Corporate executives are con-stantly under the microscope, with shareholders breathing down their necks over performance reports, quarterly earnings and stock returns. But there's a trade-off: lucrative, deeply enriching and sometimes eye-popping pay.
Stock compensation is a game corporate America plays to align the interests of corporate executives and shareholders. If executives create profits and drive up stock prices, it's a win-win for everyone. But executives sometimes have little time to absorb the complexities of their compensation packages. In fact, executives lose millions of dollars every year mishandling their compensation.
Here are a few strategies, and possible pitfalls, that executives and their advisors should be aware of to ensure they take full advantage of these compensation packages.
SEC Rule 10b5-1
If their options expire unexercised, executives will surrender a significant portion of their compensation. You would think something this dumb could never happen. But it does. Bruce Brumberg, editor of mystockoptions.com, says more than 10% of valuable options expire unexercised each year.
This happens for a combination of reasons: The executive may be too busy to realize his awards are about to expire; the company may do a lousy job keeping everyone in the loop on critical dates; or the expiration may fall within a blackout period. Most companies have gotten better at keeping employees informed, but executives with hefty pay locked up in stock options shouldn't depend on anyone other than themselves and their advisors to take full advantage of their opportunities. Executives and their advisors need to map out option expiration dates years in advance and anticipate blackout periods.
One tool all executives should have in their arsenal is the SEC Rule 10b5-1 trading plan. This allows executives to sell a predetermined amount of shares at a predetermined time and price. It makes sales automatic and allows for them during blackout periods. Rule 10b5-1 is perfect for diversifying out of company stock and making sure options aren't lost because of a lack of planning.
Instituting a 10b5-1 plan is relatively simple assuming the executive, his advisor and his legal counsel have a solid understanding of the plan and the executive's goals. The plan should include the number of shares to be sold, the share selling price and the specific dates the sales are made. Rule 144 forms need to be filed with the SEC within 24 hours after the trade on behalf of the owner.
Two Types Of Options
Mistakes happen when executives fail to understand that there are two types of stock options. The key to extracting the most value out of options is to understand each type of option and the rules associated with them.
Executive stock options come in the form of non-qualified stock options (NQSOs) and incentive stock options (ISOs). They each affect executives and their companies differently and have different tax consequences.
NQSOs are the most common form, partly because they are considered compensation and a deductible expense for corporations. That's a plus for companies, but the downside is the employee's income tax liability. These options are taxed when they are exercised, with the bargain element (the stock price minus the exercise price) treated as ordinary income, a hefty burden on the executive. Since most companies only withhold 25% in taxes on an exercise, oblivious executives will be in for a shock when their year-end tax bill arrives.