Equity Compensation Advisor

Did you know…….”Executives of public companies represent the largest segment of share holders with concentrated stock.”  By our definition, any one position that represents more than 20% of a portfolio is considered a concentrated position.

Why is this?  The number one reason executives of public companies hold concentrated stock is through the issuance of stock grants or options as part of their compensation; i.e. equity compensation.

Consequently, the factors behind why executives hold a concentrated position are psychological rather than fundamental.

The three most common psychological hold reasons are:

• loyalty to the company
•  future appreciation
•  tax avoidance

All risk, no reward?  In general, the financial markets reward investors for taking additional risk.  However, the markets provide no additional reward for risk that can be eliminated through diversification.  The reward normally will occur with a willingness to take on additional risk with a higher expected return.

Facts about volatility:  The volatility of the US stock market has historically been calculated at about .16’.  In other words, the market on average can be expected to drop 20% or more within a one year period.

The volatility of a large cap stock is somewhere between .25 and .5.  In other words, the drop in value of any large cap stock can be as much as 50% or more.  Furthermore, some large companies may have volatility between .4 and .8 and may see a drop of 80% or more within a one year period.

Expanding further on risk exposure, it should be understand that because of the high volatility of certain stocks, an executive whose wealth is tied to a single stock could easily be exposed to risk levels that are 4 to 8 times as high as a fully diversified stock portfolio.

For a more detailed discussion of concentrated risk see my white paper in our “Resource section” on our website http://www.executivecapitalmn.com/resources_and_events/white_papers.asp

Dan’s Moral:  Executives with a high concentration of company stock are exposed to additional risk without being compensated.

• Please be sure to Subscribe to be automatically notified of  future published blogs
•  Coming Soon:  Individual Case Study examples will be featured
  

For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

Simply stated, there are two components that make up the value of a stock option.  In order to better understand the value of stock options we need to become familiar with these two components referred to as the intrinsic value and the time value.
Breaking it down to the next level, we  define the intrinsic value as the difference between the current stock price and the exercise price.

For example:   Let’s examine the event of 5,000 stock options issued at $25 per share.  At the time of exercise, the  current price of the stock is $40 per share, thus, putting the intrinsic value at $75,000 (($40-$25) X5000).  This factor is often referred to as the bargain element.
Progressing along to the time value of the option, we can represent that the time value is the value based on the potential increase in the stock, between now and the expiration of the option.  Keep in mind that in general, most options have a life of 10 years.  The longer the option has until expiration the greater the time value.   Furthermore,  the time value will continue to diminish over time and at expiration the time value becomes zero.
When we tie it all in together, it is  important to remember that the time value of an option can vary drastically depending on the expiration, as well as the volatility.
Dan’s Moral:  The value of stock options can be worth more than the intrinsic value.  Be careful not to be discouraged by the current cash-in-value (intrinsic value) of your options as the overall value when including the time value may be much higher.

• Please be sure to Subscribe to be automatically notified of  future published blogs
•  Coming Soon:  Individual Case Study examples will be featured
  

For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

Taxation of Incentive Stock Options – ISO’s
In this, my fifth and final submission to the blog series on the taxation of different equity awards, we examine the “Taxation of Incentive Stock Options” or ISO’s, the benefits and tax implications.

Tax Benefits:  Holders of ISO’s are eligible for certain potential tax benefits that are not available in the previously discussed equity awards.  The main tax benefit of ISO’s is the ability to convert compensation income into long-term capital gain.   In order to qualify for the long- term capital gain rate, the option holder must hold the stock for a specified period of time after exercise.

There are four tax benefits of ISO’s over other equity awards:

1.  At the time of exercise, the option holder does not report any income for regular tax purposes.
2.  If the option holder holds the shares long enough to avoid a “disqualifying disposition” (for future blog discussion) the bargain element (gain) will be taxed as long-term capital gain.
3. The bargain element from the exercise or profit from the sale is not subject to income tax withholding or Social Security tax.
4. If the shares are sold in a disqualifying disposition, they may still be able to limit the amount of income reported to the actual profit from the purchase and sale, versus a non qualified option that must report the actual gain at the time of exercise.  This applies regardless if the shares drop in value after the exercise.

So exactly what are the potential tax implications when ISO’s are exercised?  In most cases an option holder who exercises an ISO, and holds the shares beyond the end of the year of exercise, will be subject to AMT tax.

Dan’s Moral: ISO’s give the option holder the ability to convert the gain into long-term capital gains if the proper strategy is used.

• Please be sure to Subscribe to be automatically notified of  future published blogs, 
•  and Coming Soon:  Individual Case Study examples will be featured.
  

For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

Nonqualified Stock Options
As the series continues, Part 4:  Non-qualified Stock Options are explored as we compare similarities, differences, tax implications, and timing for exercising options.  See example below:

As mentioned in my previous blog, Non-qualified Stock Options (NQO’s) are similar to Stock Appreciation Rights (SAR’s).                                         

What are the differences?   The main difference is that SAR’s provide the holder with the right to receive cash and NQO’s provides the holder the opportunity to by a fixed number of shares at a price determined when the options were granted.

• In summary:   A NQO holder does not report income until they exercise the option.  At the time of exercise, the option holder must pay the exercise price (grant price) and is taxed (compensation income) on the difference between the exercise price and the current price.

Example:

• If the option holder exercised all the options they would report compensation income of $40,000 ($45-$25 X 2,000).
• If the holder is an employee of the company, the income from exercising the option will be subject to withholding and social security tax.

Dan’s Moral:  Because there is no cost or tax implication to the holder at the time the option is granted, options allow the holder to participate in the appreciation of the stock with no cost.

• Please be sure to subscribe to our blog to be automatically notified as the series continues on the “Tax Implications of the Five Types of Equity Compensation, Part 5″. 

For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and join Dan’s network on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC