Employee Stock Options. Potential and Peril.
Everybody wants to be in on the ground floor of THE NEXT BIG THING. They want to be an employee of the next Amazon, Apple, or Microsoft, when those companies were in their start-up phase, and be granted stock options that will grow from zero to millions of dollars in a few short years.
The potential for striking it rich is appealing. But there is peril, too. The temptation is to put all of your proverbial eggs in one basket, your employer, but the peril is that the basket gets dropped and all your eggs get broken.
Let’s imagine you are an employee in a smallish company with shares listed on an exchange. The shares are trading at $2. You are issued options to buy 1,000 shares at $2 per share. This arrangement takes place twice a year. This carries on for five years, with the share price and the option exercise price always at around $2. That means you have accumulated options to buy 10,000 shares (1,000 x 2 x 5) at a cost to you of $20,000. Finally, in the sixth year, your company wins a major contract with the federal government and that big win attracts attention from provincial governments throughout Canada and national governments from around the world.
The stock that languished at $2 per share for years has quickly risen to $200 per share. You exercise your options. For the cost of $20,000 you suddenly have $2 million worth of shares in your company. Woo-hoo! It took six years, but you are suddenly a millionaire two times over!
Well, not entirely. This is a taxable employment benefit of $1,980,000 ($2,000,000 – $20,0000). Employment benefits are ordinarily fully taxable. However, in this case, because the transaction involved capital property, the disposition of options in exchange for the purchase of shares, you are allowed to deduct 50% of the employment benefit, i.e., $990,000, similar to the 50% inclusion rate that currently applies to capital gains in Canada.
That is great but it still means you have to pay tax on the other $990,000. In Ontario, the combined federal and Ontario tax rate above $220,000 is 53.53%. For simplicity’s sake, let’s assume that the entire amount was taxed at 53.53%. That means that $529,947 ($990,000 x 53.53%) is owed in taxes. Since you likely do not have a cool half-million dollars just lying around, you will have to sell off a portion of your just-acquired stock to cover the tax bill. If the shares were still trading at $200, then you would have to sell 2,650 shares to meet the tax bill (2,650 x $200 = $530,000) Still, it’s not too bad to be left with $1,470,000 Furthermore, because you paid your taxes on this benefit, the Adjusted Cost Base (ACB) is $200 per share, so any further capital gains will be taxed much less onerously.
The appeal of striking it rich is certainly there for almost all of us. However, an important part of financial planning is risk management. That is usually interpreted as the application of insurance to mitigate the negative consequences of early death, long-term disability, or a fire or other disaster destroying one’s home.
Lack of Diversification
Risk management applies to investments, too. One of the most important risk mitigation techniques in investing is diversification. If you put all your money into a single investment, that is risky. If that investment goes to zero, you have lost it all. That is why advisors generally recommend you spread out (diversify) your investments among several different asset classes.
If a significant portion of your employment incentive comes in the form of stock options, you may not have a lot of other money available to invest in a broadly diversified portfolio of Canadian and foreign equities. Depending on your age and other factors that will influence your ability, need, or willingness to take on risk, you may not have adequate investments in volatility-dampening assets like bonds or cash equivalents.
Human Capital and Financial Capital are Invested in the Same Asset
This is also a diversification issue. When you work for a company that provides stock options as part of its compensation to you, the fortunes of your employer become doubly important to your financial wellbeing. What would happen to you if your company became insolvent and went out of business?
Your human capital, your ability to earn an income, would likely be temporarily interrupted. However, if you were invested in a broadly diversified portfolio of assets, you should have a reasonable degree of confidence that your financial assets will do just fine.
Now imagine the situation where your investment assets consist entirely of stock or stock options in your company. If your employer goes out of business, you lose your job and you lose your investments. If you are relatively young, you probably have time to recover, but maybe the better answer is to make some plans to mitigate your risks at the outset.
A Risk Management Suggestion
When I began working for TD, I immediately joined the Employee Stock Purchase Plan. After the first $250, which was matched dollar for dollar, I could contribute up to 7% of my eligible earnings and receive 3.5% from TD. Effectively, I had a built-in 50% gain on my purchases of TD stock. At first, I intended to hang onto every single share and enjoy the quarterly dividends. Canadian bank stocks have performed very well over the years. Why wouldn’t I do this?
Eventually, though, I concluded that I was putting too much of my investment assets into a single company – that I was also working for – and decided that I needed to diversify my investments. I began to sell off a portion, deciding that my target was that it should not take up more than 5% of my investment portfolio.
There is a difference, of course, between an established Canadian bank and a start-up that is, by its very nature, needing to hire entrepreneurial risk-takers. Even so, I would tend to encourage people in this position to reduce their risk of financial loss by diversifying away from their employer’s stock.
There are multiple outcomes when it comes to investing in the stock of a single company, but I suppose the three broad returns one might expect are: 1. Going out of business – your investment is a complete loss; 2. Mediocre returns – your investment approximately keeps pace with inflation, but you might as well have put the money into GICs; or 3. A home run – the stock goes up and up and up.
While Outcome 3 is desired, I think that most people want to minimize the regret that would naturally arise if Outcome 1 were to take place. Even Outcome 2 would probably leave one with a feeling of regret if the broad stock market indices were returning double or triple the rate of inflation in the long term.
What to do? While I cannot, in a blog post intended for a general audience, address your ability to tolerate a loss, you might consider divesting yourself of a considerable portion of your company’s stock. Frankly, since both your employment and your wealth depend on your company, a more appropriate risk mitigation strategy would be to hold less in your company’s stock than you would in the stock of any other company, but for those with a greater risk appetite, 50% may be approximately the right choice. After all, if your co-worker hung onto all of their stock and the price went to the moon, they would be twice as wealthy as you, but you would still do very well. However, if the company went under and the stock price went to zero, you might both be out of a job, but they would have nothing while you would still have a well-diversified portfolio.
This is the 117th blog post for Russ Writes.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.