On a recent episode of the Investing for Beginners Podcast, Andrew and Dave answered some pressing listener questions in what ALWAYS is my favorite episode type that they put out. In this particular podcast episode, they talked about employee stock options, so why not drive in a bit deeper on the topic?
If you’re unfamiliar, some companies will offer their employees the ability to purchase stock options of their employer at a locked-in price as a way to motivate their employees to really take even more ownership in the company.
The question was pretty open ended, so I just want to really share all of my thoughts on it, both the good and the bad, but first I want to clarify the difference between stock options and an employee stock purchase plan.
In concept, they are pretty similar. Essentially, the company is offering discounted shares to their employees for purchase to really make them motivated to drive that share price us.
The key difference is that an employee stock purchase program is available to all employees while stock options are typically given out as a bonus to higher level management rather than giving them a cash bonus, or as much of a cash bonus.
While the two are definitely different, a lot of the good and the bad that I’m going to note for the stock options will also apply to a repurchase program!
The Good: Employee Stock Options
There is a ton of good to investing in your employer if you receive employee stock options. Typically, you will be given a fixed price that you can choose to execute the purchase of the stock, so if the stock drops, then just don’t buy! And if it goes higher, then you can purchase the stock at that fixed price.
Of course, there is a risk because if the stock price drops and you don’t buy, then you essentially didn’t get a bonus that year if that’s the way that you received your stock options, and that obviously is a huge bummer.
Once you have purchased the stocks, there typically is a vesting period where you can’t sell the stocks but then after that, you’re free to sell them as you please.
I don’t want to say that you’re locking in a gain because you aren’t, but you’re definitely locking in a price where you have the ability to buy a stock cheaper than what it is currently priced at, but you certainly could buy it and then the share price drops while you’re still in your vesting period and you don’t have the ability to do anything about it.
For the most part, I think that the good is a very, very strong benefit, especially as a manager of the company and one that likely trusts in the vision of the company, but of course there is also some bad, too!
The Bad: Employee Stock Options
The bad is more of a risk, rather than a bad, per se, but it’s something you absolutely need to consider. The first thing is one that I already hit on with the vesting period. Maybe it’s 6 months, maybe a year, maybe longer! I hate being tied to an anchor where I literally cannot sell a stock, but if I am getting a 15% benefit right off the top then I think that is absolutely worth the risk of not being able to sell!
Since 1928, the S&P 500 has only had 11 years that have given you a return of a 15% DROP or worse. Obviously, an individual stock is going to be more volatile than the entire market, so you need to make sure that you trust the company and the outlook, especially in the short-term, for the company, but since you’re working there and in upper management, you most likely have a great feel for the performance.
This is also something that you should think about with a share purchase program as well for employees, and if you’re a lower-level employed that might have less access to the information of the company that can really make the share price move, it’s that much more important to understand the outlook of the company and do your homework before blindly buying.
Normally, I am a huge advocate for always looking at the long-term, but in a case where you’re going to be tied to vesting period, I think that the short-term is more important. Even if you think that the company is going to underperform the market, you likely will still be better off to buy shares of the company and then sell them as soon as you’re fully vested to lock in those gains! You just need to keep an eye on the vesting period and know what it is prior to making any decisions.
Another potential ‘bad’ is simply becoming under diversified in your income stream. Not only do you work for this company, but if all of your investments are also tied up in the company then you are susceptible to some great gains but also some major, major losses.
Imagine if you worked at Lehman Brothers and you had a great job and a ton of stock options with the company and then they went bankrupt. Not only are your investments worth a lot less now but you’re also likely out of a job! That would be absolutely tragic to your financial situation.
I know that might seem like a stretch, but is it really worth the risk?
So, What Do You Do?
My suggestion would be to make sure that you understand the vesting period. If you like the short-term outlook of that company, at least up to and hopefully beyond the vesting period, then take advantage of the stock option opportunity that is being provided to you!
My second most important suggestion is to make sure that you are diversified. If your stock options make you under diversified, I’m not saying that you shouldn’t take advantage of the opportunity but really think about selling your stake and then moving them into an uncorrelated investment opportunity as soon as that vesting period has completed.
If you’re struggling on finding the outlook for the company, checkout the Value Trap Indicator! That’s a perfect place to start that will help you with the viability of the company in general for a long, long time!