Equity as a form of employee compensation is becoming more and more common, and not just in the tech industry. However, many employees have a hard time understanding the value of that compensation and how that should fit within their financial plans. When they finally have an opportunity to cash out, they may not know what to do with the proceeds, they may find that the amount they will take home is much less than they expected, and run the risk of making investment mistakes. Here are some principles to help you decide how to allocate the proceeds from selling your equity shares. While we don’t discuss option strategies here, knowing what to do with the proceedings is important in helping you decide when and if to exercise your options or sell your shares.
The economics of cashing out
The first thing to realize is that the proceeds from cashing out are NOT a windfall. Cashing out does not create new wealth for you. Only the form of your wealth changes. Let’s assume you own stock options in a private company and can obtain about $100K in net proceeds through a tender offer. The value of the options is $100K whether you tender them or not. The difference is how your wealth is invested. If you don’t cash out, you have an investment in a small company that may go public, which is a high-risk and hard-to-sell (illiquid) investment with a potentially high return. If you tender some or all of your options you are converting some or all your investment to cash, which is a much safer investment.
So what to do with the proceeds is really an investment allocation question, and as such, it should depend on the composition of your wealth and on your goals.
Know how much you will take home
If you are thinking about cashing out, the first thing you want to do is figure out what your net proceeds are going to be. For example, if you own 2,000 incentive stock options (ISOs) and you receive a tender offer of $65 per share, your options aren’t worth $130K. First, you have to exercise the options, the cost of which will depend on the exercise price of the options. If the exercise price is $5, your gross proceeds (the so-called bargain element) will be $120,000. Next, the proceeds are considered ordinary income and will be taxed as such (in this case the tender offer is considered a disqualifying disposition of the shares for the ISOs). So consider your likely marginal tax rate, plus Medicare (1.45%) and Social Security (if you haven’t met your max of $8,537.40 for 2020). Your employer will withhold some federal income taxes, but be prepared to possibly use some of the proceeds to meet your actual tax. In general, the taxation of your proceeds will depend on the type of option and the exercise strategy you use. Take a look here for a number of different cases.
Refocus your allocation towards your goals
Equity compensation can be a large fraction of total wealth and net worth (the difference between what you own and what you owe) of many employees, especially if they just are starting out in their career. If that’s your case, your investments are too concentrated and you are probably taking too much risk. Having part of your wealth tied up in hard to trade shares or options may also mean you have more debt than you might like, like credit cards, student loans or a mortgage. Other goals, like a safety net or saving for a down payment on your dream home or retirement may be taking a backseat.
Cashing out gives you a chance to correct your asset allocation and sync up your savings with your goals. Here are some suggestions:
Fund a safety net
A safety net is a key component of a sound investment plan, so if you have been struggling to fund one, this is probably where you should start. The safety net is particularly important if much of your wealth is tied up to one company. You can’t think of your equity comp as your safety net. The investment allocation for this goal should be very conservative.
Pay down high interest debt
You may have credit card debt that you have been slowly paying off. Now is your chance to pay it all off and start putting that effort into saving for other goals, like retirement or a future purchase. Interest rates on credit cards average 16%, so you will be getting a sure 16% return on your investment by paying off credit card debt.
Max out your retirement contributions
If you have a 401(k) plan at work and you are not already doing it, consider maxing your annual contribution of $19,500 plus an additional $6,500 if you are over 50. This will help you reduce your tax liability by the amount of your marginal tax rate. If you are already contributing to the max, consider making a nondeductible contribution to your IRA or an after-tax contribution to your 401(k) plan if the plan allows it.
Save for a down payment on a house
If you have been trying to save for a down payment on a house, consider funding that goal with your proceeds. After you have built a safety net and paid off your credit card debt, it may make sense to fund a down payment goal with some of the proceeds. Set a goal, fund some of it today, and use some of the savings capacity you freed up by paying off debt to develop a saving habit towards something you care about, like your dream home.
Leave some for general investing
It may be a good idea to keep some of the proceeds invested in a general investment bucket to help you with other potential goals and needs, including cash needed for future option exercise strategies. Having a nest-egg for future goals gives you flexibility and financial independence to pursue goals you may not have yet considered.
Paying off student loans?
If you have student loans with a reasonably low rate and have a repayment strategy that is working out given your cash flows, you may want to continue doing that and use the proceeds to fund other long term goals, including the general investing goal we discussed above. Having a general investing fund gives you the option to pay off the loan later (for example, if returns are better than expected), while paying off the loan today may mean you have to work over time to build other goals. If the rate is high though, consider refinancing or paying off at least part of it.
These are just a few ideas. As in most financial planning questions, there is no signle right-way to make use of your proceeds. It all depends on your goals and financial situation. That’s why we started there.If you’d like more help in getting started with a financial plan, take a look at our simple process.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
