Understanding Your Employee Stock Options

Maybe your employer offers stock options, or maybe you just aspire to a job that has them. If you plan on tangling with employee stock options in hopes of living like the next Google stock option millionaire, there are some basics you need to know. Let's start with what an employee stock option actually is. Employee stock options (ESO's) give you the right to buy stock in the company you work for at a price that your employer has set in advance. Notice that this does not mean you're given the stock for free! If you are deciding whether and when to buy those shares, start with these tips:

First, find your Stock Option Plan Agreement.

This is the contract between you and your employer that lays out all of the terms for when, where and how you can exercise your options and sell your stock. If you are looking at your agreement and find that what you've got is Restricted Stock, stop here. Restricted Stock Units (RSU's) are an increasingly popular alternative to the old stock options, but they are a completely different beast and will get their own post. If you do have a Stock Option Plan, then...

Look for the vesting period.

When an employee chooses to buy the stock offered by an ESO, we say she is "exercising her stock options." She can only do this, though, after the options have "vested." For most ESO plans, that is going to be 1-3 years after you get the options, and many plans set their options to vest gradually. For instance, 25% of your options might vest one year, the next 25% a year later, and so on. During the vesting period, the stock options are nothing more than a potential benefit of working for your company.

Make a note of the exercise price.

The exercise price is how much you would have to pay to buy the stock. The idea here is that your company is growing more valuable over time. So if shares are worth $10 a piece now, they might be worth $13 next year, $16 to following year, and so on. That price that you can get on the market for your stocks is known as the "strike price." So, in this example, if the exercise price that you paid your employer for the stock was $10 and you can now sell them in the open market for $16, you've made $3 per share. Great! Of course, the other possibility here is that your company's stock price goes down after you've bought your shares. And that's why you need to look further.

When do your options expire?

Your Option Agreement will have a time after which those options are...no longer an option. If you don't exercise them before that date, they just go away as if they'd never existed. Until that date, though, you can keep an eye on the company's stock price and keep considering whether exercising your options makes sense.

Where will you get the cash to buy your new shares?

If you are looking at options that let you buy company shares at a discount, you probably want to exercise those options, but you still need to figure out how you are going to pay for it. The simple answer is to come up with cash from your savings. Because that doesn't always sound appealing, a common arrangement is to buy on margin—meaning that you or your employer has arranged to borrow money from the brokerage house to buy the shares. The broker will take their money back when you sell your stocks. But be aware of the risks of margin trading if you plan to hold on to the stocks for a while.

Figure in the taxes.

As you've noticed, stock options don't count for anything unless you exercise them. But if you do exercise them, you have just received a form of payment from your employer. And that means paying taxes. The year in which you exercise the stocks, you will have to pay income tax on the value of those stocks (even if you don't sell them right away). We usually check with a client's accountant before giving advice on stock options just for this reason—if you are considering exercising your stock options, preparing for the extra taxes is crucial.

Know what kind of ESO you have.

Employee stock options come in three flavors. A Non-statutory ESO is the standard, and they are pretty much as I've described above. But there are twists with the other two ESO types. A "Reload ESO" just keeps shoveling more stock options into your basket as you use up the old ones. So if you exercised 25% of your options this year, the company will replace those with new options. For these new ones, though, your exercise price will be reset to this year's market value.

But your ESO may actually be an ISO, an Incentive Stock Option plan. These are designed to keep you out of trouble with taxes. And to do that they force you to hold on to your stock for a year between the time you exercise the options and sell the stock. With these you pay capital gains tax, a much lower rate than you standard income taxes. There is a downside, though—you run the risk of buying stocks only to watch their value drop during the year you have to hold them. That scenario is always disappointing, but it can be a big problem if you borrowed to cash to exercise your options.

 So, should I exercise my options? And when should I sell them?

Assuming your options worked as hoped and are worth some money, the question of whether to exercise stock options almost always comes down to taxes. Don't ever exercise a stock option until you have a good estimate of how it will affect your tax bill and whether the "hit" will be worth it.

Where most people get frustrated is in the question of how long to hold their company's stock once they have it. This, too, might be a tax question. If you have held on to your shares for a while, you will pay a capital gains tax on the amount your shares have gone up in the meantime (over and above any tax you paid on that initial exercise price).

But the bigger issue here is whether continuing to hold your employer's stock is keeping you from putting that money in investments that are better suited to your plans and sense of risk. Think of it this way: if you did not already own company stock, and I offered to sell you the same amount of shares in your company or in something else (another company, an index fund, bonds, etc...) which would you choose? If the answer is something other than your employer's stock, it's probably time to sell up.

