Equity Compensation Strategies: Everything You Need to Know With Derek Jess (EP.138)

0:28We all need to make smart decisions with our money. Jess, Senior Wealth Manager and Shareholder at PlanCorp, who has extensive experience and a really deep understanding of equity compensation planning. This is going to be the first of two consecutive episodes with Derek as we dive into the various aspects of equity and executive compensation plans and how to integrate them into comprehensive financial strategies. Derek has put together several fantastic graphics to accompany the conversation, and you can find those at thelongterminvestor.com. And while you're there, be sure to sign up for my newsletter that comes out every other Wednesday.

1:06Not only does that newsletter share a wealth of information, but it's also one of the easiest ways to get in touch with me. Simply reply to any of my newsletters and a message goes directly to my inbox. I absolutely love hearing from listeners and reply to every single message. And now without further ado, here is my conversation with Derek Jess.

1:31Derek Jess, welcome to The Long-Term Investor. Hey, Peter. Thanks for having me. Today, we're going to be talking about executive compensation plans. And I say executive with emphasis because it's tempting to just go equity compensation. It's really a hot topic, but there's a few things that I think fall into that bucket that truly is more executive compensation. And so Derek, we're going to dive right in so we can cover some of the basics of some executive compensation, and then get into the nitty gritty of how you and others at PlanCorp are integrating that with portfolios and into a financial plan.

2:06I was thinking that because we are intentionally calling this executive and not equity comp, maybe we could start just with deferred compensation plans. What are they and how do they work? Yeah, so this is something that maybe you don't have to be like a C-suite executive to have one of these, but just generally very highly compensated employees. It's the ability to defer far beyond limits with pre-tax dollars. You could say with an IRA or a 401k, either with a bonus, which is most common. Sometimes you can do it with salary, but it's really less of a compensation type and more of a way to get the most out of your compensation.

2:42So you would take a cash bonus or salary and then elect to put a certain amount in a deferred compensation plan to be paid out later instead of today. And the main reason to do that would be for tax planning purposes. They're similar to 401ks in some ways, but they're also really different too. And I'm sure we can get into those today. Yeah, that would be great. And just to continue on though, with some of just laying out some definitions and moving into equity compensation specifically, I think it's important just to say equity compensation is simply compensation awarded to an employee in the form of a company stock instead of cash.

3:17And so each award is known as a grant of company stock. The grant date is the date an equity compensation grant is issued by the employer to the employee. And the vesting date is the date in which the employee receives the full control or possession of that equity compensation grant. Derek, you do a lot of work on this type of thing with clients. And since I mentioned vesting dates, maybe you can go through the vesting schedule and the differences there. Yeah. So when you get an award, you get that grant, you don't have it right away. And so there's a few different ways that that can be structured.

3:49The two most common that I would see would be a time-based vesting schedule. That's either you get like a little bit over time, maybe that's each month or a quarter or year for a three to five year period, or it's called graded vesting, or there's cliff vesting where I get awarded my bonus in the form of whatever, we'll get into the different types of equity comp, but I get it all at once at the very end, So maybe I have to stay at the company for three years or five years before I actually receive any value from those. So that's called a cliff vesting schedule. Beyond that, there's a couple of other ones more common at the executive level.

4:26There could be a performance-based component as well, and this would usually be in tandem with time-based. So I still have to wait three years until I get it, and there has to be some sort of company metrics that are hit. Maybe that's tied to stock price or profitability. the formulas there can get very convoluted, but usually tied to the business overall in the stock price and maybe even to the specific performance of the individual. If that hits, those are typically would be like a multiplier effect or half of my grants are time-based and the other half of this particular grant I get if these performance-based metrics are hit too.

5:02And then something you'd only see in the private space would be something that's a liquidity event-based investing. So if If you're a private company that's looking to IPO soon or hoping to get acquired by a private equity firm or just a larger company, none of what I get would vest until that merger acquisition IPO happens. And then at that point, I'd get it. And so those are often also in tandem with time-based are called double trigger vesting to where I've got to do my time-based and the company has to go public or be bought in order for those to actually come into my possession and have any value to me.

