for $95. Why Do You Want Stock Options? Stock options are a method of compensating and retaining employees and giving them an incentive to do well when the company does well. Options are unique in that they are subject to financial leverage. Let s take our XYZ stock option as an example with an exercise price of $100 and a current price of $110. This option has an intrinsic value of $10. If the price of the stock goes to $111, a holder of one share of XYZ has seen the stock value appreciate approximately 1%. For the stock option holder of XYZ, the intrinsic value of the option has increased from $10 to $11 a 10% gain! When this same form of leverage is applied to hundreds or thousands of stock options, you have the potential to create extraordinary wealth. However, it s far from obvious about how to handle stock options that have current value, but still have time to run before expiration. Do you cash them in and take your profit, or hold on in the hope that the stock rises further? The answer depends primarily on how large your current gain is and how much more time you have before expiration. Intuitively, the bigger the gain the more tempting it is to cash in now; conversely, the more time you have left, the more opportunity for future appreciation you are giving up by exercising early. Financial professionals use sophisticated option-pricing models (a popular one is called Black-Scholes) to estimate the remaining time value of the option. If the time value is small relative to the gain, then it may make sense to exercise early. When you exercise your stock options you are effectively buying the stock at the exercise price. You can then decide to sell the stock immediately or hold onto it. With most options, you are taxed on the difference between the current stock price and the exercise price at ordinary income tax rates. There is another variety of options called Incentive Stock Options (ISO) that require additional tax considerations. Eric Lewis CFA, CFP is Bedrock s Chief Investment Officer and a member of the firm s investment committee. How Do You Manage Stock Options? It s clear what to do with a stock option that is about to expire. If it is in the money, you exercise it; if not, you don t. A common, but by no means universal, strategy is to sell the stock immediately upon exercise in what is called a same-day sale, thus locking in your gain.
Bedrock Capital Management. Inc, Bedrock Newsletter February 2012 4 Restricted Stock Units (RSUs) By Tony Blagrove CFA, CFP What Are They? Restricted Stock Units represent shares in your employer s stock that you are scheduled to receive in the future if certain conditions are met, such as your continued employment until a certain date or the company achieving specified performance goals. When the conditions are fulfilled, the shares vest and are released to you. Commonly, your employer will grant you RSUs that vest at regular intervals such as every year on the anniversary date of when the RSUs were first given to you. When the RSUs vest they are taxed immediately (as ordinary compensation income) at their full value on the vest date. Typically, your company will withhold taxes at this time by taking back a portion of the shares, and you are free to sell the remaining shares. If you hold onto the shares, any further appreciation in the stock price will be taxed at the short-term capital gains rate if the shares are held up to one year and long-term capital gain rates thereafter. How Do You Manage RSUs? RSUs will never expire worthless like unexercised stock options. Since you have already paid taxes on the full value of the shares you received, you can, and perhaps should, sell them immediately after they vest, thus reducing your exposure to your employer with little to no additional tax liability. Employee Stock Purchase Plan (ESPP) By Eric Lewis CFA, CFP What Is It? An Employee Stock Purchase Plan allows employees to use regular payroll deductions to purchase company stock, usually at a discount to the current market price. How Does It work? You sign up for an ESPP before the beginning of an offering period (commonly every six months). Your payroll deductions are accumulated during the offering period and then used to purchase discounted shares at the end of the period. The discount applied will vary by employer but is often 15%. In addition, many ESPPs have an option-like look-back feature that allows you to purchase the stock at the price at the beginning of the offering period if it is lower than the current price. This can be a great deal if the stock price has risen sharply. period) should participate to the maximum extent possible. How Do You Manage Your ESPP? Calculating taxes on sales of ESPP shares is notoriously complex. The taxes you pay depend on several factors including the amount you paid for the shares, the amount of the discount, and how long you have held the shares. Part of the income may be reported on your W-2. Your company HR or Stock Administration department may be able to help you better understand how ESPP shares are taxed and how your company reports the sale. You can also use personal finance software or consult with your tax professional or financial advisor to estimate the taxes on your ESPP shares. We recommend carefully analyzing your ESPP shares before taking any action due to their tricky tax calculations. Why Participate? The main benefit to participating in an ESPP is the discount you receive it s almost like free money. In our opinion, just about everybody who is eligible for a typical ESPP (one with a discount and a look-back
