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Welcome to the 31st edition of the Tech Financial Planning (TFP) newsletter.
If you Google “what to do with my equity compensation” you get 823 million results!
How the heck are you supposed to make a good, wise, financial decision?
Particularly if you are new to equity comp or have more complex situations?
In this newsletter we’ll break down a framework for making decisions for your equity comp and review 3 specific scenarios with some real life examples.
TL;DR
Equity compensation has so many different components and factors, people can become paralyzed and not make decisions
Viewing your equity comp through 3 scenarios - conservative, middle, aggressive - can help you make better decisions
There’s typically no clear or right answer, but making some decision is better than doing nothing or ignoring the situation
Why a framework?
Equity comp is tough.
There’s so many different types and acronyms.
It can become overwhelming and when that happens, people freeze.
They don’t make decisions.
Sometimes this can work out for the best, but more often it can hurt more than it needs to.
Stock options expire
Paying more in taxes
Selling at the wrong time
So it can be helpful to have a framework to help make decisions.
The Framework
The framework presents 3 scenarios:
Scenario 1: The safest and most conservative. Protects against the downside, but upside can/may be limited.
Scenario 2: Somewhere in the middle
Scenario 3: The riskiest and most aggressive. Big potential downside and upside
Importantly, each scenario has pros and cons.
We are often trained to think of the riskiest scenario as bad, but there are situations where it can make sense.
Jeff Bezos never would be worth bazillions of dollars today if he sold his Amazon stock immediately after it IPO’d in 1997.
In general, Scenario 2 is the “split the difference” scenario, and candidly, in my experience it’s the one most people pick.
It also usually takes the most amount of planning and strategy, but it can work really well.
Instead of going through generalities, let’s look at 3 specific equity comp examples and a specific planning example based on real life scenarios.
Please note: I can’t possibly cover every pro, con, risk, and intricacy in this post. This is intended to help you start to think about your equity comp in a more thoughtful, proactive manner. Please do your research and talk with your financial advisor and/or tax professional.
Example 1: Exercising Incentive Stock Options
Incentive Stock Options (ISOs) are one of the more complex parts of equity compensation, and we will not go into all the various details and specifics.
Scenario 1 will be the most straightforward (for the most part). You don’t exercise any of your shares until your company IPOs.
Once your company IPOs, you exercise and sell them all immediately (assuming you aren’t in a blackout period.
There’s very little risk and you don’t have to deal with AMT, but you will likely pay more in taxes than if you exercised proactively.
On the other end of the spectrum, you exercise as much as possible without putting yourself in financial jeopardy.
If your company has a successful exit, you have the highest potential for tax savings.
But it may require a lot of cash up front, both for the exercise cost and tax bill if you trigger AMT.
Plus, if your company never has a successful exit, you may have flushed a lot of cash down the toilet that you could have used elsewhere.
Then there’s the middle. With ISOs specifically, this can be a great option. Without going into the intricacies of AMT, there is usually some amount of stock options we can exercise each year without triggering AMT.
This is called the AMT crossover point.
Put another way, we can exercise some incentive stock options without getting hit with taxes.
This can be a nice sweet spot, but it takes more planning.
There is also still risk involved.
Over a longer time period, this can be a great scenario.
Planning example
Last summer I had a client who was leaving a private company that’s grown a ton over the past 5 years.
They had a number of stock options to exercise and we determined if they exercised all of them, they would trigger AMT.
Without going into all of the details, they were comfortable with putting up the cash to exercise and pay the tax bill because
They are confident in the trajectory of the company and want to participate in the upside
Even if the company never goes anywhere, they will still be on track to hit their other financial goals
So for them, it was (and is) a risk worth taking.
Example 2: A Concentrated Stock Position
Let’s say you went through a successful IPO and you're sitting on a nice big pile of company stock.
What should you do with it?
Scenario 1: Sell now and diversify.
A common rule of thumb is to hold no more than 10-20% in any one stock.
So once you have the big position, the textbook answer is to sell a big chunk of stock and diversify your portfolio and investments.
While this might be a best practice, it’s much easier said than done.
Scenario 3: Let it ride
Don’t sell until you need the cash.
Or as Mike Troxell said on Twitter, “hold/ignore until there’s a problem.”
This is the path of least resistance, but also the default if you choose not to plan.
More often than not, you are incurring unnecessary risk.
Scenario 2 is somewhere in the middle.
As Mike says in that same tweet, “though sell-all is by the book, most like to hold a % of the stock…I imagine I’d hold onto some percentage if I worked in tech.”
Everyone’s situation is different but I think this can be a great strategy.
But that’s the thing, you need to have a strategy.
How and when you’ll sell, based on time or price targets.
Covered calls can be a good option to a) force you to sell at predetermined prices and b) generate some income
I have clients that are on all ends of the spectrum.
On the more conservative end are clients that don’t want to hold a single share of an individual position. They would much prefer to sell immediately and have the peace of mind of a diversified portfolio.
On the other hand I have clients who don’t want to sell for any reason. They are convinced their company stock is the next big thing.
Planning Example
Right now I’m working with a client who has a bigger position in company stock and they have been hesitant to sell so far, for a number of reasons.
But they would also like to be in a position to do some real estate investment in the next year, and to do so, they would need to sell some stock.
So right now we are working through this framework to evaluate what makes most sense for them.
If we do nothing and the stock price falls, they may have to either a) push back their timeline or b) sell more stock than they’d like.
If we sell now and the stock price goes up, they probably will kick themself for selling early (even though the textbook answer & “best practice” would be to sell immediately, particularly with a known purchase in the next 2 years).
My guess is we land somewhere in the middle
Example 3: RSUs vesting
This is similar to the concentrated stock scenario but still worth going through.
When your RSUs vest, you have a decision:
Sell all of them
Sell some of them
Sell none of them
If you chose to sell some or all of them, you also need to decide what you want to use them for.
This is where it makes a ton of sense to have a plan of action ahead of time
Planning Example
Let’s go through an example where they chose to sell some (most) of their vested RSUs)
In this example, this person gets $80,000 in RSUs this year.
Off the top, they will have about $25,600 in taxes withheld by their company.
From there:
We will set aside $8,000 (10%) to cover additional taxes because they are in the 32% tax bracket
We will set aside $8,000 (10%) for a bigger trip
We will keep $8,000 worth (10%) of RSUs because they want to hold some of their company stock
We will take the remainder ($30,400) and put it into their taxable account into more diversified investments.
Putting it all together
Even with a framework, it can be tough to make a decision.
There is rarely a clear right answer.
Which is why it’s personal finance.
When I work with clients it’s trying to figure out a) what choice most aligns with their life and their goals and b) what can they live with?
Can they live with selling out of their company stock completely in order to buy a house and fund long term investments, knowing that if their company became the next Apple, they could have left millions on the sideline?
Or if their company did become Apple 2.0, they’d be kicking themselves for the rest of their lives, and accordingly if it crashed, they are ok pushing back some of their goals.
But what I’ve routinely found is that taking even some action is almost always better than doing nothing.
It’s better to pick a direction and course correct over time versus sit in perpetual paralysis by analysis.
If you want to talk through any of these frameworks, particularly in applying them to your own situation, let’s talk.
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If you're a tech employee feeling stuck and want to work on:
Building a systematic approach to building wealth
Making the most of your equity compensation (stock options, RSUs, etc)
Maximizing your cashflow
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