Choosing The Right Equity Compensation Mix Can Be Risky

C/Suite, Tell Us About The Good Old Days of Equity Compensation:

In the mid-nineties, our clients were granted 100% of their equity compensation in the form of Stock Options. The idea was simple: stock options are like a 10-year, non-callable, interest-free loan from the employer invested in company stock. If you were awarded 10,000 options at a strike price of $100/option, that award had the equivalent loan value of 10,000 X $100 = $1,000,000. Here’s the cool part, you NEVER had to pay it back if things went bad, and you could keep any gain above the interest-free loan of 1-million! If the company stock grew in value by 7%/year, the rule of 72 says that the stock price would be $200/share at the end of 10 years. If you exercised your 10,000 options just before they expired, the gross value would be 10,000 X $200 = $2,000,000, so you, as the award holder, could keep $1,000,000 (taxable as ordinary income). Sweet deal, or as we like to say: suite deal!

If the stock only ever hit $99 a share, after being awarded at $100/option, then your options would expire worthless; no harm, no foul because you had successive 10,000 option tranches (or more) awarded every year!

Back in the day, a pattern began to develop in equity compensation. The sponsoring company tended to raise the number of options annually awarded at the same level of responsibility. Shareholder advocates grumbled as the size of the award for a particular officer, which may initially have been 10,000 options at $100/option, grew to 15,000 options at an appreciated strike price of say $150/option over time. Officers at the same level of responsibility were now getting an interest-free, 10-year loan equivalent of $2,250,000 (15,000 options X $150/strike). Not unsurprisingly, things started to take a turn toward awarding fewer options and more restricted stock.

C/Suite, what’s different about restricted stock?

If the same company awarded our hypothetical officer 4,000 Restricted Stock Units (RSUs) at $100/unit equivalent price, that was like a fully-forgivable loan of 4,000 units X $100/unit = $400,000. Still sweet; however, the RSU deal was different. RSUs are not exercised; they vest, and one keeps the after-tax value regardless of stock price. So, the RSU award wasn’t and isn’t a loan; it was a means of short-term deferred compensation tied to continuing employment. A typical vesting scenario would be 100% vesting 4-years after the award.

Here’s the quid-pro-quo: if the stock were valued at $131/share (7% growth/yr over 4-years), then the RSU holder gets a taxable check for $131 X 4,000 = $524,000. However, if the stock price was less than the award price – say, $99/share – the RSU holder keeps the net of $99 X 4,000 = $396,000. An RSU is a bird-in-the-hand because, at the vesting point, the in-the-hand value can never be worthless unless the stock price crashes to zero! As you recall, with a stock price at $99/share, the option grant expires worthless with a strike price of $100/option. In this sense, options have a greater risk, but with a 10-year window in which to exercise, the passage of time can turn a temporary negative value back into a massive gain. 

So C/Suite, what’s going on today? And which is better: RSUs or Options?

Our job is not to declare which is better. That is YOUR job. Our job as an advisor is to give you context and let you decide what’s best after being armed with high-quality information. A young officer carrying large education debt might want the bird-in-hand RSU to wipe out education loans ASAP. A veteran officer who plans to remain at the sponsoring company till retirement might prefer the greater leverage of stock options to build up retirement wealth. Indeed, one person’s floor is another person’s ceiling. That’s why getting advice from the water cooler is a horrible idea!

Today, many companies assign a fixed equity award value to each employment level. Let’s assume that value is $1,000,000. Many companies allow an officer to pick their pleasure: 100% options, 100% RSUs, or various percentage steps in between. The RSU calculation is easy: take $1,000,000 and divide that by the company stock price on the award date, say $100/share, then the officer would be awarded $1,000,000 divided by $100/share = 10,000 RSUs if the award was taken as 100% RSUs.

For decades, options have used a valuation method called Black-Scholes Value. Black-Scholes is a highly regarded option valuation methodology used for accounting purposes in most public companies. However, because of the potential for zero value, the nature of stock price volatility, and the 10-year duration of the grant, Black-Scholes always calculates out as significantly less than the current stock price. For the sake of example, let’s say the CFO calculates the Black-Scholes value to equal $25.00/option. Then, the number of options awarded is calculated as follows: $1,000,000 award value divided by $25.00/Black-Scholes Valued = 40,000 options awarded to equate to the 10,000 RSUs!

So, which is best: 10,000 RSUs or 40,000 options? Indeed, nobody knows. If you’re unsure, then maybe some of each are best for you. Your decision is NOT one and done; it is a decision that is made every year. Find a great advisor.

We conclude with a chart we prepared for a 38-year-old VP of one of our region’s largest Fortune 500 companies. We assumed retirement at age 62 with a two-year look back to her previous RSU awards. Options carry a 10-year life both pre and post-retirement and are exercised just prior to expiration. The numbers are smaller than the above examples, but the context is spot on. We compare taking 100% RSUs as the officer had been doing for previous years versus taking 50% options and 50% RSUs. Rarely, if ever, do clients see the following career-spanning analysis; they merely sense it and make their decisions accordingly. We sincerely hope the following chart provides better context:

*For Illustrative Purposes Only

Note: in this example, we ignore the time value of money and income tax, yet it is fascinating that there is 5x the economic potential in taking 50% options and 50% RSUs versus taking 100% RSUs! So, is it worth taking the RSU bird-in-the-hand if there are potentially 5X the value of option birds-in-the-bush? That’s your decision! We delight in bringing great context to you and your family!

Stoddard Barnhill
sbarnhill@thebahnsengroup.com

Phillip Barnhill
pbarnhill@thebahnsengroup.com

Share
Share on facebook
Share on twitter
Share on linkedin
Share on email

The Bahnsen Group is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.

All data and information reference herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary, it does not constitute investment advice. The team and HighTower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.

Third-party links and references are provided solely to share social, cultural and educational information. Any reference in this post to any person, or organization, or activities, products, or services related to such person or organization, or any linkages from this post to the web site of another party, do not constitute or imply the endorsement, recommendation, or favoring of The Bahnsen Group or Hightower Advisors, LLC, or any of its affiliates, employees or contractors acting on their behalf. Hightower Advisors, LLC, do not guarantee the accuracy or safety of any linked site.

Hightower Advisors do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client’s individual circumstances and can change at any time without notice. Clients are urged to consult their tax or legal advisor for related questions.

This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates.

About the Authors

Phil Barnhill, CLU

Private Wealth Advisor
Director of Risk Management

Stoddard Barnhill, CFP®

Private Wealth Advisor

For nearly 25 years Phil has worked exclusively with senior leaders of public and large private companies. Over the past six years Stoddard has been carefully mentored in this niche market, leading to a highly-specialized practice knowledge within the team. This focus on corporate executives and their family dynamics comes with significant insights into executive compensation, stock concentration, equity monetization, and the full life-cycle of a career in the C-Suite.

Looking for something specific?

Play Video
Play Video
Play Video
Play Video
Play Video
Play Video
Play Video
Play Video