During a steadily rising stock market like the 12-year period leading up to this year, equity compensation in some form of stock options was a relatively straightforward financial planning exercise that mostly involved navigating through and around taxes.
But in a down market, particularly one where the downside appears so uncertain, even financial advisers who specialize in stock options are finding themselves deep in new puzzles related to when and how, or even if, clients should take ownership of company stock they have been granted.
“There is some inherent leverage involved with stock options,” said Rob Greenman, partner and chief growth officer at Vista Capital Partners.
“When the employer stock prices surge, folks can utilize this form of compensation to fund their dream vacation home, but when prices fall from the grant date, there’s zero value and they’re back to renting that summer home,” Greenman said. “It can really be feast or famine.”
In basic terms, a stock option’s grant price is the value of the stock on the date it’s awarded to an employee. This follows a vesting period during which the employee has the option to exercise the right to take ownership.
Depending on the type of option being granted, and there are multiple flavors, the employee typically can buy the stock in the future at the stock’s price when it was granted. This is great news if stocks are going up. When stock prices are falling, it starts to look like useless compensation because it would involve paying the previously higher price at the grant date for stock that is now cheaper.
But there are myriad wrinkles in the stock option game, as detailed by Daniel Zajac, lead equity compensation enthusiast at Zajac Group.
“The good news is you may get more [restricted stock units] than previous years with new grants,” he said. “And if you have [incentive stock options], you may be able to exercise and hold more with lower [alternative minimum tax] impact.”
“A major challenge of managing stock options during market downturns is if and when the strike price drops below the market price — then you’re underwater and the options are literally worthless,” he said. “There are tax advantages in these downturns, too. If you exercise incentive stock options or nonqualified stock options when the market price is lower, the initial tax impact of the exercise can be reduced.”
Marc Kadomatsu, managing partner and director of financial planning at Human Investing, described the reduced tax liabilities as a “small consolation benefit … assuming they are nonqualified stock options.”
“This current down-market cycle has created issues for those with stock options that are expiring soon,” Kadomatsu added. “These apply to those close to expiration date, as well as people who are leaving their company and have 90 days to exercise their options. Ideally, they are exercising these options when the market is at a higher point, so they have a choice to either exercise and sell them at a low point or exercise and hold the stock and wait for a potential recovery before selling them again. The opportunity is that any new grants that they receive will be at a low exercise price, providing those shares with a high upside opportunity if there is a recovery in the market.”
Equity compensation is slightly more straightforward in the public company markets, where stock prices are reported live throughout the day.
When it comes to private companies, where options are often viewed as the potential riches down the road, the planning challenge can sometimes involve a bit of psychology, said Ann Lucchesi, managing director at SVB Private. Since most private companies are valued annually, Lucchesi said it’s important to remind clients that the overall market is driving down valuations, rather than the state of the specific company.
“Typically, the conversations will be around explaining that the valuation has gone down but the enterprise value has remained the same,” she said. “A lot of lessons were learned from the dot-com bubble. It only becomes negative when you go through periods like that when the enterprise value of the company goes down.”
By way of a silver lining, Lucchesi said companies could use the lower valuations as a way to attract talent because they would be granting stock options at prices seemingly well below the company’s enterprise value.
“Companies are looking at it as a way to attract people,” she said. “But we really haven’t seen this event in the past 12 years. It’s new for a lot of people who haven’t gone through it.”
Another common form of equity compensation often lumped in with stock options is restricted stock units, in which an employee is granted stock that the employee takes ownership of according to a pre-set vesting schedule. In this case, the employee doesn’t need to buy the shares; as soon as they’ve vested, they move into the employee’s taxable brokerage account at the current market price.
In a down market, that means the employee is often getting stock at prices below the grant price, which creates the potential for locking in losses for tax management purposes.
“It gets tricky when the price drops,” said Tricia Rosen, founder of Access Financial Planning.
“Even if it goes down, you’re still being given something you wouldn’t have had otherwise,” she said. “Locking in a loss is better than not getting any kind of bonus whatsoever.”
Rosen warned that the temptation to lock in a loss, which would require a stock sale, needs to be measured against any regular vesting schedule.
“The tricky part is if the stock was granted at $50 and has a market value of $40 when it’s vested, the employee who effectively purchased at $50 now has a $10 loss,” she said. “If the employee wants to cut their losses and sell it, if they sell within 30 days of it vesting, they now have a wash sale and won’t be able to use the loss to offset gains.”
The other major tax factor that a down market presents is the potential to lessen the impact of the alternative minimum tax.
“At the point you exercise the stock option, the implied gain is an add-back item for AMT,” Lucchesi said. “Sometimes, people who have never paid AMT could find themselves pushed into it, but with the implied value down, there’s a smaller amount of add back in the spring.”
“In the case of incentive stock options, if this spread is significant enough, it may trigger the AMT at the end of the year,” she said. “While this is one opportunity posed by a down market, the challenges of turbulent market conditions usually outweigh any possible benefits.”