5:35And Derek, you sometimes will joke that people come to you knowing that you have so much knowledge on this topic and say, hey, I got these stock options. And they mean that so broadly, and maybe that they aren't actually stock options. So maybe we can start by talking through the basics of restricted stock and then stock options. So let's start with restricted stock. Maybe give us a high level overview of what that is. That's a great place to start. Restricted stock is more closely related to what most would understand is cash compensation, except instead of cash, you get company stock at some point in the future.

6:11So as a simple example, if I've got a target bonus of$300 ,000, and maybe that's supposed to pay out to me in three years. So we'll call that a three-year cliff vesting schedule. I get it all three years from now. Instead of$300 ,000 cash that I get three years from now, I would get$300 ,000 being the target amount. And let's say that the price of stock at the company I work for is 25 bucks a share. Instead of getting that cash, I'd be awarded 12 ,000 shares of company stock in the form of restricted stock units or restricted stock awards. Those are very similar. And what that's going to be worth three years from now could be a lot more or a lot less than 300 ,000.

6:48It's tied to a specific number of shares that I was granted. So that target is at the date of grant. And then what happens between then and whenever they eventually vest, that's very much up to what the price does for company stock. So that's restricted stock. What about stock options? I mean, there's probably a few more moving parts that people need to understand there, right? Yeah. So whenever you have a stock option, even when it vests, I actually don't own anything yet. Instead, you own the right to buy stock at a previously agreed upon price. And again, that's usually tied to whatever the price was on the date that that was granted to you.

7:28And so if it was$25, like in the example I had last time, I might have 36 ,000 options as an example, if my bonus target is 300 grand at$25 a share. And let's say I get three years down the road, those have completely vested. I don't have anything until I exercise that option. So this is one of the key terms to know when you exercise a stock option, you're saying, Hey, I have the right to buy this at 25 bucks a share, the price is currently a hundred. I'm going to exercise my right to buy stock at$25 a share. And at that point it becomes taxable and we can talk about taxation here in a bit. And then I would acquire the shares.

8:06And there's three or four different ways that you can go about exercising that, but you don't own anything until you exercise. And if you leave the company retirement or you get another job, these have expiration dates. Usually it's about 10 years from the date that it was granted, but sometimes they can be much shorter. If you let this lapse, your option lapse and don't exercise, then you lose the ability to do that. So then any value that you could have captured there is gone. So it's really important to know what is the expiration date of my stock option and are there circumstances that would lead that to be something different?

8:40And I can assure you the answer is yes. So there's special rules. If I leave, maybe I have 60 or 90 days to exercise my stock option. And at that point, it expires instead of in 2028, like it said in my grants agreement. So it's really important to know those things. You'd sure hate to have it lapse without you exercising and miss out on a potentially a substantial amount of wealth. And taking this one layer deeper, people have non-qualified stock options. They have incentive stock options. What are some big differences that you feel like people should be aware of? Because again, And sometimes just people know they have some sort of equity compensation, but there are pretty substantial differences in the taxations of those.

9:21Yeah, that's where the difference lies is how they're taxed. So with a non-qualified stock option, there's no taxable event that happens at Grant. There's no taxable event that happens as those options vest, regardless if it's time-based, performance-based, anything like that, because I haven't bought anything yet and I could still lose it, right? Like if I don't exercise the option, there's no value. And that's kind of the key trigger for the IRS is when is that risk of forfeiture gone? And at that point, that's whenever there's a taxable event. So with a non-qualified stock option, when I exercise that option to buy shares worth $100 and I buy it for 25 because that's what my strike price was, that discount that I got effectively of 75 bucks, all of that is taxable as ordinary income and it's wage compensation, right?

10:09So subject to social security tax up to the social security wage base, and then Medicare tax too, and perhaps the additional Medicare tax. And then at that point, you own the stock outright as if you had just purchased it on the open market. And the same kind of rules apply, hold it for 12 months in a day, and any gain or loss is long-term. And if you sell before then, then it's short-term. With an incentive stock option, there's actually no regular income tax due whenever you exercise it. but there's this other phantom tax calculation that goes on in the background called the alternative minimum tax that you have to be aware of.

