A Holistic Approach to Managing Ones Equity Compensation

A Holistic Approach to Managing Equity Compensation 
Geoffrey M. Zimmerman, CFP®

Introduction

Equity Compensation Instruments (abbreviated in this article as ECIs) are a component of many corporate employees' total compensation.  Common forms of ECIs include Incentive and Non-Qualified Stock Options, Restricted Stock, Stock Appreciation Rights, and Performance-Based Stock Grants. The tax aspects of ECIs range from simple to complex, and the ECI landscape is constantly changing as tax regulations and corporate objectives evolve. 

Successful development of equity compensation strategies begin with a discussion of the role that ECIs will play in an ECI owner's financial life along with a conversation about the core values, beliefs, and activities that are meaningful to the holder.   The greater the value of the ECIs and the greater portion of the manager's personal wealth these represent, the more important this contextual conversation becomes.  While the structure of this conversation will generally be consistent across many client types, the components will vary in content and in importance, depending on the circumstances of the client.  For the purposes of this article, I will classify ECI holders into three broad categories:  Wealth Accumulator, Corporate Insider, and Financially Independent.  Note that these categories are not mutually exclusive. 

Planning Concerns for Wealth Accumulators:

Planning for the Wealth Accumulator usually involves qualifying and quantifying goals related to financial milestones and managing risk.  Common goals of the Wealth Accumulator are planning for retirement (or being wealthy enough to make work optional sooner than might otherwise be the case); funding college education, or the purchase of big-ticket items (e.g., vacation home).  For the Wealth Accumulator, the primary role of ECIs is to provide a greater share of the funding for these goals.  

With their incomes, net worth and often health benefits tied to the success of their company, Wealth Accumulators will benefit most from planning strategies that prioritize risk management, promote diversification, and generating cash flow as needed to fund goals.  Tax minimization should play an important but secondary goal for the Wealth Accumulator:  Many a fortune was lost during the bear markets of 2000-2002 and more recently in 2008 because of the misguided focus on tax results over profit maximization and risk protection.  Accumulators who implement strategies based primarily on tax optimization risk seeing their plan self-destruct at highly inopportune times, when the markets prove uncooperative.  It is far better to keep a small fortune (and pay some taxes) than to lose a large one (while possibly still having to pay some taxes).

Corporate Insiders face additional planning considerations because their actions are highly visible, and watched by regulators, shareholders, and employees.  Corporate Insiders are subject to trading windows - and may only sell (or arrange to sell) company stock during these periods.  When trading windows do open, significant sales of company securities by Corporate Insiders may be perceived by the markets as a negative outlook on the company.  There are often political pressures within the company to discourage selling.  Lastly, because of their intimate knowledge of the company and natural tendency to see things close to us more positively than might be deserved, the Corporate Insider may discount the risks involved in holding a concentrated position in the company stock.  Consequently, these additional factors increase the complexity of the decision framework for highly placed corporate executives.

Financially Independent executives are not faced with critical planning concerns regarding their ECIs, since by definition; these executives are not reliant on their ECIs to fund retirement or other accumulation goals.  However, maximizing and preserving the value of their grants is often still important; as such, a decision framework also needs to be put in place for these individuals.

Once the advisor and the client have discussed and have mutual understanding of the client's primary objectives and the role played by the client's ECIs, the focus can turn toward identifying and quantifying specific goals and developing specific actions to support the objectives

Using Equity Compensation to Fund Accumulation Goals

For all but the Financially Independent, planning strategies for ECIs initially begins with the larger plan first, a.k.a. traditional financial planning using a lifetime cash flow analysis.  This involves discussion around elements related to lifestyle and goals.  A client describes their ideal vision of the life they want to lead and the financial milestones they would like to attain through their lifetimes, and for the community and family legacies they may wish to leave.  From the vision, the goals may then be quantified in time-bound, dollar-denominated terms.  For example, a client accumulating assets to fund retirement should have a vision of what retirement looks like for them, and how that vision compares to their current lifestyle. By the end of the planning process, they should know at a minimum the answers to the following questions:

• When do I/we want to retire?


