Incentives matter. This maxim is one of the first things taught in Economics 101 class. Stock options are a powerful compensation mechanism that can encourage loyalty and performance from corporate executives. Stock options come in many forms and can get confusing. Here are some foundational reminders to get us started.
A stock option is the right to purchase shares of stock at a pre-determined price at some point in the future. Stock options can become valuable when stock price increases sharply.
What are some of the types of executive stock options?
There are many types of stock options. Here are the three that we see most often:
- Restricted stock–There is often confusion between restricted stock and restricted stock units. Restricted stock is a grant of shares that the executive cannot sell until those shares are vested. Once vested, shares typically do not expire. An executive may hold the shares, sell them, or gift them — just like the shares purchased on the open market. From a planning perspective, it is important to understand that restricted stock is taxed on the day it vests —which means that it could potentially result in a significant tax burden during the vesting year.
- Restricted Stock Units (RSUs) – RSUs are a popular form of executive compensation. They are issued to employees through a vesting schedule based on company performance. RSUs give the executive an interest in the company but have no monetary value until they are vested. RSUs are taxed during the vesting year, with the tax calculation based on the value of shares on grant date. This, too, could be a significant taxable event.
- Performance shares – Performance shares can be an “all or nothing” proposition. In this scenario, equity is issued to the executive only if certain corporate performance targets are achieved. Earnings per share (EPS) or other operating performance thresholds are some of the common targets. The goal of deploying performance shares is to tie a portion of executive pay to performance. With performance shares, the value of shares awarded on the vesting date is typically considered to be taxable income. Any gain in the value of shares at the time of sale could potentially be subject to capital gains taxes.
Restricted stock and RSUs are two of the most common equity vehicles today and there is one key difference between the two. Restricted stock is an equity vehicle that transfers the stock to the recipient on the date of grant subject to certain vesting restrictions. Unlike restricted stock, RSUs are not an actual transfer of stock on the grant date but rather a commitment to transfer stock or cash equivalent once vesting conditions are met.
Should stock options be used for CEOs?
Executive compensation became a hot topic following the corporate scandals that rocked the financial world in the early 2000s. At that time, many executives did not consider long-term implications of their decisions, with their focus limited to hitting next quarter’s earnings per share target. In the wake of the Enron, WorldCom, and Tyco sagas, tying pay to long-term company performance became a priority.
Stock options can provide good incentives, yet no single measure can hope to eliminate the drive or the pressure to make decisions for short-term gain. It is difficult to keep humans focused on long-run success. One advantage of stock options is that by giving the executive more equity ownership, the executive’s financial interests get align with the interests of the company.
Why do employers use stock options in addition to salary to compensate their employees?
Companies today often wish they had more employees who think like entrepreneurs. And yet, it is difficult to instill an entrepreneurial culture through traditional salary compensation alone. One possible solution is to leverage equity compensation.
Alignment of incentives between employees, executives, and shareholders can work well, uniting everyone around the goal of growing the value of the company. There are stories of companies that display their stock price in social areas, like break rooms or inside of elevators, effectively training their people to look at the stock price as a barometer of their personal success. Using stock as a form of compensation can also create additional flexibility by finding a balance between salaries today and the potential upside of stock options in the future.
Can consultants get stock options?
Consultants can receive options as compensation; however, this payment arrangement is rare. When all or part of a consultant’s compensation is in the form of stock options, the company can benefit from stronger interest and motivational alignment between the executive team and the consultant. One potential disadvantage is that equity-based compensation is driven by the long-term success of the business — whereas a consultant is often hired for a brief stretch of time.
Are stock options a good employee benefit?
Stock options have the potential to be a great employee benefit and a valuable part of the overall compensation package. They can provide significant financial upside if the stock price increases. What’s more, tax treatment can be favorable: while shares are taxed when vested, gains are not taxable until shares are sold, and then at the more favorable capital gains tax rate.
It is important to note that many executives face a concentrated portfolio of company stock due to the options that have vested and appreciated over time. Speak with us at SYM Financial Advisors to check on the degree to which your portfolio is diversified. In a perfect world, the success of your investment portfolio should not depend on the success of any one company.
What are the key problems with executive stock options?
Executive stock options have benefits and risks. For the company, additional shares flooding the market can dilute the value of stock that is already outstanding. In the long run, such dilution could be costly to the shareholders. Stock options can help align individual interests with the interests of the company, but they do not insure the company from mediocre managerial performance.
For executives, tax consequences of both vesting and sale can be complicated. Stock options also put an individual in a position where they must rely on the collective efforts of their co-workers and the executive team to earn an equivalent of a deferred bonus. And, finally, there is a potential concern of risk concentration when the executive’s financial future is tied with the value of company stock.
At SYM Financial, our team has the experience to advise on your concentrated stock positions and to assist with liquidating shares strategically in a tax-smart way. Long-term success is based on making prudent financial decisions today.
What do you do with stock options when leaving a company?
Executives should review their stock option documents to determine the timeline and terms of vesting. It is also important to review tax implications of exercising stock options. Exercising a significant number of options in a single year could potentially create a significant tax bill.
If possible, it is advisable to spread the tax liability over a few years. SYM Financial can create an optimal plan for you.
Stock Options for Executives
SYM Financial Advisors has experience with stock options as a form of executive compensation. Restricted stock, RSUs, and performance shares have become common forms of compensation for employees, managers, and executives. Our team has experience with compensation plans from many employers in the area.
SYM Financial is here to help executives manage their stock options. The right plan can potentially deliver significant tax savings — and peace of mind.