Think Like An Investor

I came up with this post after meeting with a favorite client today. She's a charming and intelligent woman with a good career and a 401k who, until recently, had never thought of herself as an investor. Investments were complicated things designed for wealthy people. And then she realized that she wanted to buy a home. Part of our problem with the term "investor" is that too many of us picture this when we hear it:

There is some kind of vague understanding out there that "real" investors have special access to a supply of financial jargon, legal tricks and overpriced cuff links that somehow make sense of those relentless scrolling stock prices on CNN. And let's face it, throwing in tax references (tax-deferred, capital gains, tax efficiency) isn't helping. It's enough to make any reasonable person throw her hands up. And it's no surprise that so many of us, even when we actually have investments, don't think of ourselves as investors.

Watching the determination with which my client approached her goal of homeownership really brought home what we are doing wrong when it comes to investing. Buying a home is a form of investing, but where talk of 401k's and index funds makes people feel overwhelmed and anxious, talk of mortgage calculations and down payments has a completely different effect. People who feel empowered as they approach home ownership. And that's important. Because while I am the first to point out that homeownership isn't a good investment for everyone, the real estate industry has done something right by making clear that every buyer should feel like she belongs at that proverbial homeownership table just as much as any coiffed businessman in navy suit.

Since the great home building boom of the 1950's, Americans have understood that our economy depends on the willingness of  "average" middle-class people to buy homes. But we seem to have forgotten that our economy depends on those same people to hold up everything else, as well,—grocery chains, cars, professional services, restaurants, charities, and yes, stock markets. Because no matter how wealthy our wealthy class gets, they are never going to make, hold or spend enough money to sustain a modern economy (feel free to ask me why "trickle down theory" was a clever illusion).

All of this leaves us with a dilemma. Most of us believe that we are cut out to be investors in housing, even if we aren't quite ready, yet. And we believe (even if we have temporarily forgotten) that we, in fact, are the U.S. economy when we work and when we spend. But we don't seem to realize that we are also the "public" behind publicly traded corporations and the only reason that stock markets are worth tracking. The hard truth is that we depend on these markets to ensure that we have funds to live on after 65 and that we have the money to buy homes (or to help our children buy them). So how do we convince one another to demand a little more clarity around the retirement plans and investment accounts on which we depend? How do we claim our places at this other table?

Are You An Accredited Investor?

I considered calling this post "What The Heck Is An Accredited Investor?" But unless you are hanging out with stock brokers,  you probably don't even recognize the term. That's a problem, because the SEC's accredited investor rule often dictates what you are allowed to invest in and what sort of businesses can afford to ask you for an investment in the first place. The rule has kept our money flowing in certain directions since the aftermath of the Great Depression. And for the first time since then, we are seeing serious efforts made to change it. So what is it and why should it matter to you?

So, are you an accredited investor?

Accredited Investors are the holy grail of ambitious start-ups and private fund managers. If you fall in the Accredited Investor category, the SEC assumes that you can look after yourself (financially, anyway), so many of the careful protections they put in place to keep us all from being squirreled out of our money don't apply to the deals you can make. You would think, then, that you'd have to be very rich or very sophisticated to be an Accredited Investor. The fact is, though, that a lot of well-off but not necessarily "wealthy" people are starting to fall into this category. And it's hard to see where we get the idea that they are all that financially sophisticated.

There are two ways that someone usually qualifies as "accredited":  1. you have at least $1,000,000 in assets (not including your home), OR 2. you made at least $200,000 a year for the past two years and believe you will earn that much next year (the number is $300,000 if it's you and your spouse jointly).  (SEC Reg D, Rule 501).

That first category pulls in quite a few retirees whose pension funds grew over the decades or who inherited retirement funds or property from their own parents. Some of these folks are very sophisticated about money. Most of them probably are not. And while earning $200,000 a year is a great thing, that's not exactly rare or a sign of financial sophistication, either. Sophisticated or not, though, if you are an accredited investor, private businesses, start-ups, hedge funds and other sometimes murky investments are out there looking for you.

Does That Mean I Can Invest In the Next Tech Start-up?