• How much will I/we spend and on what?


• How will I/we spend my/our time?


• How much capital do I need in today's dollars to fund my desired retirement lifestyle?


• What is the minimum rate of return needed to sustain retirement?


• By when do I need to have accumulated my retirement capital?


• To what extent can/should I take downside risk in my investment portfolio without jeopardizing my ability to retire (and stay retired)?

Once these questions are answered, the client and the advisor are better prepared to discuss the role played by the ECIs, and how they fit in with the client's goals.  These conversations will also necessarily include setting diversification targets, and identifying the need for and the timing of any cash flow from the ECIs.  These factors will then help guide the formation of a plan and decision framework for the ECIs.

In other words, decisions about the ECIs can only be optimized when they are seen as part of a total context for the client's current circumstances and what they hope to experience in the future.

Implementation

When the time comes to implement the plan, a basic decision flowchart becomes an important method to ensure shared understanding and of keeping the advisor and the client working in concert.

An ECI decision flowchart consists of one or more "if-then" statements that translate into specific actions.  These actions are based on metrics that are both quantifiable and easily monitored.  Actions may be based on the price of the underlying stock; be event or date driven, or formula based.  For example:

• Price-based action: An action (usually a sale or exercise of the options) triggered when the underlying stock price reaches a specific price target.


• Event/Date-based action: Time-based actions are triggered when a particular event or date occurs, such as a vesting event, the approach of an expiration date, or a needed purchase.


• Formula-based actions: An action triggered based on the ECI reaching some calculated milestone. Examples include option theoretical value; stock and option concentration measured as a percentage of the overall investment portfolio, or percentage of goal attainment. These formulas will be explained in detail in subsequent articles.

Actions tied to the above metrics can operate individually or in combination. For example if the value of the ECIs were sufficient to provide more than enough after-tax wealth to meet the holder's financial goals, a combination strategy might involve first capturing enough wealth to reach financial independence, and then attempting to maximize the value of the remaining ECIs.

In addition, implementation plans based on quantitative data like price, event, or formula metrics need to be monitored regularly to facilitate timely decisions.  Software applications such as https://www.stockopter.com that deliver email alerts to both advisors and clients provide an efficient means to help ensure that action is taken when needed. 

A final word for the corporate insider:  The use of a price-based decision flowchart is particularly useful for Corporate Insiders who are subject to trading windows and other restrictions.  Once established, price-based ECI strategies can be implemented using a 10b5-1 trading plan, which establishes a specific exercise and sell strategy based on pre-established trigger points.  10b5-1 trading plans are put into place during an open trading window, and typically run for a fixed period (e.g., 2 years).  Once established, a 10b5-1 trading plan can execute during blackout periods or during closed trading windows.  In addition to supporting the Corporate Insider's financial plan, 10b5-1 trading plans can help avoid the risk of an ECI (e.g., a stock option) expiring in-the-money, yet unexercisable due to a closed trading window.

Summary

In summary, advisors specializing in the area of Equity Compensation can best help their clients though the following:

• Understand that money and wealth are not the end game; they are means to an end. It is important to first understand the motivations of clients, and the role their wealth plays in the overall scheme of their lives.


• Once the motivations are understood, goals should be identified and quantified to determine how the ECIs can help fund the client's accumulation goals.


• Establish an ECI decision flowchart for the client based on their goals using quantifiable price, event/date and formula metrics that can be easily monitored.


• Implement the plan by monitoring the client's decision triggers on a regular basis and taking action when thresholds are met. Corporate insiders should be encouraged to use 10b5-1 trading plans to automatically take action during blackout periods.


• Periodically review the plan, making adjustments that reflect changes occurring with the client's goals and circumstances, and as external factors warrant (e.g., tax laws, market movements, etc).

Geoffrey Zimmerman is a Certified Financial Planner and Senior Client Advisor with Mosaic Financial Partners Inc. (www.mosaicfp.com)   He may be contacted at 415-788-1952 or by e-mail at:  geoff@mosaicfp.com