10:44So for regular tax purposes, we'll ignore AMT for a bit. When I exercise, say it was a 25 grant, that's my strike price. I buy for a hundred and then I later sell for$150 a share. No regular tax due when I exercise. And then whenever I sell at 150, that full$125 gain there is all long-term capital gain, assuming I do this in what's called a qualifying disposition. So I've held on to the shares for more than 24 months since the grant date and more than 12 months since I exercised my option to buy the stock. If you do that, then you get this preferential treatment of capital gain on the whole thing.

11:24Remember back on non-qualified stock options, when you exercise that initial discount of between a hundred bucks and 25 bucks, that's all ordinary income. So that's a better deal, right? Capital gain rates tend to be always lower than ordinary income. And so that's what makes ISO so attractive, except at some point Congress decided and the IRS decided, well, that's a really sweet deal. So we're going to add this whole AMT thing to that, to where it's not taxable for ordinary income tax purposes when you exercise, but it does count for AMT. And there's totally different rules and how that calculation goes.

11:59But I think the helpful way to kind of summarize it today is that you pay the higher of the two. So if my regular income tax calculation is a tax liability of a hundred grand, and if I run all of my income, including that discount on the ISO exercise, and there's a few other adjustments, kind of preference items bake into there. If my AMT calculation is 130 grand, I pay 130 grand. So it'd be a hundred thousand dollar a regular tax for federal, and then a$30 ,000 AMT at that point on top of it. And it will come back to you eventually, and we can get into that, but that can really create some pretty substantial cashflow problems if you're not aware that that's coming your way.

12:39And especially as we're working with executives, I mean, that could have a substantial amount of value in exercising ISOs with a price that's way lower, a strike price that's way lower than the fair market value. And if we're not taking into account cashflow, regardless of all the perfect tax outcomes, that's a problem. And so that's the biggest concern is a cashflow crunch with AMT. And then eventually getting all of that back because you would in the form of an AMT credit, it just takes time. Much of it can come back whenever you sell that stock down the road, 12 months in a day or more later, but there's all sorts of considerations.

13:14I've got the opportunity cost. I could have been doing something else with that money. In the meantime, it might take me 10 or 15 years to get that whole credit back. And that matters. There's more to it than, well, I'm really just prepaying tax. I'll get it all back eventually. It's like, well, when? And if the price drops substantially from the time that you exercise to when you sell, it could be a really long time. And so it ends up kind of being a sunk cost. When you're hinting at a lot of the nuances that go into planning around these situations, something that I do want to dig into, but before we move on, there's one last piece of would all group as executive compensation, even though there is an equity component to it, which is employee stock purchase plans.

13:53Not necessarily compensation, but certainly a really good benefit that both executives and non-executives at some companies have access to. Can you give us just a quick overview of that before we dive into some of the planning stuff? Just to clarify, so ESPPs aren't exclusively for executives. In fact, if you are more than a 5 % shareholder of a company, which if we're talking a publicly traded company, you're really probably a C-suite executive at that point. You actually can't participate in an ESPP and probably less applicable here, but you also can't, like you have to be an employee. So you couldn't be like an outside board member.

14:26They wouldn't be able to participate in it either, but the overwhelming majority of people would be able to. And you're right. Like it's not a form of compensation. I don't receive it through payroll, but you can only get it if you're an employee there. So I'm just think of it as like a perk or an employee benefit. And in that sense, the compensation piece is the special discount you can get by participating in it. And so that's why it's often grouped in with equity comp is because it involves company stock and it is something that only employees can participate in. So the difference with an ESPP is it's not tied to any, it's not W-2 income.

