How to Build your Employer Stock Participation Scheme into your Financial Plan

Equity participation schemes and stock-based income, once the preserve of senior executives and startup founders, are becoming ever more common for employees right throughout the corporate hierarchy.

We guide many clients that have the opportunity to include employer equity schemes in their remuneration. They often seek advice from us on how or whether they should participate. Some of the questions we receive are:

• Should they be contributing more salary to buy into their company’s success?

• Should they buy shares or options?

• How does it relate to shorter term needs such as cash flow?

• How does an employer equity scheme relate to their long-term goals?

• What are the risks?

• How does it fit in with the rest of their financial plan?

Interesting

Employer share schemes have many names and structures. ESOPs, RSUs, EPPs or any number of other in-house terms all describe schemes that allow staff to receive part of their compensation in the form of stock or stock options issued by their employer.

To clarify the basics and explain the jargon: what is the difference between equity, stocks, shares and options?

Equity, stocks, and shares are all interchangeable. They are different terms that mean the same thing. It means when you own a small piece of a company. In some countries this is called a share, as in your own x shares in a company. In other countries they use the work stock instead. The term equity simply describes what it is, as you own a portion of an organisation, you have equity in it.

If your employer has a share/stock/equity scheme, if you participate you will own some shares in that company. There may be some conditions around this which we will expand on below.

Options are a bit more complicated. In financial jargon speak options are called a derivative. If you receive options, you are given the right, but not the obligation (this is important) to buy a certain number of shares in that company, at a date in the future, at an agreed price. Without getting too technical, the option itself has a value however employer schemes often do not allow the sale of options themselves.

We will explain how options work with an example: you are offered 100 options. These might cost you 10 cents each. Each option grants you the right to purchase 1 share in two years’ time, at the price the shares are at today, in this example, €10. Jump forward to two years in the future.

If the company shares are trading for less than €10, you won’t ‘exercise’ your options to buy the shares for €10 as you can purchase them in the market for less than that. In this case you would let your options expire. This comes back to that point above that options give you the right but not the obligation. You can reject them.

If however, in two years’ time the shares are worth more than €10, it is worth exercising the options. Because you can buy the shares for €10 and sell them at the market price which is more than that.

This is how options work.

However, an employer equity scheme is dressed up or whatever the acronym used to describe it, the basic principles remain the same. Instead of cash, a staff member can receive an equivalent value of equity, sometimes at a discount as a portion of their salary or bonus. If you are working for a company that pays good dividends to shareholders or has strong growth prospects for the future, this can seem like an attractive proposal. It is important to be mindful that not all schemes are created equal and the terms of these plans vary hugely between companies, so how should you decide whether (and how much) to participate in a share/save scheme?

Every policy will have rules regarding strike prices or uplift (the equivalency between how much cash you sacrifice and the value of stock you are given in return), vesting dates (how long you have to hold the stock or option before you can sell it) and execution (how much you can sell at one time and when you can make the sale). Knowing and understanding these terms is vital for your financial well-being.

Investing

Firstly, you need to understand the terms of your agreement with your employer. The strike price of a stock option or restricted stock unit (RSU) is essentially the price that you are deemed to have paid to buy it. Some companies will incentivise staff to participate in the scheme by offering a discounted strike price (eg. 50% of the market value at issue) or an uplift (eg. for every 2 units purchased, one additional unit will be awarded). Stock options will normally be awarded at a discount, but then you can either exercise the option to buy later on or let the option expire if there is no financial benefit to you as per the example above.

These sorts of inducements can be very attractive as they would mean an automatic increase in value, even if the stock price doesn’t go up by the time you sell your shares. However, you always need to bear in mind that gains are usually taxable. Depending on where you pay your taxes, there may be income tax, capital gains or even both applied to your stocks because they came from your employer. In some situations, tax will be payable on the value of the asset when it was awarded, in others you could be taxed on the value when you sell it. Otherwise, there may be one tax to pay on the value you originally received, and a different rate of tax applied to any growth in that value. Understanding these consequences could leave you better off or worse off when the taxman comes calling, so always speak with your accountant before committing to a stock participation scheme or exercising options.

Vesting

Vesting dates essentially refer to when you will be allowed to sell any stocks that you buy or earn from your employer. They are normally put in place to protect the issuer of the shares by preventing any spike in trading whenever employee shares are issued and encourage corporate loyalty among shareholding staff. It is quite common for stock options or RSUs to have a vesting period of 3-5 years.

You should always be aware of vesting periods and how that might affect your portfolio and your tax position. Assets that you are given now and can’t be sold for another 36 months could adjust your risk profile and the level of your diversification.

As you accumulate shares with your employer, you are gradually becoming more and more financially dependent on that one, single company. At the same time, unvested shares, stock options and some other forms of employer-awarded shares will have no voting rights and might only be tradeable through the company’s internal system.

Divesting

Once your shares or options are vested, they will either become certificated, meaning you can keep them in your accounts the same as any other stock holding, or tradeable, meaning that you can convert them to cash at the current value. At this point, it’s time for some objectivity.

If you are confident in the strength and performance of your company, and you feel that you and your colleagues can help maintain that success, you might want to hold on to some of your employer’s shares. This is no different from holding shares in any other business and should be part of a well-diversified portfolio.

The big danger here is what we call concentration risk. As you accumulate these stocks, without selling them, they will begin to represent an ever-larger proportion of your net worth. A good rule of thumb for any investor is to aim for no more than 10% of your wealth to be held in any one single asset. Whether it’s gold, shares in a particular company or equity in a property, if it makes up more than one in ten of the dollars or euros that you have saved, your financial well-being may be at risk from market pressures or damage to that particular holding.

Finally, think about how much influence your company has on your financial situation, and whether that is reflected by the level of influence that you have on the company’s performance. If half of your family’s wealth, half of the household income and additional insurances or pensions are all tied to the fortunes of that one business, you should be looking to sell and diversify some of that position to protect your goals. Speak to your financial advisor and accountant about and equity benefits you have with your work and find the most efficient way to incorporate them into your financial plan.