Equity Compensation: Big Opportunities, But Beware the Risks
We all like hearing that we’re good at our jobs. It’s nice when kudos from your employer come bundled with dollar signs, or when a company backs up the cash truck to entice you to join their team. At times, a company may value you so much that it offers you a piece of the pie in the form of equity compensation.
A small slice of equity compensation can give you a meaningful boost in your income. A bigger slice might offer a bigger—maybe even life-changing—financial windfall. Or not. Luck plays an important role. But it’s also important to manage your equity compensation by balancing its potential risks and rewards.
Taking time to understand the details of your equity stake and how it fits in with your overall financial plan can help you make the most of this added compensation. What’s more, doing so can help you steer clear of dangers such as concentration risk—the risk that too much of your wealth is tied up in a single stock.
Equity Compensation Basics
Equity compensation can come in lots of different forms. You might receive stock options, restricted stock units or the ability to participate in an employee stock purchase plan. The equity package you receive might come with a vesting schedule, which determines how quickly you’re able to take ownership of your shares. For companies, these vesting schedules accomplish an important goal: They help keep you around longer.
Each part of your equity compensation package—from vesting rules to the types of shares you might receive—comes with a slew of caveats and fine print that are important to understand. For instance, your stock options might come with an expiration date for exercising those shares. Miss that date and you may miss out on the opportunity to acquire company stock at a deep discount. (If the share price fails to rise to the occasion, with no discount available, you may intentionally let them expire unexercised.) There also are tax implications for your equity compensation: Understanding the ins and outs of your agreement can help you manage your tax burden and let you keep more of the equity you’ve worked so hard for.
In short, it makes sense to become familiar with the contours of your particular equity compensation offer. But fortunately, you don’t need to become an expert in its every nuance.
At Stordahl Capital Management, we commonly advise clients on the wealth-building possibilities of their executive compensation packages. This includes helping you make the most of the opportunities, integrating the package within your greater wealth goals, and collaborating with other resources available to you.
For example, your company’s HR department or benefits administrator likely can give you a lot of helpful details. Your accountant can weigh in on issues such as taxes, and a lawyer can help you decipher your agreement’s legal jargon and factor that equity compensation into your long-term estate plan.
Understanding the Risks of Equity Compensation
One downside of equity compensation is that it can tie up a large portion of your wealth in a single stock. This is known as concentration risk.
Not all risk is bad. In fact, a foundational part of investing is taking on risk in exchange for potentially higher returns. This is systemic risk—the risk inherent in the financial markets at large. However, concentration risk typically doesn’t reward you in the same way. Yes, there’s the long-shot potential for that single company to perform extraordinarily well and drive up the value of its stock. But unlike the systemic risks of investing in the stock market, concentration risk also means your wealth is tightly tied to one company’s performance—and if that performance is poor, it can spell trouble for you.
Every company faces a litany of idiosyncratic risks. For instance, a scandal might taint its brand or even plunge it into dire financial straits, or its business could be irreparably disrupted by an upstart competitor. If the company’s stock price falls, your concentrated portfolio will follow suit.
What’s more, relying on your employer for your income and long-term savings can put you in a precarious position. If your company performs poorly, you could end up on the losing end of a corporate reorganization. All of a sudden, a big component of your wealth is in freefall and your primary source of income has dried up.
Consider this example: In 2020, as a result of the pandemic, ridesharing company stock prices tended to lose value as ridership plummeted. Some of these companies laid off thousands of workers. Employees who also held equity compensation stood to lose not only their paychecks, but also a chunk of their potential personal wealth at the same time.
Finally, holding concentrated positions in stocks is speculative by nature, a de facto form of stock picking. The odds you’ll pick a stock that will outperform the broader market are low. In fact, it’s incredibly difficult for professionals to do, despite access to vast amounts of data. Consider that 60% of actively managed large-cap U.S. equity funds failed to beat the S&P 500 in 2023. There is an opportunity cost in remaining in a concentrated investment because it can keep you from sharing in the gains of a broader stock market rally.
“But” you may counter, “I know my own company, and I’m confident its future is bright.” This is a common reaction—and maybe a sign you’re falling into a common behavioral tendency known as familiarity bias. It can lead you to the false assumption that your own company is safer or more of a sure thing than other companies. The fact is, your familiarity may actually be keeping you from making a level-headed investment decision. Instead, lean on objective data and research rather than feelings to inform your investment decisions.
Solving Concentration Risk
You can minimize concentration risk through diversification, carefully divesting company shares and investing in broad market funds. Holding large swaths of the market helps smooth out the effects of volatility, maximize long-term returns and manage systemic risks while dampening unnecessary idiosyncratic risk.
If you work for a privately held company, selling your shares can be more tricky—and perhaps not possible. In that case, we can sit down with you to weigh your options for minimizing concentration risk. For example, that may mean building a larger emergency fund to give you more protection from the unexpected or exploring financial strategies to hedge your equity position.
If you want to discuss this or anything else that is on your mind, we offer a complimentary 15-minute call to discuss your concerns and share how we can help.
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