RSU and Stock Options

RSU and Stock Option Strategies for Tech Professionals & Executives

Almost every public company in the US utilizes equity as a component of compensation; and it makes sense as it aligns and motivates employees to increase the value of the company. Generally, the higher you are in management, the higher your percentage of equity as compensation. Generally, compensation is composed of Cash, Bonus and Equity; and in public companies equity is commonly between 20% - 60% of compensation for manager/director/VP level employees.

What is your strategy for monetizing this equity? The overwhelming majority of people have no strategy at all.

At Hathaway Financial, we provide the specialized, fiduciary guidance needed to turn concentrated stock positions into long-term financial independence.

Most common forms of equity compensation:

• Restricted Stock Units (RSUs)

• Stock Options

Both RSUs and Options can vary significantly in their legal and tax structure and both present unique opportunities for wealth creation.

Restricted Stock Units (RSU) Strategy

RSUs are quite simple in theory: Receive company stock when it vests.

Unfortunately, many or most people do not think carefully about their goals, risk tolerance and general strategy about:

What to do when the Stock vests?

What is your RSU Strategy?

Most can not answer this question succinctly. Sell all when vest, hold a %, sell later, etc…

Overview

Restricted Stock Units (RSUs) are a form of equity compensation in which a company grants an employee the right to receive shares of company stock at a future date, usually after a specified vesting period.

The employee does not own the shares immediately; instead, the RSUs vest over time (e.g., 25% per year over 4 years) or upon meeting performance goals, at which point the employee receives the actual shares.

Once vested, the shares are taxed as ordinary income based on their fair market value on the vesting date, and the employee can then hold, sell, or transfer them like any other stock.

Concentration Risk

If you hold your RSUs after vesting you are making an implied decision to buy your company's stock over all other investment options in the universe!

Is that a decision you stand-by? You may have extreme conviction in your company and perhaps asymmetric information leading you to believe that it will out-perform alternative investments, but the concentration risk is significant; i.e you now have your paycheck and investment portfolio tied to one company.

Taxes

Simple example. You're granted 400 RSUs; 25% cliff vest at 1 year and the remainder vest monthly over the last three years.

So after a year you vest 100 shares. Does your company give you 100 shares?

Usually not. When your RSUs vest they are treated as ordinary W2 income. In most cases your company will withhold shares to cover your estimated tax liability. So for example, you may vest 100 shares, but the company might withhold 35 shares for taxes and deliver 65 shares to your brokerage account.

Those shares are now "unrestricted". They're like any other stock sitting in your brokerage.

Do you hold them? Sell them? In general, most people should sell some portion of their RSUs when they vest.

Why? Because on that day their cost basis = tax basis. You can sell them for cash and have no tax event(i). Why? Because you already paid the taxes as ordinary income when they vested! So you can take the cash, buy stocks in other companies. Etc…

(i) The day your RSU vests and lands in your brokerage account, it is no longer "restricted". You can hold, sell or trade it. Capital gains clock starts that day. So theoretically, there is no tax if sold immediately upon vest. This is impractical due to market operations, as the stock will immediately begin changing value the minute the market opens, creating some capital gain or loss. Further, the amount of stock your company withheld – in the example above 35 shares or 35% – is an estimate and your true tax liability is calculated when you file your tax return.

Stock Option Strategy

Stock options can be a powerful wealth-builder! They can exponentially increase your wealth – more than RSUs – but the company stock has to go up, or they can expire worthless.

Stock Options come in a variety of flavors and can be difficult to understand.

Overview

Stock options are a form of equity compensation that give an employee the right, but not the obligation, to purchase a specific number of shares of the company's stock at a predetermined price (known as the strike price or exercise price) within a period of time (commonly 10 years).

Typically, options vest over time (e.g., over 4 years) or upon meeting performance milestones, after which the employee can exercise them by paying the strike price to acquire the shares.

If the company's stock price rises above the strike price, the employee can profit by exercising and selling the shares (or holding them); if the price stays below, the options may expire worthless.

Taxes

Generally public companies issue non-qualified stock options (NSOs). It is common however for private companies to issue Incentive Stock Options.

Non-qualified stock options (NSOs) are taxed as ordinary income on the spread (fair market value minus exercise price) at the time of exercise.

Incentive stock options (ISOs) offer potential favorable tax treatment—no ordinary income tax at exercise (though they may trigger alternative minimum tax), and qualifying dispositions (meeting holding periods) result in long-term capital gains tax only. They can be quite complex!

Strategy

Stock option strategy is EXTREMELY important to maximizing your income. Unlike RSUs, that are simply shares of stock when they vest, options that vest are contracts to buy the company stock at a predetermined price (exercise/strike price) and you must have a strategy to determine when to exercise!

You do not want to exercise simply because they are "in the money".

Example

Let's say you have 100 vested options to buy your company stock at a price of $10 and it is currently trading at $20?

Should you exercise? Should you exercise and sell? Exercise and hold? Wait?

Stock options are a "leveraged" instrument. What does that mean? It means the more your company stock goes up, the more valuable they are.

Consider these two examples:

1. Exercise and sell now. You pocket $1,000 pre-tax. Calculated as 100 × ($20 market price - $10 exercise price).

2. Wait. Stock appreciates to $40 and you exercise and sell. You pocket $3,000 pre-tax. Calculated as 100 × ($40 – $10).

Here's the "mind trick": Between scenario (1) and (2), the Stock price increased 100% or 2x ($20 to $40). However: your income increased 200% or 3x; i.e. $1,000 to $3,000.

Think about that: Stock goes up 2x, but the value of the option increased 3x.

HOW IS THIS POSSIBLE? The beauty of options; also the curse. Meaning the more the stock goes up, the more your income increases non-linearly; but the reverse is true as well: Stock goes below $10 and your income is Zero!

Options are extremely complex. If you don't understand them thoroughly you should seek professional guidance; the monetary reward is simply too material to not have a plan!

Employee Stock Purchase Plan (ESPP) Strategy

Employee Stock Purchase Plans (ESPP) are very common in public companies and while they're not generally considered a component of compensation (as the program is generally offered on the same terms to all employees) the program can still be a key tool to increase your compensation.

Generally ESPP is a company-sponsored program allowing employees to buy shares of the employer's stock at a discount (typically up to 15%) through payroll deductions over an offering period (often 6–24 months). Many include a look-back provision (commonly six months), setting the purchase price based on the lower of the stock's fair market value at the offering start or purchase date, maximizing the effective discount.

Think about that for a second! You are getting a 15% discount on the company's stock!! No matter what!! Free money.

Taxes

Taxes can vary significantly depending on the plan's design, how long you hold the shares and when you sell the shares. With appropriate planning you can structure this such that the 15% discount is ordinary income, but the increase in stock price can be long term capital gains tax (i.e. more favorable than ordinary income).

Again, complicated. The point is you need to understand it and have a plan.