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Tim Kochis

Are Your Clients Losing Out on Stock Option Wealth Opportunities?

Here’s a common sense, strategic approach to deciding when to exercise and when to sell that relies on the unique skills of dispassionate advisers, like you.

November 14, 2011
by Tim Kochis, JD, CFP

Once the stuff of great envy and the maker of fortunes, stock options have fallen from the pinnacle of public awareness. After the dot-com burst, a few notorious abuses, the (over) reactions of public disdain, Congressional reform and some iconic companies, like Microsoft, abandoning stock options altogether, it’s time again for advisers to pay closer attention.

With large grants during the depths of the market declines, re-pricing of older grants and very substantial subsequent recoveries in stock values, maximizing stock option wealth and minimizing the taxes invoke the unique skills of qualified advisers. Since that growth in value has occurred despite frightening levels of stock market volatility that now seem to be the norm, more than ever, stock options require a strategic approach to building wealth.

Where to Start

The temptation is to forecast rates of growth in the general stock market or in the price of the specific option stock. While the future stock price obviously will determine what would have been the right thing to do, that future price is unknowable. So, assisting clients now to take a strategic approach to the exercise decision and the separate decision to sell the acquired stock, either immediately or eventually, should rely, instead, on what the stock price must be, at any available future point, to justify the array of exercise/sale decisions.

But even before getting to the arithmetic of various break-even calculations, the fundamental question is why the client exercises the option at all: to hold the stock for some time or to capture the available current wealth to diversify it or to spend it. Clients and many advisers sometimes get confused about how to manage the opportunity by losing track of why they are exercising. Keeping focused on the purpose, whether to hold back the stock or sell it, is key to optimizing the strategy.

Exercising to Hold

If the goal is to hold the stock, the fundamental strategy is to postpone the exercise until just before the expiration, achieving the long-range benefit of whatever the stock will produce while deferring the cost of acquisition (exercise price plus any immediate tax liability: regular income tax, employment taxes, alternate minimum tax (AMT)). Sometimes the desire to hold is based on long-range investment conviction, but occasionally only because the client is an executive of the company and has limited choice about selling for legal or for career purposes.

In any event, the deliberate delay strategy is often counter-intuitive and will strike many as seriously flawed: What about possibly higher tax rates in the future? What about capital gains treatment after holding for a year? What about dividends? What if I can never use my AMT credits? All good questions and all have a calculable future circumstances that might justify taking action early.

Calculations are what expert, dispassionate advisers do. The results, however, are usually that future tax rates won’t be high enough to justify early exercise, dividends are rarely big enough to compensate for the opportunity cost of exercise price and taxes and the benefits of capital gains treatment only apply if in fact the stock price increases by enough to pay for a year’s worth of opportunity cost. Make those calculations. Let the decision about going early or waiting (remember, the client intends to or is effectively forced to hold the stock anyway) be based on genuine conviction of what the future price will be.

Exercising to Sell

The other side of the strategic divide involves selling the acquired stock to use the proceeds for some spending goal or to reduce overall investment risk by diversifying. Well, then, when do you begin to focus on the opportunity? In all cases, this is subjective.

For diversification, the threshold arises when the client sees an option spread that the client would really hate to lose. Maybe it’s some absolute number: $50,000 or $100,000?; or maybe some relationship to base salary: 25 percent or 50 percent? In any event, the spur to action is neither trivial nor overwhelming. So, work with your client to agree on a number that is worth some careful attention once it arises, but until then, relax.

For purposes of spending, the threshold is easier to identify when the after-tax proceeds buys something important, such as a fancy new car, a second home, the kids’ college education or early retirement. Whatever adequately motivates the effort of exercising and currently selling and foregoing possible future gains.

Risk Differentials

Where the objective is to sell, calculations of required future prices can also be crucial. Continuing to let the option ride could produce even more proceeds to diversify or fund a nicer car or a better second home. What are the future stock prices necessary to justify waiting after the original target spread is already available? The adviser must select the appropriate compounding rate to arrive at those future price thresholds. For diversification, the choice should be the client’s opportunity investment rate. What could those diversified proceeds be expected to produce? Note that the leverage inherent in an option means that those required prices will always be less than that general opportunity rate. That inherent advantage needs to be balanced by the greater risk of the concentrated, undiversified position of the single stock. If you have actual volatility statistics for the optioned stock (usually found in the proxy statement), you can relate that to the observed volatility of some broad index, like the Standard’s & Poor Index (S&P 500), to highlight the differential in individual versus diversified stock risk. Remember, diversification is your client’s objective here; avoid being overly distracted by the mere possibility of future price gains.

Where the motivation for the sell strategy is spending, the compounding rate is not an investment rate, but instead a “utility rate”, idiosyncratic to the client and to the spending goal. These utility-based opportunity rates are usually very high and thus produce required future prices that seldom draw sufficient confidence. The client very rarely decides to postpone the currently available goal and possibly risk achieving it.

Conclusion

While it’s impossible to predict the future, it’s also impossible to avoid making some guesses about what the future might be. Make sure you don’t try the former and be sure to put careful parameters around the latter.

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Tim Kochis, JD, MBA, CFP has nearly 40 years of experience helping clients make the most of stock option wealth. He is the recipient of the Charles R. Schwab IMPACT Award and the P. Kemp Fain Award. Register today for the 2012 Advanced PFP Conference on January 16-18, 2012 in Las Vegas to hear Tim speak on this topic.

*The AICPA’s PFP Section provides information, tools, advocacy and guidance to CPAs who specialize in providing tax, retirement, estate, risk management and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter, apply to become a PFS Credential holder.  For more topics such as this, join us at the 2012 Advanced PFP Conference on January 16-18, 2012 in Las Vegas.