Stock options aren’t what they used to be back in the day, when a “Microsoft millionaire” and “Microsoft employee” were basically synonymous, and when tech people in general thought of early retirement as age 30. But as a part of some clients’ assets, they remain potentially important, as well as misunderstood, and in some cases emotionally charged. Because of that, the discussion with clients about options can be almost as important as the analysis itself.
Options are less popular today for a number of reasons. They need to be expensed on company income statements, whereas in the past it was possible to simply footnote them. A lack of understanding about options has prompted companies to move toward restricted stock and other alternatives. Two major market corrections in 15 years didn’t help, since they left boatloads of options underwater.
“This was a catastrophic problem across industries as a result of the 2008-09 recession,” says Scott Feraro, founder and managing director of Pepin Consulting.
Stock options still can be very lucrative if handled properly. But there are situations in which people can easily make mistakes with them. These may be the most common:
They exercise the options early for no good reason. Over the years, I’ve met a number of people with options who essentially told me that their strategy had been to exercise in-the-money options as soon as they vested, regardless of the price. Ouch. The reasons varied, but the option holders shared a misunderstanding of the vehicle. Fortunately, our clients should be talked out of making that mistake by their advisor in the vast majority of situations. Outside of extraordinary cases like a financial emergency (or, of course, pending expiration), it is hard to think of why it would make sense to exercise an option that is only narrowly in the money.
In educating clients about options and their potential value, it can be helpful sometimes to employ the analogy of a real estate mortgage. “Suppose a bank was willing to lend you 100% of the purchase price on a new home, at zero interest, and with the provision that if the home fell in value by half you could mail back the keys, no questions asked and with no damage to your credit rating. What would you think of that deal?”
From there, it’s a short hop into the reasons the option has value—leverage, combined with insurance. For the client with an option where the strike price is $10 and the current price is $12, it’s easy to demonstrate how a bump in the stock price of a little more than 8% to $13 produces a 50% gain in free (after-tax) equity bestowed by the company (from $2 to $3). And while the leverage also works in reverse against you, it only does so down to the $10 strike price, beyond which you don’t care because you decline to exercise the option. To take such an asset, financed with an interest-free loan from the company, and cash it in—well, let’s just say that if you really need that new boat, let’s find a different way to pay for it.
We ignore, for now, the legitimate case for diversification, because it is rare that the available profits from options so narrowly in the money will make up a sizable portion of one’s portfolio. That discussion comes later.
Clients sometimes mistakenly exercise stock options to get capital gains treatment. Occasionally, a client might also suggest exercising the options quickly, when they are close to the strike price, so that he or she can bank more of the future stock appreciation by converting ordinary income to capital gains (assuming that the options are non-qualified). On the surface, it can seem to make sense. However, the first flaw in the thinking is the assumption that the stock price is going to go up. When the client exercises, he is forgoing the interest-free loan and putting only his own capital at risk by buying the shares.
With the current price close to the strike price, it’s easy enough to show how a potential, avoidable loss on the stock could dwarf the potential tax savings.
When it’s your own capital, there is also an opportunity cost—tying up the assets needed to exercise 1,000 options, for example, at the $10 strike and pay the taxes on the $2 profit. The client sacrifices the profit that the $10,000-plus might earn, just to reduce taxes on the profit that the $12,000 might make. It is difficult to imagine circumstances where that would make sense.
But what if the client argues that the other investment opportunities are lousy and that the stock is going to the moon, creating huge potential tax savings? Even if the prediction turns out to be right (and healthy skepticism about such a prediction is in order), the client will have been better off keeping the options and using the cash to buy more of the same stock. (This assumes that it is publicly traded, of course.)
How about a cashless exercise? If the client knows the stock is going up, why would he want to give up most of the shares?
Clients ignore concentration risk. Maybe the more common issue, though, is that clients want to throw caution to the wind and hold the options regardless of how high the price goes. Maybe the strike price is $10 and the current price is $70, but the client wants to hold the options—or exercise them and hold the shares. While the mistakes with early exercising and capital gains can be diffused by logic and numbers, this third problem is more challenging, because it’s possible to talk and talk to the client and still come up against a brick wall when he says, “Yeah, I know, but I think the company is going to do great.” But that doesn’t mean advisors should not try. We point out how much of his wealth he would lose if something unforeseen went wrong with the company and how that concentration risk is exacerbated by his having human capital tied up in the company as well.
Concentration risk can also come into play, though less directly, if the client holds incentive stock options and receives preferential tax treatment. (The granting of ISOs has just about disappeared over the past 10 years, says Feraro, though grants from years ago can still show up on clients’ statements.) Here, the client may want to hold the stock for a year after exercising to have the entire spread between the exercise price and sale price taxed as capital gains. However, the client’s loss of that preferential treatment under the alternative minimum tax makes the reality of the situation much more complicated. The AMT credit notwithstanding, it may well be that holding all the shares will ultimately produce no more of a tax advantage than holding a portion of them. An accountant that well understands incentive stock options and the role of the AMT credit will be helpful here.
What happens if the accountant is confident that the tax advantage can be enhanced by holding all the shares? As much as we hate to throw away a substantial tax break, we may find it necessary to recommend doing exactly that if the risk of exposure to one stock is too high. As with most risk/reward balancing acts, the approach will be different for every client, depending on his or her circumstances and emotional makeup. But we all know what exuberance can do, and how employees can become enamored of their company stock.
In such cases, numbers may give way to the cautionary tale. Back in the winter of 2000, I was at a party in Seattle with mostly Microsoft employees. Their company’s stock price was in the mid-90s, down some $25 off its high, enough to get the attention of people who had grown accustomed to a one-way ride. I recall this one man confidently taking a swig from his bottle of beer and waving off the anxiety. I don’t remember his exact words, but it was something to the effect of, “Don’t worry. It’ll turn around, and in six months it’ll split again.”
We all know what happened. By Memorial Day, the stock was in the 60s. By Christmas it had fallen into the 40s.
Paul Palazzo, CFP, COA, is Managing Director of Altfest Personal Wealth Management.