My company is public, how can I maximize my restricted stock units, stock options and ESPP?

Cristina here! Recently, many of our clients who work in tech have become curious about how to maximize their stock compensation. As a financial life designer, I know that owning stock in a successful company is a great way to build significant wealth. As a student of behavioral finance, I also know that we as human beings aren’t the best in staying invested in company stocks for the long term. In a previous post, we discussed the different types of stock compensation. So, depending on what type of stock you have, how can you make the most informed decision on when to cash out?

In this blog post we’ll talk about the mistakes individuals make around the three most common forms of stock compensation for publicly traded companies:

• Restricted Stock Units (RSUs)

• Employee Stock Purchase Plans (ESPPs)

• Stock Options (ISOs/NSOs)

Next, we’ll talk through how we help our clients cultivate awareness around these mistakes. Finally, we'll discuss how to avoid making them in the first place. Feel free to scroll down to the section headings that pertain to your specific situation.

RESTRICTED STOCK UNITS (aka RSUs)

As we’ve mentioned on this blog before, Restricted Stock Units - both time-based and performance-based - are the most common form of stock compensation across the technology industry today. If you're granted RSUs, you get to own them without putting any money down (unlike when you are exercising options). Think of RSUs as a cash bonus, with similar tax implications.

If your company is already public, we recommend cashing out your RSUs as soon as they vest. Once cashed out, these excess funds can be re-invested to fund your near or mid-term goals like paying off your high-interest debt, funding your emergency fund, or growing in your “Freedom Fund” or a diversified investment portfolio until you’re ready to retire early or start your own company.

Although there is no tax advantage in holding onto your RSUs after they vest, a common mistake employees of public companies make is neglecting to cash out their vested stock. The reason? For some, it’s inertia. You know, ‘an object that is in motion stays in motion’...well, the opposite is also true. In behavioral economics this is known as the status quo bias. As Nobel Prize-winning Behavioral Economist Richard Thaler put in his book Nudge: Improving Decisions About Health, Wealth, and Happiness, “People have a strong tendency to go with the status quo or the default option.” But think about it: if you were paid a cash bonus at the end of the year, would you turn around and invest 100% of it into any company’s stock, let alone your company’s stock? For most of us, the answer would be “no!”  - but that’s exactly what you’re doing if you keep those RSUs invested. By investing the proceeds of your RSUs to meet your goals, the compensation you worked so hard for transforms. What once seemed intangible becomes a windfall of energy to reach your goals much faster.

EMPLOYEE STOCK PURCHASE PLANS

An Employee Stock Purchase Plan, known as an ESPP, is an employee benefit program within public companies that allows you to buy company stock at a discounted rate (up to 15%). In most plans you may contribute up to the lower of 15% of your salary (pre tax or after tax depending on the company) or $25,000 each year. Companies will offer discounted stock to their employees through payroll deductions during a 12 or 18-month offering period split into two or three different six month purchasing periods. By participating in your company’s ESPP you’re getting a discount on buying your company’s stock. For most company ESPP plans, you are able to get a discount on the lower of two valuations - the price at the beginning of the 6 month period or the price at the end of the 6 month period. As an example, let’s say your company’s stock is $15 at the beginning of the 6-month purchasing period and $20 at the end of the period. You would be able to buy the stock at $12.75 (85% of $15). Your discounted price is known as the offer or grant price and $2.25 ($15 - $12.75) is your bargain element, even though the stock was worth $20 when you received it.

Is your ESPP qualified or non-qualified? Among companies today, qualified plans are the most common. An easy way to figure out if your plan is a qualified plan is to check your ESPP plan documents. If you have a “Section 423 ESPP” then your ESPP does qualify under the US Tax Code and it means:

• You can purchase company stock at a discount.

• You can postpone recognition of tax on the discount you received until the shares are sold.

• Further tax benefits may be available based on how long the shares are held.

A non-qualified ESPP does not offer the employee-related tax advantages described above. Unlike a qualified plan, applicable taxes on non-qualified ESPP shares are due at purchase. Nonqualified plans are not subject to the rules that pertain to qualified plans, but there is no tax advantage of any kind in these plans.

A common mistake people who participate in ESPPs make is not understanding the impact selling the shares they’ve acquired from their ESPPs will have on their tax bill. Here are a few examples:

If you sell your shares as soon as you’ve purchased them:

You’ll pay ordinary income on the discount you receive, also known as the bargain element. Because you’d be selling the shares before they have any time to gain or lose value, there likely won’t be any additional tax you’ll have to pay.

If you sell your shares within the year you’ve purchased the shares or within two years of the beginning of the offering period:

You’ll pay ordinary income on the discount plus short term capital gains (the equivalent of your ordinary income tax rate) on any growth in the stock. If your company stock has done nothing but go up in value, this is the worst possible scenario.

If you hold your shares for more than a year after the purchase date AND more than two years after the beginning of the offering period:

Again you’ll pay ordinary income on the discount received, then any profit above the gain from the discount will be taxed at long term capital gains rates.

If you’re part of an ESPP plan, we recommend contributing an amount that makes sense for your monthly budget - remember that your participation in the ESPP means your take home pay will be reduced because money to buy the company stock is taken from your paycheck before it hits your bank account.

If there is an immediate need for cash to fund a big life goal the year you’ll purchase the stock - like a wedding, a down payment on a house, or a big tax bill, the stock from your ESPP is a good resource to tap. To get this strategy right, you have to liquidate the stock immediately following the date of purchase. On the other hand, if there is no immediate need for cash in the year of purchase, you’re better off staying invested until you reach the 1 year anniversary after the purchase date and two years after the beginning of the offering period because you’ll owe less in taxes (see example three above). Once the anniversary dates are reached, evaluate if your company stock makes up more than 5% of your net worth. If it is, then it’s time to sell the stock, pay the taxes on the sale, and re-invest the cash into a diversified low-cost investment portfolio that is earmarked to fund your longer term objectives (any goal 5+ years out).

STOCK OPTIONS (ISOs/NSOs)

Stock options at their most basic form give you, the recipient of the stock option, a right but not an obligation to buy your company’s stock at a certain price (strike price) before a certain date. All of this is detailed in your grant document. If you decide to buy the stock, it is referred to as ‘exercising the option’. An option could be worth something...or nothing. It depends on your strike price, the current stock price, the ability to sell the stock and the tax implications for holding or selling the stock - all of which is quite complicated!

When it comes to options, many make the common mistake of spending too much time forecasting the possible future price of their soaring company stock (ie. letting fear and greed take over) instead of focusing their efforts on what they can control. In behavioral finance the tendency to focus on the potential upside - but not the downside - is called the hot hand fallacy .

So what’s in your control when it comes to the options you hold?

First, know what type of options you hold. Are they Incentive (ISOs) or Non-Qualified (NQSOs/NSOs)? Although they might sound similar, each type of option is taxed differently. For example, if you exercise an ISO and do not sell the stock, it does not impact your taxable income, but it increases your alternative minimum tax income, so you will owe alternative minimum tax (and this can be significant!!). If you’ve received more than $100,000 in ISOs in a given year, the remaining portion of your options will be treated like NSOs. There’s a lot more to know about the differences between ISOs and NSOs, so the first step is to understand how much you have of each option.

Second, arm yourself with knowledge about your company. You may know a whole lot about your team or business unit, but have you taken the time to understand the fundamentals of your company at large? If you didn’t work for this company, would you still be confident that investing a large amount of your net worth would be a good move?

Third, get educated by reading your grant documents. Yes, grant document are created by lawyers who seem to exist to make things confusing, but knowing things like the rights you have as a shareholder after you purchase the stock or the amount of the company you will own if you exercise your options (as an example, Amazon has half a billion shares of stock outstanding!) can bring more context to your decision.

Finally, figure out how much of your current cash are you willing to dedicate for the chance of greater upside. Even though it might seem like a no-brainer to exercise every option you were granted, we recommend our clients spend no more than 10% of their net worth exercising. After you’ve exercised your options, you’ll now own stock that will be invested...for awhile. While it stays invested, life will still go on - emergency expenses will come up or you may need cash for a big purchase, like a house.

Stock compensation, if executed well, has the potential to be life-changing. With the correct strategy, you could buy a house, take an extended sabbatical or invest it for the day you’re ready to start your own company. Staying aware of the mistakes people make can increase your mindfulness around these complex decisions and will help you navigate the best path forward.