14:59It doesn't come through payroll. You actually participate by making contributions through payroll over a, it's called a purchase period. Usually it's three to six months where you're just every paycheck, a certain dollar amounts going in. And at the end of that purchase period of three months or six months, your company takes that cash and then uses it to buy company stock. The benefit there is that there's some sort of discount mechanism built in that can range usually from five to 15%. And if it's just the simplest plan with no, what's called a look back period. It's just maybe a five to 15 % discount, whatever the plan rules are on whatever the price is on the end of the purchase period.

15:40So if that's December 15th, it's just, here's the price. It's a hundred bucks. You get a 15 % discount off of that. There are some plans that have a very valuable feature called a look back provision. So same deal, five, 10, 15 % discount, except instead of just being tied to whatever the price is at the end of that purchase period, it's either that or some date in the past. And this would be the beginning of an offering period, usually 12 to 24 months ago. And so that discount would be applied to the lower of the two. And so if it was 50 bucks at the start of my offering period, and that was a year and a half ago at the end of this particular purchase period, now it's at a hundred bucks.

16:20I get a 15 % discount on$50 because that's lower. So now really I've got a substantially larger discount than 15%. And that's a really valuable provision. And then if the price dropped since then, like no big deal, you still get the 15 % discount on today's price because it's lower than what it was. So having that like lower of the two deal is a really, really good one. And it can be a pretty valuable benefit. There are some limitations. You can only purchase up to$25 ,000 worth of stock in any given calendar year. So that's not 25 grand of my own money. It's 25 ,000 worth of stock. So the amount you can actually put in is the less.

16:57And then the company may have additional rules of up to maybe they have a dollar amount that's less than that or up to 15 % of your salary or whatnot. So you've got IRS rules to think about. And then there's going to be some company specific provisions around there, too. But this is one of those things that can be easy to kind of write off of like, you know, I don't really need to mess with that, especially if there's a look back provision there. I mean, you could be leaving some money on the table by not participating in this, especially as you think about it, doing it over five or 10 years, 25 grand, potentially substantial discounts.

17:29Like you can accumulate some pretty good wealth here in addition to stock options, RSUs and other cash components of your company. Yeah, it makes for a really nice employee perk. And I think all these things that we're talking about, you know, you start building a position in your company stock. And I want to talk a little bit about how someone should think about integrating their company stock with their overall portfolio and their financial plan. But I think we have to talk about, before we even do that, just the general risks associated with being concentrated in a single stock. Now, I think owning more than 5 % to 10 % in any individual stock exposes you to some of the risks that we're going to talk about.

18:09But ultimately, the risk is even greater when you're an employee of that company. because you have a concentrated position in it. And unlike a random investor with a concentrated stock position that could just hurt their portfolio, you are in a situation where a single company can hurt your portfolio and your income. So if your company stock tanks, then your job security and your income are probably going to be a greater risk too. So when I'm in meetings with you, Derek, I feel like people sometimes don't really appreciate how risky it is to own a lot of your employer stock. I mean, I think in general, Sometimes people don't realize how risky it is to own a concentrated position, whether it's their employer's stock or not.

18:48But the data on the risks of owning concentrated positions are really powerful. And way back, I'm looking actually right now. So back in episode 63, I took a deep dive into the question of whether people should own individual stocks at all. And there is a study from JP Morgan that I referenced in that episode. I'll link to it in the show notes. I'd like to read a couple stats that I think are pretty mind-blowing on the historical performance of individual stocks from 1980 to 2020, which is when the study is covered. So using a universe of the Russell 3000 companies, which represents a little over 98 % of the investable US stock market, roughly 40 % of all stocks have suffered a permanent decline of 70 % or more from their peak value.

19:34That alone is crazy. But then you look at the return on the median stock since its inception versus the investment in just the plain total US stock market or the Russell 3000 index. And that median stock performance versus the Russell 3000 was minus 54%. Now, the same study also found that two thirds of all stocks underperformed versus the Russell 3000. And for 40 % of all stocks, their absolute returns were negative. So I know you've in the past, Derek's shown some data by sector where like, hey, where do these catastrophic losses happen? And they're biggest in energy and tech, which are around like 60 % of energy and tech companies experience one of these, which interestingly, is where equity comp is most prevalent.

