Does your company offer stock options? The first thing that may come to mind when you hear about “stock options” is Enron and all the scandals. The media didn’t hold back in reporting about people that had their entire retirement savings vested in company stock and watched it all get wiped out.
But that isn’t what this article is about. Those were people who had invested their entire retirement savings into company stock plans for years. Stock option grants are something different .Some companies offer you a chunk of stock either when they hire you, or an option later on to buy shares with part of your pay check. Companies that offer stock options also have 401K funds and the whole gamut of investment vehicles (which I don’t recommend) as well, so you aren’t steered into putting all your retirement savings into company stock.
Given that, let’s dive into what’s available in the world of stock options. First of all, stock options come in many different flavors. They should be analyzed like any other financial instrument.
- What are the risks?
- What are the costs?
- What are the upsides?
- What are the downsides?
Given this much, let’s delve into some of their aspects and see if we can reach some conclusions.
Stock Option Grants
First of all, let’s look at grants. These are chunks of stock the company agrees to give based on a certain schedule. The quantity of stock is part of your salary negotiation and after you’re hired, it’s a done deal. Some companies might issue more grants later on, but there is typically no negotation at that stage.
Generally, grants are structured with a certain dollar figure in mind, and are set up with a strike price discounted against the current value of the stock to support that. For example, they may set the price at which you can exercise 20% below current price and then figure out how many shares to issue to achieve a certain dollar figure. If they plan to give you $20,000 worth of stock and the stock price is $100, they might issue 1000 shares with a strike price of $80/share. That would leave with a profit of $20/share x 1000 shares.
It is common that stock options are not granted immediately, but instead on a certain time table. For example, you receive 25% of your grant one year after your hiring date, and the rest spread over the following three years on a monthly basis. Or it could be something completely different. There is no end to the permutations.
When it comes time to exercise your option, there are usually several choices. An often seen choice is the ability to buy the stock at its discounted strike price and sell it at market value, all on the same day, letting you pocket the difference. Using our previous example, if you have receive 250 of your 1000 shares, and the price hasn’t moved since they hired you, you can expect to receive $5000 before taxes and fees. If the share price has doubled to $200/share, then you would get $30,000. Big difference ehh? But if the stock price has fallen to the point of being below the strike price, then you would have to pay, so it’s highly unlikely you would even exercise your option at that point.
Let’s examine the risks. It’s possible to negotiate for more options, but one risk is that they might reduce your salary. When I secured my existing job, I knew that stock options were relatively risky, and so I argued that I couldn’t pay my mortgage or feed my family on stock options. I got a higher salary because that was right for me. You might be different. Perhaps you already have enough salary from you or your spouse, and so would like to take on the risk of a bigger stock grant.
Upsides? If the stock price soars, you can make a big profit. Just be prepared with a strategy if your stock option turns into big money.
Downsides? Your stock option can fall flat and become worthless. This is a real risk, so don’t plan on big stuff based on your stock option. Always have an exit strategy if your option fizzles. For example, my current stock option has yielded tremendous gains in the first two years, but in the past six months, the price has fallen. Since I don’t need it for anything, and have other parts of my wealth building plan in action, I am waiting on a better time. That is risky by itself, and carries certain psychological challenges.
You can never know if it’s the best time to cash in on an option. When things go sour, our psychological instinct is it sell and stop the losses. But if you wait, things may recover. Or they may not. This is tough to weather, and is a key reason you shouldn’t depend on your stock option as a central part of your wealth building plan.
But there are many hidden positives. Whatever I get out of it is more than I would have gotten at my old company. And my company has already granted me another stock option about a year ago that is starting to vest. Plus, they plan to roll out a third one in the next few months. These are really great opportunities to let come to maturity, so I would never turn them down.
There are other stock options known as Employee Stock Purchasing Plans (ESPPs). This is a deal where your company sets aside a piece of each pay check (perhaps 5%) over a given time frame, like six months. Then on a certain scheduled day, they use that money to buy stock at a discount like 15% below market value. You can opt to sell the shares on the same day, exacting an almost guaranteed 15% profit. I have even seen companies that look at the beginning and end of that six-month time period, and offer 15% discount on the low point, sometimes offering an even bigger profit potential.
What are the risks with an ESPP? The risk is actually quite small. Given that you are awarded the shares and can sell on the same day, it’s almost a guaranteed profit. Only if the stock has a huge nosedive on one day, a rare event, would you suffer a loss.
Costs? Basically, how much of your paycheck can you do without? It’s coming back in six-months, so this isn’t a long time to handle.
Upsides? If you get the stock at 15% discount, and at the time of purchase, prices have risen 10%, you could be looking at 25% growth.
Downsides? If you hold onto the stock instead of cashing it in on the trading day, you enter the psychological battle of deciding when to sell the shares.
Bottom line: I would set aside as much I can afford to get that return six months later. In general, I would shoot to cash in on that growth every six months and not try to time them.
I have seen other financial advisors and talk show hosts generally look down on stock options. They describe them as risky, dangerous, and invitations to financial ruin. That is way overblown and without merit. However, don’t trade in important salary for options. You can’t depend on the returns of stock options. Instead, they are an opportunity to gather more capital to feed your wealth building plans. Also, if I haven’t made it clear, stock options have lots of variations. I have mentioned a few types that I have dealt, with this shouldn’t be considered comprehensive. If you have encountered another variant, feel free to leave a comment or send me a message.