Why, yes it does—maybe. Your Accredited Investor status matters because it means companies can ask you to invest even if they haven't gone through the paperwork and review process that the SEC usually requires in order to sell an investment to the general public.  This can be a very good thing. With SEC public investment filings costing hundreds of thousands of dollars, smaller but equally worthy companies often just can't afford to the process. Limiting themselves to accredited investors means that they still have to follow some basic laws related to what they tell you (and don't tell you), but they don't have to come up with the independent audits and elaborately detailed paperwork. Note, though, that this also means they don't have to make all of that information public for inspection. In other words, it's up to you to make sure you ask the right questions.

What Should I Ask?

You should always ask questions about any investment before handing over your money. But if you are thinking of investing in an unregistered investment as an accredited investor, it's up to you to avoid the Ponzi schemes and the half-baked business plans. You need to ask some extra questions:

1. Who is selling you this thing? Make sure you research the person or company selling you the investment. That might be the company you are investing in, but it might also be an advisor, a hedge fund manager or a broker. Every day the SEC brings charges against people selling fake investments or giving misleading information to investors. Not everyone is caught, but a lot of these names end up on publicly available databases. Start with FINRA's Broker Check site and the Investment Advisor Public Disclosure website to find out more about a broker or advisor;

2. How much will I be charged? A start-up probably won't charge you for giving them money, but a hedge fund definitely will. Be sure you understand any fees you are paying to buy the investment (keep in mind that there might be two layers of fees if there is a broker and a fund involved);

3. How long do I have to leave my money with you? Ask whether your money will be locked in for a period and under what conditions you could sell the investment to get out. Hedge funds almost always require you to leave your money in for a period of time to ensure the manager can follow her long-term strategy. If you invest in a start-up or private business, the only way out will be if someone wants to buy your stake—never a certain event!;

4. How will it make money? Be sure you understand the plan for making money. An investment fund should have a clear, understandable strategy for bringing in returns. A business should be able to show you reasonable (and readable!) estimates for when and how it will make a profit. Make sure you figure in the fees and liabilities to this calculation in case your broker/founder/fund manager doesn't;

5. What can go wrong? If someone tells you there is no risk to an investment, walk away immediately—no such investments exist. Make sure you understand all of the ways your investment could lose value so you can decide how comfortable you are with that risk;

If, after you've asked those questions, you still don't understand something, get an expert. Don't let company representatives, brokers or even your own advisor gloss over the important facts about what you are buying. If the expert in front of you can not make these things clear, or if you are worried that he or she has a conflict of interest, bring in another expert review the materials. Ask an accountant, attorney or financial advisor who is not involved in the deal review the particulars.

For more questions that every investor should ask, check out the SEC's online investor guide.

What They Never Put In the Financial Marketing Materials

Lately, I have had a lot of questions from people who are feeling ready to do something with their finances. Sometimes it's a matter of making your way out of a difficult financial situation (recovering from illness or unemployment, finishing a degree, paying off a debt, etc...), but often it's just a sense that you've been just wandering along without any particular plan or purpose. Thanks to a flood of shiny ad campaigns from the big brokerage houses, people often think this boils down to opening a retirement account somewhere. Here is what I tell people to think about before you go shoving all your money into an IRA.

Retirement Accounts are Great...But Not If You Need Money Now

The reason personal finances is so hard is that it demands that we think near-term, mid-term and long-term pretty much all at once. Like any financial advisor, I love getting my clients on track for the post-65 years. But dreams of a cushy retirement are only moderately comforting if you unexpectedly have to replace your car next week. Worse yet, if you do have to reach into your retirement account for an emergency, you will probably pay a penalty 10% of your hard-saved earnings for the privilege of getting your money back. All of those well-advertised retirement accounts (401k, IRA, Roth, Pensions, etc...) are great vehicles for the long-term. And unless you have reached your 60's, they are pretty useless for dealing with life as it is right now. Put the retirement account on the list, but not at the top. Instead—start with your emergency fund.

Life is Poetry, Budgets Are Fiction: Why You Need An Emergency Fund

How many times has someone told you that all you need to do is create a budget and stick to it? The advice usually comes with an ugly but orderly spreadsheet and a sort of smug assurance that all you need to do is follow the numbers. But experienced advisors are usually happy to admit it—budgeting doesn't work. The reason of this is simple, really. You don't live in a spreadsheet.

It isn't just that people have emotions and stressors that flicker through their thinking, changing their decision-making moment by moment. We all know what it's like to leave the house with one plan for the day only to have chucked the whole thing out the window by lunchtime. The problem is that even if we stick to the plan, the world won't necessarily cooperate.

