Congratulations! You’ve been awarded incentive stock options in your company.
This may be the most amount of money you’ve seen in your lifetime. As such, you would be best served developing a solid written game plan for managing your “winning hand.” Don’t fail to plan with a financial decision of this magnitude.
I’ve seen dozens of stock incentive plans for companies — both private and public. The most common form of stock based compensation offered by privately held companies to its employees are incentive stock options or ISOs.
Typically, new full-time employees are granted a number of shares of stock on their date of hire based on the current market value per share. The first page of the agreement often specifies the following:
- Name of optionholder: This is you, the employee. The legal owner of the options.
- Date of grant: The date you were given the shares.
- Number of option shares: The total number of shares you were given.
- Exercise price (per share): This is also called the “grant price” or “strike price.” This is the price you will pay for each of the shares you were given, even if the actual stock price is higher the day you cash in.
- Vesting start date: The date your shares begin to vest. When your shares are “fully vested,” they are fully yours.
- Type of options: The two most common kinds of stock options are incentive stock options (ISOs) and nonqualified stock options (NSOs).
- Vesting schedule: The amount of time you’re on the hook before all of the shares are fully yours. In some cases vesting is associated with meeting specific performance goals.
Once you’ve been with the company long enough — usually 4 to 5 years — your stock options will be 100% vested, meaning you can cash in when you’re ready. By then, the shares hopefully will have appreciated in value so you have what are called “unrealized gains” in your company’s shares.
You may be wondering what you should you do next. Many people start with the tax implications, but letting the tax tail wag the dog without considering other critical factors can be a catastrophic financial mistake.
Below is the game plan I put together for my clients when stock compensation makes up a meaningful percentage of their net worth. This five-step plan should help you avoid some of the common pitfalls affecting investors:
1. Quantify your goals.
For example: You’re planning to purchase an apartment in San Francisco for $1 million. You’ll need around $200k stashed away for a conventional 20% down, 30 yr. fixed mortgage.
Colleagues at your company may discourage you from selling shares. They’ll tell you, “Don’t sell now, you’re foregoing tremendous upside.” Don’t listen to them. For every Facebook and Google there are hot tech IPO duds like: On Deck Capital, Coupons.com, GoPro, Fitbit, to name a few. Stick to your plan and do what makes you comfortable. We all have different goals and risk tolerances.
2. Set aside 3-6 months of living expenses for a rainy day fund.
If you don’t already have one established, use a portion of the proceeds from exercising and selling your stock options for a rainy day fund.
Life gets in the way. Having a rainy day fund affords you flexibility. Whether you decide to take time off, or perhaps are considering a career change, having this fund will give you the financial freedom not to have to take the first available job.
3. Don’t ask everyone in your network for advice.
Your accountant, colleagues on your team, wealth advisers, friends, family: Everyone you know will each have different suggestions based on their training, background, relationship with money and inherent biases. YOU know YOU best!
4. Find an accountant well versed in the taxation of stock options.
According to Walt Medling, a certified public accountant at Bay Area Tax Group, there are three kinds of taxes you should consider when exercising your incentive stock options: ordinary income tax, long-term capital gains tax, and the alternative minimum tax (AMT).
Long-term capital gains are preferable, but only attainable if stock is held for at least two years from grant date and one year from exercise date. And it’s important to be aware that income is often recognized for AMT purposes at the time you exercise options, long before you may be selling stock and putting cash in your pocket.
Proactive planning with an expert can significantly help with cash flow management, projecting future tax obligations, and maximizing your tax saving opportunities.
5. And finally, diversify.
When you exercise and eventually sell your incentive stock options, you’ll be presented with a new issue: what to do with the cash in your brokerage account. Not to worry. There are a number of options available to you, depending on your financial advisery needs. You can work with a robo-adviser, the most well-known to the millennial generation being Betterment and Wealthfront.
Robo-advisers provide a low-cost automated model investment portfolio of passive exchanged traded funds (ETFs) based on results obtained from their questionnaires. And if you happen to be investing more than $5,000, you may consider Schwab’s robo-advisery offering, Schwab Intelligent Portfolios, which charges no advisery fee, account services fee or commissions.
If, however, you decide that when it comes to your financial well-being, you’d prefer a relationship with a human financial adviser who can cover anything from stock options to budgeting to collaborating with your accountant, attorney, and more, be sure that the adviser you decide to work with is a fiduciary, and therefore legally required to put your best interests first.
Aaron Hattenbach, AIF® is the founder and managing member of Rapport Financial, a registered investment advisery firm headquartered in San Francisco, CA. Rapport Financial specializes in advising technology professionals at public and private companies with stock based compensation.
SEE ALSO: A founder-turned-venture-capitalist reveals how to not get trampled by a unicorn startup if you’re an employee with stock options
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