By Adrian Colarusso, CFA, CFP®
November 7, 2022
I’ve heard dozens of “stock stories” this year. These are the tales of clients and friends who’ve experienced the highs and lows of tying most of their fortunes to a single company.
I grew up in this industry taught to avoid single stock investing in favor of broad diversification. After all, thousands of whip-smart professionals compete valiantly for the slightest informational advantage to beat the market with their stock picks. Therefore, the current share price of a stock is a reasonable approximation of its fair value.
At Target Rock, we hold as a core investment principle that it’s not our role to outsmart the stock market’s valuation of individual companies. But if you zoom out there is another principle we cannot ignore: concentration can create wealth, but diversification helps protect it.
Concentration creating wealth is not a platitude about mental focus, although it could be that, too (read: Deep Work by Cal Newport).
Concentration risk is jargon for “putting all your eggs in one basket”. A nest egg allocated this way is rightly considered in danger. However, to create the outsized nest egg that some people crave, one method may be to throw everything – your time, money, and attention – at a single, high-return opportunity, diversification be damned.
If you could own only one business, what would it be?
Start-up founders and family business owners take concentration risk to a noble extreme. But another group has more choice in calibrating their concentration risk – all you fine company men and women who receive stock compensation.
Stock compensation is growing in popularity and complexity across public and private companies of all sizes, in all industries. It has migrated down the org chart from the C-suite and founding classes. If you’re earning company stock alongside your cash compensation, your emotions may vary widely depending on your knowledge of how your package works, and of course, how your company is doing.
I’ve observed or heard secondhand some mistakes that have cost my friends (or their friends) real money.
Without further ado, here are
the Seven Sins of Stock Compensation.
1. You don’t ask for what you deserve
Your talent and effort drive the value of your company’s stock. You should participate in that value creation to the greatest extent possible.
Equity or options grants are often a negotiable aspect of your compensation package, and not only when switching jobs. Consider laying groundwork for the ask upon successful completion of a high-profile project. Be ready to follow up at the appropriate stage of the compensation cycle or ahead of an upcoming funding round.
HR often standardizes the packages, making them tough to influence. But maybe you’ll find yourself in an “ask and you shall receive” situation if couched correctly with the right advocates.
My older son has become obsessed with hockey. I’m waiting for the right opportunity to teach him Wayne Gretzky’s most famous adage: “You miss 100% of the shots you don’t take”.
Call me if you want a sounding board to help you work up the guts and hone your pitch.
2. You don’t fully understand the tax implications of your action or inaction
There are too many to cover, and they can be deliriously tedious, but I’ll highlight two.
One story I heard involves Incentive Stock Options (ISOs) and a surprise mid-six-figure tax bill. “I thought ISOs didn’t trigger taxes until you sold the stock!” this person may have wailed. ISOs are tax-advantaged in the normal tax code world, but not in the parallel universe of Alternative Minimum Tax. Turns out this is super relevant if you have ISOs.
Another is a common misconception people have about the tax treatment of their Restricted Stock Units (RSUs) and their many derivatives. RSUs and PSUs are taxable as ordinary income on the day that they vest. There is no tax trick to be had. After they vest and the share price starts to move, then you’ll experience capital gains or losses. But that’s in addition to the income tax you’ve already incurred.
I heard one story where the share price fell so quickly after vesting that the tax bill was higher than the value of the shares that had vested! Oof.
There are strategies to prepare and maybe even mitigate the lifetime tax effects of RSU vesting. (For example, recall my two-part series on Donor Advised Funds).
The trickiest aspect of stock compensation is navigating the interplay between taxes and risk. You might face tradeoffs with no right answer, besides what feels best for you in the context of your complete wealth picture.
3. You don’t fully understand the investment risk of your action or inaction
It’s hard to imagine an investment rationale for any single stock to exceed a few percent of one’s net wealth. I’ll borrow straight from a paper my former colleagues at BlackRock wrote.
Here’s a stat that might blow your mind and spook you straight: Over the last 35 years, 39% of stocks fell by 50% or more and never recovered.
Me: *Ghost-with-hands-on-face emoji*
You (probably): Well, not my company…
The paper is chock full of statistical zingers against single stock concentration risk. I won’t bludgeon you with them; people remember stories more than stats anyway.