Budgets depend on the illusion that we can forecast the future, so they don't tend to leave room for broken tail lights and dry cleaner emergencies, much less emergency room visits and sudden layoffs. You can't control these things, and you can't plan for them, but you can create an emergency fund that will soften the blow. And this is the crucial part of thinking short-term—emergencies can happen next week or next month or even tomorrow. Make sure to start (but not necessarily finish) your emergency plan before you start on the long-term thinking.

Saving is Simple. Leaving the Money Alone? Not So Much

As every Top 10 Financial Tip list will tell you, you should auto-deposit part of your check every month into a savings account. But those lists often fail to mention what the savings is for. Creating an emergency fund and saving for a big purchase are very different things. In fact, you are almost always better off to use separate accounts for them. Let's call this second account the "Occasion Fund."  You use it to build up money for the big occasional spend (wedding, new place, the big birthday party...). Discount the need for these things at your own peril. Sure you can survive without them, but survival is not our goal here, and life demands some celebrations.

Unless you possess superhuman discipline, you will find yourself reaching for a just a little extra money from somewhere when they come up. It's better to have these moment in your plans. A word of caution, though—unless you are far wealthier than I, that fund won't cover every event you could turn into an occasion. This fund is all about mid-term thinking. Before spending out of this account look a little further into the future to decide which of the upcoming events in life most merit the spend.

Life Doesn't Work Step By Step

In the orderly world of planning, we want to tell you to do all these steps in order: first put aside 3-6 months expenses for the emergency fund, then start the long-term retirement planning, and then the occasion fund. But the truth is, this is rarely realistic. You do need to start putting money in for emergencies first. But it won't be long before that opportunity for a weekend away comes up. So, don't fight it. Split your automatic savings between the emergency account and the occasion account. Sure, it will take you a little longer to meet your goal in both accounts. But life, unlike financial plans, is about a lot more than the end goals.

And remember what I said about that Budget spreadsheet? I can't tell you when or why, but some day you are going to spend down one or both of those accounts. Stuff happens. Having charge of your finances means being knowing you have the know-how to build it all back up again.

Why Everyone Is Talking About Inflation

Well, not everyone, necessarily. But all of those chatty economists. And your grandma, of course ("Why is this store so expensive? You know, I used to be able to buy a loaf of bread for a nickel!"). But we are seeing signs that inflation is on the rise after years of a whole-lot-of-nothing. So what does it mean and why should you care?

Inflation, of course, is that phenomenon whereby the loaf of bread your grandmother could by for a nickel now costs $4.25. As economies grow, there is more money moving faster amongst more people. More dollar notes swirling around means they aren't as hard to come by, which means you have to give up more of them to get the same thing. If you are an average shopper, this doesn't sound great. I personally would love to go to the grocery store without wondering if my son will actually eat his inheritance. But really bad things happen if inflation goes too low. Consider this story from your great-grandmother's era—

Inflation in the U.S. has averaged about 3.32% over the years from 1914 to now. But in between there have been a few times when things went crazy. In June of 1920, the price of all sorts of products skyrocketed by 23.70%. That's like watching your neighbor by a car for $20,000 and four weeks later, having to pay $24,740 for the exact same car. It gets worse if you think about the fact that the CPI (Consumer Price Index) by which we generally measure inflation includes a lot more than cars—groceries, rent, medical costs, clothing, services and supplies are all in there getting ridiculously expensive all of a sudden.

It was a moment of spectacular political failure—the feds had slashed spending and raised interest rates to try to balance the budget, and everyone panicked. But what followed was equally bad. By June 1921, prices had dropped to the point where it became obvious that no one was buying anything. That month, the lowest inflation rate in U.S. history came in at -15.80%. Over the 18 months that the recession lasted the wholesale price of a lot what we buy fell by well over a third. Things were cheap because no one was buying. And the jobs disappeared as a result; unemployment went from a pretty normal 5.2% to a painful 11.7%. That's almost 12% of American who could work not being able to find a job.

All of this brings us to our current predicament. Our own Great Depression (after the 2008 crash—thank you, Wall Street) pretty much killed off inflation. The money just wasn't moving. And as much as we enjoy the lower prices, we've been counting on inflation to make a return (along with some more jobs, thank you).  Fortunately things are finally looking up. Inflation has gone from -2% this past April to .1% in June (total for the past 12 months). Still not impressive, but better than the goose egg we've been looking at since 2008. And speaking of eggs— they accounted for most of the inflation in food this summer (it was a tough spring for chickens). So you might do better to stick with that loaf of bread after all.