A 7-point decision framework for equity comp

For employees with compensation tied to their company stock, questions like "Should I exercise?" "Should I sell?" "Should I hold?" can look simple. It's the financial advisor's job to canvas a range of considerations and decide which of them should drive decisions.

Tax is one variable, of course. But so is the size of the position, overall diversification, liquidity needs, personal goals, expectations around performance and restrictions imposed by the company or equity plan. 

A common mistake is letting one of those considerations — and it's usually tax — lead the charge. A tax hit is immediate, measurable and painful. People can calculate the bill created by an exercise or sale. By contrast, the cost of remaining concentrated is harder to grasp because it depends where the stock goes next.

As a result, an employee may avoid selling to sidestep a substantial capital gains bill, even if that leaves a large share of their wealth exposed to a single company. With options, that concentration can carry even greater risk because a decline in the stock can produce a much larger percentage decline in the value of the options.

READ MORE: How to use equity compensation to boost RIA valuation and more

7 ways to assess company stock

A better planning process starts by looking at seven related dynamics.

This framework gives advisors a methodology for assessing the employee's full picture, pinpointing what matters most and turning those priorities into guidance. 

1. Value: Start with what the equity is worth today and what it could be worth under different stock-price scenarios. If it has already created more wealth than the employee expected, the priority may be shifting from further gains to protecting what's already there.
2. Tax: Exercising or selling can create substantial tax liabilities. These costs should influence the timing and size of a transaction without dictating whether the action makes sense.
3. Concentration and risk: The more wealth tied to one company, the greater the potential damage from a sharp decline in its stock. This exposure should be assessed in the context of the employee's overall financial position.
4. Liquidity and cash flow: Exercising, taxes and near-term spending all require cash. The question is how much liquidity the employee needs — and whether selling company stock should provide it.
5. Personal goals: What is the equity ultimately meant to fund? Pinpointing retirement,  homebuying, education, philanthropy or another objective can help determine how much risk the employee is willing to keep.
6. Stock outlook: Confidence in the company matters, but that's only one consideration. An employee can remain bullish while concluding there's too much riding on one stock.
7. Corporate and plan considerations: Blackout periods, insider restrictions, holding requirements, exercise windows and other rules determine which strategies are actually available and when they can be used.
   

READ MORE: Between 2 concentrated-stock strategies, a clear winner

Fear of a taxable event

These considerations often create trade-offs. Reducing concentration may create a tax bill, while selling may also provide needed liquidity. An employee may remain confident in the company while deciding that protecting some of the wealth already created matters more than capturing every additional dollar of upside. 

Take an executive with roughly $7 million in employer stock and options, representing about 70% of his investable wealth. After significant tax surprises in the past, he's inclined to keep holding rather than trigger another taxable event.

Seen from the tax angle, the decision to hold makes sense. Look beyond taxes, however, and things get complicated. The position in question has already created far more wealth than the hypothetical executive expected. Analysis of different stock-price scenarios shows that a meaningful decline could erase a substantial portion of that wealth, with the option position potentially falling even more sharply in percentage terms. The executive also has significant short- and medium-term liquidity needs.

This doesn't mean sell everything. The information gives the advisor a basis for helping the executive determine how much risk to reduce, when to act, how much liquidity to create and how to manage the tax consequences.

In the hands of an experienced advisor, the framework helps move the employee from basic questions like "Should I sell?" and "How do I avoid a tax hit?" to an understanding of what to do, how much to do, when to do it and why to do it in the first place.