Bedrock Capital Management. Inc, Bedrock Newsletter February 2012 5 Managing Your Employer Risk By Tony Blagrove CFA, CFP There are three ways to manage your employer risk: sell the stock, gift it in a tax advantaged way, or hold the stock. SELL-The easiest and often the best way to reduce your employer risk is to sell your company stock. You should sell your stock in the order that makes the most sense financially and with taxes in mind. Selling any directly-held shares (from RSUs and your ESPP) with losses is your first priority. Next you should look to sell any employer shares you own in a tax-deferred account (your 401(k) or deferred compensation plan, for example). After you ve sold your employer stock held at a loss and stock held in tax-deferred accounts, take a look at your stock options. Determining which options to exercise and sell requires analyzing not only how much they are worth but how much you d be giving up by exercising now. Lastly you should sell employer stock held at a profit in order of lowest capital gain to the highest. GIFT-If your employer stock has appreciated considerably you may want to consider giving away some of your shares. If you give regularly to charity donating appreciated employer stock allows you to not only reduce your Employer Risk, but you can also write off your deduction against your ordinary income. The amount you can deduct depends on the stock and the type of organization you give it to. There are many planning strategies that can be used to maximize the tax advantages of giving your stock to charities including Donor Advised Funds, Family Foundations and various charitable trusts. There are also rules specific to the donation of ESPP shares that make the decision more complicated. We recommend working with your tax professional or financial advisor if you are thinking about donating stock. You can also give appreciated employer stock to family members. Giving to your children will allow them to sell the appreciated shares and pay possibly no capital gains tax if they are at or below the 15% tax bracket. You should be aware of the Kiddie tax that is applied to any unearned income of more than $1,900 per child and is taxed at the parent s marginal tax rate. There are also many estate planning strategies that can be used to gift your stock to family members. There are other restrictions that may apply and we recommend seeking professional advice before you undertake any giving strategy. HOLD-If you want to hold onto your employer stock you need an action plan that will help manage your employer stock. A plan could include selling your stock on a periodic basis or at a price trigger point that when the stock reaches certain price levels you sell a pre-determined amount of shares. There are also many sophisticated hedging strategies using stock options in various combinations to reduce the overall risk of holding your company stock. Again we recommend seeking professional advice before you undertake any of these strategies. Not having a plan in place can lead you to hold a large position in your company stock and run the risk of bad news hurting your employer stock. As mentioned earlier, bad events can be swift and take place in a matter of days. A plan to sell the stock helps you maintain discipline when the stock is moving higher. By not selling any shares your total Employer Risk is increasing as the stock becomes more valuable. It is hard emotionally to accept the idea that rising employer stock will ever go down in price. However selling your employer stock as it appreciates and diversifying into a mix of large, medium and small company stock and fixed income will reduce your overall risk and preserve your hard earned wealth. There are cases when you can t sell your employer stock. Company executives are restricted to when they can sell company stock. We recommend company executives talk with their compliance departments and seek individual advice before attempting to diversify your employer stock.
Bedrock Capital Management. Inc, Bedrock Newsletter February 2012 6 Handling Sudden Wealth If you have suddenly come into a large sum of money, whether it s a payout from an inheritance, the lottery, stock options, or a favorable verdict in a lawsuit, there are some important steps that you might want to take. First and foremost, try to keep your bearings about you. Don t immediately quit your job; avoid any temptations to spend most or all of it on frivolous items. Be on the lookout for crooked financial operators who make offers that seem too good to be true, or friends and family who appear out of the blue with loan requests and business proposals. Don't feel that you have to invest your money right away. There's nothing wrong with letting it sit in the bank while you carefully consider your options. Before planning your long-term investment strategy, make sure you've taken care of some immediate needs. Establish an emergency fund (make it three to six months' worth of expenses), and if you've been carrying consumer debt like car loans or big credit-card balances, now's a great time to pay it all off. Finally, consider how your windfall can serve you for long-term goals such as paying for children's education and your retirement. The questions are many. You might want to consult with a financial planner, who can help you figure out all the complicated variables and options. No matter how you've obtained your windfall, there will be tax consequences. It is highly recommended that you consult with a tax lawyer to make sure you follow the right steps. 2012 Morningstar, Inc. All Rights Reserved. The information contained herein (1) is intended solely for informational purposes; (2) is proprietary to Morningstar and/or the content providers; (3) is not warranted to be accurate, complete, or timely; and (4) does not constitute investment advice of any kind. Neither Morningstar nor the content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. "Morningstar" and the Morningstar logo are registered trademarks of Morningstar, Inc. Morningstar Market Commentary originally published by Robert Johnson, CFA, Director of Economic Analysis with Morningstar and has been modified for Morningstar Newsletter Builder. Joel Shaps, CFP, CIMA President Bedrock Capital Management. Inc, 5050 El Camino Real Suite 204 Los Altos, California 94022 joel@bedrockcapital.com bedrockcapital.com Tel:650-964-7024 Fax:650-964-7037