In a recent discussion in a Whatsapp group with sizable representation of members from IT, Banking and new-age startups, the pros and cons of owning company stock options came up and the topic generated huge interest. Approximately, 30% of the members in the group have significant investment tied to their company stock options and are not sure about how to get the best out of it.
Remember, all over the world, startups and technology companies have used stock options to compensate, motivate and reward employees. This helps employers get the best out of their employees and retain best talents. There are many published stories about employees getting rich with stock options but very few published stories of the stock options which became duds for the employees.
Here are a few pertinent questions and observations from the discussion for the benefit of the broader community.
1. If you are planning to work for a startup, should you opt for stock options and if yes how much stock options as part of the compensation is advisable?
The startup offers a considerable number of stock options to lure bright talents. Many times, the number of options offered are up for negotiations in lieu of the reduced salary. That helps an employer reduce their current cost and motivate employees to contribute to the collaborative effort to make the company successful.
If the companies do well and get bought by a biggie or successfully list in the market, the employee stands to gain substantially. But remember approximately 80% of the startups may not be successful. In that case, it becomes important for the employee to validate whether their startup falls in the top 20%. The employee needs to understand the differentiated offering of the company, business model, financial strength and the pedigree of the investors of the company. Since startups are privately held companies, many of these pieces of information are not available in the public domain and hence the employee needs to do his own due diligence. He needs to make sure that the company has an exit strategy (company’s sale, listing in the stock market) for stock options aligned to his timeline otherwise proceeds from the options will be muted.
Once upon a time, I was offered 5000 stock options of a startup at the strike price of 50 cents (USD 2500 investment) in lieu of the salary reduction by USD 10,000 / annum. Since I was not sure about the company’s performance in the future, I decided to forego the option. It so happened that the company got listed in the stock market and at its peak, it was trading at USD 93 per share. If all shares sold at that price, it would have fetched approximately half a million USD. In hindsight that was a risk worth taking.
2. I am in a publicly listed company and own a significant number of stock options. What shall I do?
There are a few basic checks which you need to apply to your investment in company stock options:
Emotional Risk – If you are working for a company for a long period, you may develop emotional connect and may like to hold onto all your vested stock options of the company. You need to be rational and ensure that the investment in the company’s stock options is aligned to your risk profile and is as per your asset allocation. That means you should let go your stock options if your financial plan demands that.
Lack of knowledge about Equity investment – Not all employees who receive stock options are well versed with the equity investments. Since the stocks options are performance incentive, it will keep accruing to you annually and may result in high exposure to the company’s stock. In that scenario, it is important that you quickly learn the nuances of the equity investment or take professional help or advice to get the optimal return from this investment. Please note that the status quo may result in significant loss of the associated wealth.
Concentration Risk – Your job and stock options are with the same company. If the company performs poorly, the stock price decreases, there will be pressure on the salary and there could be possible job losses. Since all these events are positively correlated hence diversification is a necessity and that means you should keep reducing the number of outstanding vested stock options and invest it elsewhere.
If your exposure to the company stock option is more than 5% – 10% of your equity portfolio then you should seriously consider rebalancing.
Historical Performance of the company – If your company’s stock has done well in the past that does not guarantee a better return in future. Being an insider there is always a tendency to favour holding own company stock as there is a belief that you know your company better than anybody else. But the truth is that you may not know all the factors which can influence your company’s stock price. Hence you should take an objective decision.
Opportunity cost of money – Understand that the value of your stocks option today is the money available with you. If you need to invest that money optimally, where and how you will invest. And accordingly, take decisions.
The stock options could be one of the significant triggers in building wealth for you hence you should play it right.
Till date, I have worked for 5 companies, two startups (privately held) which became public and 3 publicly listed companies and all of them offered stock options. I must say that the ownership of the stock options has been a welcome move in building wealth.
Remember, to be wealthy, you need to be lucky and to be lucky you have to take chances but always take calculated risks.
The writer is a SEBI Registered Adviser and Founder of FinMyn (https://finmyn.com). He provides Fee-Only Financial Planning and Investment Advisory services. If you want to know more about him, click on https://finmyn.com/about/.