20:18But it's honestly, it's really closely followed by the others. I mean, when I look at healthcare, consumer services, consumer discretionary, all around 50%, really everything but utilities has a very high percentage. And most of the time, these catastrophic losses happen for factors outside of management's control. And so I think you and I both have sat in meetings together. We sit in meetings separately where this becomes a big issue. And so I just wanted to make sure that we highlighted that clearly before going into some other key considerations when integrating equity compensation into a client's portfolio or financial plan.

20:54So excuse the long monologue here. Anything to add to that? And if not, why don't you start talking about some of the other things that you think about when incorporating it into a client's plan? I mean, I love that you just went through that. The same exact study I'll reference to. I think the point that I would emphasize there is one of the very last things you said is that these are most often for reasons outside of management's control. People think, oh, well, my company is not Enron. We're responsible and not fraudulent. And so that's not going to be a thing for us. This is currency risk.

21:23It's policies and regulations coming out here in the United States or in China. It's intellectual property theft. There's so many risks involved that are outside of control of even the best management executive team. And the point of emphasis I want to throw on there is that also means beyond your control too as an employee. And so I think that it's not uncommon for people to think, oh, well, I'm just going to like work really hard and make a really big difference here. And I'm going to be able to impact the value of my stock from the work that I do. I think it's really hard to make that case unless maybe you're a C-suite executive, except even then I would still challenge it because even if you know where the company's headed, you don't know what competitors are doing exactly.

22:11And like things can just flip on a dime. Look back at last year, the Fed decided, hey, maybe inflation isn't as transitory as we thought it was. And now we're going to be super aggressive on raising rates. when that happens, interest rates go way up. People are less excited to have money in really high growth stocks that are super, not overly expensive, but just it's more expensive to buy a dollar of current earnings and say a growth stock than it is say a value stock. And most growth, like tech is growth, like that's a growth stock. And you just saw tech stocks, I mean, plummet in 2022 and much more than the overall stock market.

22:48And there were tons of layoffs there too, just kind of behind the scenes that I do think it seems like a soft landing is maybe more likely than not. I don't know, but there is no discounting the hundreds of thousands of people that have been laid off in tech last year. And it really came from interest rates, which created crunches that makes it harder to raise capital in the form of markets or loans, whatever, that had nothing to do with what tech companies were doing. And so even if you know where the company's head and everything just works perfectly according to plan, even if you can master what I just laid out as impossible to predict, you don't know how investors are going to react to that, right?

23:25And so it's just not reasonable to think that, oh, well, I can influence the price of my company's stock and therefore I need to hold onto it because we're doing great things here. You just don't know. Progress economic data doesn't translate directly into market returns. I mean, you've talked about this on your podcast before, Peter. And so it's just side tangent a little bit there, but it's something that I really come across a lot as a reason to hang on to company stock. And I can't help but pile on one more time. And we could probably do a whole episode on all the reasons that you and I hear that people want to hold on to their stock.

23:59But I do feel like in 2022, going into it, like late 2021, early 2022, you'd hear people say, well, we just had our investor day and I saw the projection and it's really great. And just a reminder of like, what is stock returns? Where do stock returns come from? They're from earnings growth. They're from cash return to the shareholder, whether that's dividends or buybacks, and they're in changes in valuation. And changes in valuation is this mix of market psychology and calculus that nobody can predict. And it's really like, how much do people really feel like buying your earnings? And so no matter what outlook you have or the company has or how great it is, you are at the whim of millions of market participants on how that third factor, which is so enormous so often, really plays out.

24:46So thanks, Derek. I think important thing to put at the front of how we think about incorporating company stock into a portfolio and financial plan. There are so many considerations. I don't know if you want to go into them in great detail or if you just want to fire off a bunch, but I'll give you the floor and let you tackle it how you see it making sense. Yeah, I think I can just kind of walk through some, just kind of high level. Let's figure out where you are today, what's gonna be coming down the pike, what you want out of your money, what's your comfort level with risk, and then figure out how does my company stock then fit into all of that and the bigger picture of my plan.