Are You Maximizing Your Employee Stock Compensation? Fundamentals of Investing

One of Left Brain's specialties is working with corporate executives. What are some of the important financial techniques around employee stock compensation that executives should put into their financial plan to maximize their wealth? We answer this question and much more in this week's Fundamentals of Investing. I'm your host, Brian Dress, director of research and an investment advisor here at Left Brain, joined as always by our CEO and Chief Investment Officer, Nolan Langford. Who has made much of his career working with corporate executives. Nolan, welcome to the program.

Thank you, Brian. Glad, glad to be here talking about this important topic.

Glad to have you. Someone with a lot of experience in this forum. In this edition, we're going to cover 3 forms of equity compensation that are often available to corporate executives and some of the methods we have employed with clients to take best advantage. One is employee stock purchase plans or ESPPs. The second is restricted stock units or RSUs. And then the third is stock options. So there are a lot of different techniques and strategies around all three of these, and we're going to cover all those today. Nolan, I'm going to just jump in. Can you speak to the importance of optimizing employee benefit plans with specific respect to equity compensation?

Yeah, that's a good lead-in, Brian. You know, as we're all aware, if you're a corporate executive, a big part of the comp plan deals with the company stock. And of course, these are for executives that work for a company. That's publicly traded. That means that company has a stock that trades on a public exchange, and corporate executives receive some form of their compensation package with some— something tied to the company stock. So it's very important that they understand the bells and whistles of each plan and to look at their individual situation to see how they should participate and which plans are going to be most beneficial to them.

We've got a lot to cover, Nolan, so we're going to jump right in to topic 1. So topic 1 is Employee Stock Purchase Plans. Those are ESPPs. Nolan, what are ESPPs and how do they work and what are some of the advantages in terms of taxes and other, other advantages?

Yeah. So ESPP, that's an acronym for Employee Stock Purchase Plan. It's named pretty descriptively. If you're an executive at a corporation and HR comes to you and allows you an opportunity to get into the Employee Stock Purchase Plan, then as an executive, this is something that you definitely want to consider. Basically, it allows you to buy the company stock. It's usually deducted from your paycheck on each payroll period. The money goes into some fund, and then at a certain date, the company actually buys shares on your behalf. And that's kind of the basics of the employee stock purchase plan. There's a lot of other details that we'll talk about here in a second. But that's the general overview of a plan. You're buying stock, your company stock, through your payroll, through your paycheck.

Anybody can just go out and buy the company stock just in a brokerage account or what have you. But can you speak to some of the advantages that come along with purchasing stock in an ESPP or that employee stock purchase program?

Sure, Brian. So there's a few. I do get it taken directly out of my paycheck. So that is a convenience for me, and that is helpful. I think the bigger benefit is economic. So a lot of companies will offer a discount. So they may say something like, hey, you can put in X amount as a max per paycheck, we'll buy you our shares at X amount off. And the most common discount we see is 5 to 10%. Some companies are more generous and a few companies don't allow any discounts, but most of them somewhere in the range of 5 to 10%. So there's an economic incentive as well. And then there's a third thing. A lot of companies buy the stock periodically. So it's not every payroll period. Every payroll period there's a deduction, the money goes into a fund. But a lot of companies will buy the shares quarterly. Some of them will buy it semi-annually. And I've even seen an annual before. And that could be beneficial as well, because if they're doing it periodically, then they usually use an averaging or an average price. And so the price you're purchasing may be lower than the market price the day of the purchase.

I want to speak a little bit to the logistics because, you know, part of the reason we're making this video, Nolan, is a lot of employees out there have these benefit plans. There are lots of bells and whistles that go along with it, but they don't necessarily know all the mechanics of how it all works. So I wanted to speak specifically to the logistics of these ESPP plans. So those are enrollment periods. We've got liquidity. Taxes, and how often someone can purchase shares. So you did cover that fourth one. So talk a little bit about enrollment periods, liquidity, and taxes that go along with ESPP.

Brian, most companies will have an enrollment period annually, and it typically happens in the fourth quarter.

And then talk a little bit about liquidity. For, you know, for instance, if someone purchases shares, what sort of liquidity they generally have in these plans.

That's a really important topic to touch on, liquidity. Because I think liquidity is important from a couple of different viewpoints. The first one is I need liquidity to actually buy the shares. You know, if I'm spending 100% of my paycheck on my household expenses, it's probably not going to be enough liquidity there to actually put money away in these shares. And then the second part of the liquidity issue is after I own the shares, how readily available are they to be sold? Good news on that front. Typically, they're very, very liquid. So an example that I use that a company is buying the shares quarterly or even semi-annually, typically within a few business days after the purchase is made, the shares are available in an account that the employee can then, if they want to sell and liquidate, they could do that right away.

So taxes just work as they normally would for any other investment?

Yeah, you're typically going to get capital gains either long or short term. If shares are held for 12 months or more, it's long term. And less than 12 months, if there is a gain, it's short-term. And it's the same thing with loss. If you're unfortunate enough to have purchased shares at $100 and subsequently they fall to $90 and you sell, the IRS will take— let you take a capital loss for that transaction.

Okay. And then the final question on ESPP, and then we'll move on to these other topics. Nolan, how does an investor determine whether they should participate and how much?

Yeah, I think that's the magic question. You know, the how much part, that's always going to be an individual choice based off of the person's liquidity needs, their financial situation, how much extra cash flow they need, etc. So that one's a little bit more difficult. The bigger question is, should you participate? So there's a few things to think about. One is, is there a discount? And the second one is, how likely are the shares to appreciate? The only reason that we would buy shares is because we thought they were a good deal. and it was possible that our shares could go up, giving us an economic incentive to participate. The discount is the big one. You know, if a company is not offering any discount in their employee stock purchase plan, I think most employees, it's gonna be a heavier lift to get the employee to participate. Basically, the only benefit you're gonna get is dollar cost averaging and just the ease of use because it comes outta my paycheck. So typically, if there's a discount And the larger the discount, I think the more likely employees are to participate.

Excellent. All good information on ESPPs. Let's move on to one of the other types of benefit plans in the equity compensation realm, and that's restricted stock units. So, topic 2 is restricted stock units, or RSUs, as we often hear them called. Nolan, tell us what RSUs are and how they usually are granted to employees.

So, restricted stock units, there's a variety of ways they can be granted. I've seen them given to executives as bonuses. When an M&A transaction is done. But more commonly, it's a part of just an ongoing compensation plan. It can be sign-on bonuses that are given with restricted stock units, but more commonly, you know, they're given out generally it's the first quarter of the year is when I think they're most often issued sometime between March and May, and then they're issued generally with a certain amount of shares. So in this example, let's assume Company A issues me, Nolan Langford, 100 shares of company stock, restricted stock units. So I have this stock and just like the wording says, they're restricted. That means I can't sell them right now and I cannot cash them in. They're restricted. And if we think about restriction, the most common form of restriction is usually a 3 or 4 year cliff. So in my example, let's assume I was awarded 100 shares of stock from ABC Corporation, or in this case, let's say from Left Brain issued me 100 shares of stock, and if it's a 4-year cliff, then every year 25 of those shares become available for me to actually physically own them and sell them if I'd like.

And I just want to point out what Nolan is pointing out and describing is what we call vesting schedule. So these RSUs or restricted stock units usually do vest according to a schedule, meaning a certain amount is available to you to sell every year for 4 years or 3 years or whatever the vesting schedule is. So just want to make people aware that when they see the term vesting or vesting schedule on their benefit plan, that that's what that is. And then, Nolan, I want to talk about vesting a little bit more in detail. Let's talk about having a strategy around vesting. Should you sell and when?

Again, this is going to be an individual decision a little bit. The other decision is going to come down to the corporation you work for. And how the corporation is performing. Now, stocks tend to follow the trajectory of the business. And unfortunately, Brian, as you and I know, we've seen a lot of publicly traded companies. They don't all do well and all the stocks don't automatically go up. A lot of them do. I would dare to say most of them, but not all. So one of the considerations is if you work for a thriving corporation revenues, profits, there's growth, there's expansion, there's a lot of buzz around the products and services, then there's a good chance then you're working for a company that's going to have an appreciating stock. So I may want to hold that stock and keep buying it for a while and ride the wave higher. If, on the other hand, you know, my stock was issued to me by, you know, Rite Aid or Bed Bath Beyond or some company that was you know, going bye-bye, I'm probably not going to be as comfortable holding that stock. So it is really business dependent. And this is where we can be helpful or your financial advisor. We're happy to help. You know, certainly the economic outlook for whatever business you work for is going to be a really important consideration.

Yes, Nolan, it seems like almost all of these questions are subjective to this individual situation. So as you said, very important to speak with somebody preferably outside of your company where you can get some advice on figuring out what to do here. Let's talk about the third topic, that's stock options. Owen, what are stock options? Who receives them? And what are we seeing in terms of use of stock options relative to the restricted stock units that you just mentioned as well?

[Speaker:OWEN] Yeah, so let's start with who gets them. And the answer is not very many people anymore. They used to be a lot more popular. You know, I remember when I started in the industry in the late '90s, you know, a lot of companies, a lot of executives we work with, it wasn't uncommon to see somebody come in with, you know, both types of stock options, non-qualified incentive stock options. I know we're going to talk about the different types in a while, but it's very rare that we see them anymore. And I think part of the reason is the accounting rules changed. And companies now, they used to— didn't have to expense the issuance of stock options. But FASB, the Accounting Standards Board, changed that rule some time ago. and now they have to be expense. And because of that, the reaction on Wall Street was publicly traded corporations then stop issuing stock options in lieu of these restricted stock units. Um, so it's a different type of transaction. But back to your question, usually these are the very, very high-ranking executives that are still issued stock options. And options can be very, very lucrative. Let's say it's Nolan. I'm issued stock options from Left Brain Wealth Management, and today the stock price is $100. I get issued the grant today at $100, but there is a vesting schedule, and those options may not be eligible for me to exercise for some time. Typically, again, it's usually a 3 or 4-year vesting schedule. So a year from today, let's imagine Left Brain Stock has gone from 100 to $150, then that can be very lucrative for the executive. That means I can buy the shares for $100 from left brain and immediately sell them in the marketplace for $150. And that extra $50 I get almost for free. And that's the power of stock options if you have an appreciated stock.

Okay. And then you did allude to this, Nolan, two types of stock options. Can you explain the two different types of stock options?

Yeah, the more common one is what we call a non-qualified stock option. And then the other type is what we call an incentive-based stock option. This isn't that relevant for most people, the names. The big difference is the tax treatment of both of them. So in operation, when I mentioned, hey, I got the shares issued or the stock grant issued at 100, it went up to $150,000. That won't change no matter the type. The difference is just the tax treatment. When I exercise a non-qualified stock option, even if I don't sell it, but just exercising it is taxable. I have an incentive-based stock option. The exercise part will not trigger a tax liability. It's not to actually sell. So it's just the tax treatment of both of them is a little bit different.

We've heard the term expiration. That's important in options. And let's talk about the strategy that you might have around options and expiration and also tax strategy.

Yeah, good point, Brian. All of these stock options do have an expiration date and universally everyone I've seen, it's been 10 years from the date of issuance. So even if you get to year 1, in my example, I used the left brain issued me stock options at $100. And let's imagine after year 1, the stock had not gone up. Let's imagine the stock had gone down from 100 to 80. Well, I don't need to really do anything. You know, the stock option is out of the money, so it has no economic value in year number 1. But I still have 9 more years to capture upside. So if I get to year number 2 and the stock then has appreciated to $120, then I now have that $20 of economic value. So 10 years just gives me a longer period of time to see the stock appreciate.

So consider the example you just mentioned, uh, of the stock just went up to $120 in year 2 of the 10 years. Is there a strategy around exercising in year 2 or maybe waiting going forward around taxes or anything else?

Yes. And it gets kind of complicated. So if anybody out there that's a viewer that has stock options, we'd love to work with you, or if you have an advisor, but certainly do not go it loan. There's a few things to consider. One is taxes. You know, if I have a boatload of these options and generally they're given out, it's not like the restricted stock units where they're usually given out in hundreds. The stock options is usually thousands. There's usually a lot more of them. And so you could potentially, when you exercise, you could create a huge tax liability for yourself. So you want to be really, really careful, especially— I've seen a lot of executives want to exercise because they need the money before the holidays. They don't want to run up a bunch of Christmas bills and travel. So they may think about doing it in the fourth quarter because they need the money. But from a tax standpoint, you know, you could be setting yourself up for a lot of pain in a few months because the tax season is right around the corner. So be really, really careful from a tax standpoint. The other thing I would say is, you know, executives often change careers or change jobs. They get recruited often. So if you're thinking about making a, you know, a a move from one company to the other, that would be another consideration for, hey, maybe it makes sense for me to exercise these options now. And then the final one is just going to be your overall exposure to the stock. You know, if I own the stock in my 401(k) and I have the stock purchase plan and I have restricted stock units and I have these stock options and my paycheck is reliant on this corporation, you may have overexposure to this company, particularly if it's not an appreciating company. So your exposure to the company stock will be another important consideration of when and how you should exercise and sell.

Okay, Nolan, we're going to leave it there. It is a more money, more problem situation when you get these employee stock compensation packages. So it is important to take note and be detailed in the way that you strategize around these. We would ask you to like and share the video if you found this useful and share this with your colleagues because, you know, there's not a lot of information out there for executives from the company in terms of how to handle these. Subscribe and hit the bell for notifications. That way, you know, next time we're out with these videos. We did want to close out by saying this, you know, company HR, they're not going to be very helpful with this. They're not in the business of giving you advice on these programs. They may be able to give you some basic information. But if you're looking for a way to strategize and find a good way to take full advantage of these programs, you do want to work with somebody. It's crucial to find someone competent to help you make these critical decisions. That's something we specialize in here at Left Brain, and we're going to put our information down on the bottom of the screen so that if you do want to get in touch with us and see if you can find a way to more optimize the way you're handling your employee stock purchase plan, restricted stock units, and stock options, please get in touch and we'd be happy to help. With that, we're going to close out and we'll see you again on the next Fundamentals of Investing.