But people forget how unstoppable some of these companies seemed before they become relatively irrelevant: Yahoo!, Sun Microsystems, Sears, GE. Check out the paper to see their stock charts.
Concentration in those companies are examples of catastrophic loss. But another sneaky risk is underperformance. A few of you are holding shining star companies that have catapulted to the top of the universe since you’ve owned them. Over the next 10 years, top performing companies have tended to revert to average performance at best.
The same risks exist in pre-IPO companies, even if the data isn’t as easy to summarize as public stock returns. I’m certainly not saying don’t outlay cash to exercise your options. But the current environment speaks for itself. Liquidity events can be delayed, and valuations can fall.
Every time you are blessed with the vesting of some RSUs, the most fundamental question you must ask yourself is “if my company paid me this in cash, would I turn right around and put it all into our stock?”.
I’ve never seen anyone take a lump sum equal to several months’ salary and buy their company’s stock on the open market. Yet I have seen many people let their vested RSUs ride without much of a second thought. This is often a symptom of endowment bias, and it’s quite a tail-wag of the dog.
Reasonable people hang on to their RSUs for years after vesting, and for some, that has worked out swimmingly. If you want help looking at what your wealth picture may have morphed into and map out a strategy to navigate your tax liabilities and your concentration risk, give me a call.
4. You do some casual insider trading
Here’s one reason you might want to hang onto your vested stock despite its concentration risk: you have information about your company’s prospects that the public is not aware of, and you have high confidence the stock will do well as a result. Watch out for familiarity or overconfidence bias driving your investment thesis.
But what if you’re wrong, or worse, the opposite comes to pass? You somehow come to lose confidence in your company’s stock relative to the diversified market portfolio you could own instead. Perhaps that loss of confidence can be tied directly to a piece of material non-public information. As my Dad likes to say in any loosely relevant situation, quoting some movie I don’t even know: “Now yous can’t leave.” “Oh, come on Adrian you haven’t see A Bronx Tale?!” Thanks $GOOG.
If you are important enough at your company, you probably have blackout windows where you cannot trade your company’s stock. Avoiding blackout windows is only thin protection from insider trading accusations by the SEC. The legal consequences are serious.
So, between the coming and going of material non-public information, blackout dates, vesting schedules, and volatile share prices, it might be challenging to execute an intelligent divestment strategy on your own, free from risk of raising red flags.
This is where a 10b5-1 plan comes in, which outsources this problem to a trusted advisor who can transact on your behalf as long as you define the strategy in advance.
5. You miss a deadline that might cost you the value of a car or a house
A few examples of many:
“I meant to sell my RSUs when they vested, but forgot, and now they are down, like, 40%.”
“I forgot to exercise my ISOs within 90 days of leaving my prior company aaaand they’re gone.”
“I didn’t know I could make an 83(b) election on my early exercise options and pay taxes on today’s nominal value instead of the future value, while also starting the clock for long-term capital gains taxes, but only within 30 days from the grant date.”
6. You fuhgeddaboudit when you leave your company
This ties to #1 (asking for what you deserve) and #5 (missing deadlines). The unifying point is that when transitioning companies, carefully consider your stock comp for both the company you’re leaving and the one you’re joining.
Don’t leave your job a month before a big block of options or RSUs are about to vest.
Don’t forget to exercise your ISOs within 90 days of leaving a company if that makes sense in the context of your wealth picture.
Don’t forget to ask your new company to take into account the unvested equity you are leaving on the table with your old company or accommodate the start date you need to harvest an upcoming vest.
7. You fail to plan and thus plan to fail at harvesting the full potential of your stock compensation
Have I convinced you to make more thoughtful decisions about your stock compensation?
Navigating stock compensation is both an art and a science. You may need to “do the math” and engineer an optimal strategy for your situation. But it’s often equally important to develop a high-level plan that fits your goals and helps you sleep well at night, limiting the risk of future regret.
You may have to make decisions with incomplete information and understand that hindsight will be 20/20. But if you reflect on your highest priority goals and most desired outcomes while keeping expectations in check, your stock compensation will serve its highest purpose for you and your family.