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The year 2020 will be remembered for many things, including that it was full of company IPOs, or initial public offerings, in which a private company offers the public an opportunity to purchase shares of its company stock. If you work for a company that has gone or is planning to go public, and you have equity awards in the company such as incentive stock options (ISOs), nonqualified stock options (NSOs), restricted stock units (RSUs), or even common stock, you may have heard that you should always sell your shares as soon as it is allowed. In fact, this is a fairly common recommendation from financial advisors. But is it really always in your best interest to sell immediately? While it is often prudent advice to sell, it may not be the right decision for you. Perhaps you are a career starter who had a big windfall after your company went through an IPO, you have a stable income, and all of your basic needs are met — does it still make sense to turn around and sell everything right away? Let’s explore some common myths surrounding when to sell your equity awards.

person holding phone with equity award vesting schedule on phone

Myth 1:You should always sell all your equity awards as soon as possible.”

First, it is important to say that there are certainly some scenarios in which selling your equity awards immediately does make sense. For example, if you are older and nearing retirement, or if you are mid-career and the equity awards you hold are your primary source of wealth, then it often makes sense to sell a substantial amount of your equity in order to diversify your wealth across different asset classes. Concentrated wealth can be good for accumulating more wealth, but it is not ideal for preserving it.

Let’s revisit the example above. A young career starter who has a high risk tolerance may actually prefer to hold onto their equity awards for further upside potential. Perhaps they anticipate their company stock to increase in value over the foreseeable future, and they can also handle any bumpiness along the way. In this scenario, maybe it doesn’t make sense for this individual to sell all their equity awards, but rather hold onto some — or even a large share of them — until their circumstances or expectations change. 

If you are going through a second company IPO, you may also want to hold onto your awards. Imagine you worked for one company that had a successful IPO and you experienced a significant windfall, at which time you sold your equity awards and diversified your wealth. Now you have a stable income and all of your basic needs are met. Maybe with this second company’s IPO you retain your equity awards for further upside potential. In this scenario, the risk of retaining company shares is more palatable given it is just a portion of your overall wealth, not the entirety of it. 

Another consideration with any selling of equity awards is the tax consequences involved. The type of vesting schedule will determine how and when equity awards are taxable. If there is a subsequent lock-up period after your shares have vested, that will restrict the ability to sell awards for a predetermined period of time, typically six months or so. After the lock-up period ends, it can often make sense to wait another six months before selling such that you will receive favorable long-term capital gains tax treatment.

Myth 2: “You should sell all your ‘in the money’ options first since they may be worthless if the stock price falls.”

If you are an employee that has received different types of equity awards, then there may be a sequence to how you want to sell each of them. You may have been led to believe that you should always sell your “in the money” stock options first regardless of the strike price or expiration date. With stock options, “in the money” is when the market price has surpassed the strike price. The strike price is what it would cost you to buy the shares. “Out of the money” is when the market price is below the strike price. Your downside risk with options is capped in a way that it is not with RSUs. With options, you only participate in losses up until the market price reaches the strike price, whereas with RSUs, you participate in losses until the market price reaches zero. Since your downside risk is more limited with options, it frequently makes sense to sell RSUs before exercising and selling your options.

Then, among your stock options, the first ones to consider exercising and selling are those with lower strike prices or options that will expire sooner. Because you participate in losses up to the strike price, options with lower strike prices have more downside risk. With regard to expiration dates, the sooner the options expire, then the sooner you will have to exercise them anyways, leaving less runway for appreciation. Options with a higher strike price provide more leverage as you participate dollar for dollar in the upside while the downside is capped at that strike price. Options that expire several years out allow much more time for participating in growth before paying taxes.

Myth 3: “You should never exercise and hold your stock options — it’s too risky.”

There is no one-size-fits-all strategy when it comes to stock options, and there are some situations in which it may make sense for individuals to exercise their stock options and continue to hold the shares. 

With ISOs, if you hold onto the shares at least one year after exercising and two years after the grant date, you will receive long-term capital gains tax treatment upon selling the shares. So, if you can tolerate the stock price volatility over the course of a year, you may benefit from the favorable tax treatment of your sale. Additionally, the Tax Cuts and Jobs Act of 2017 created more flexibility with the number of ISOs you can exercise in any given year without being subject to any sort of tax liability. This is especially true for high earners.     

With NSOs, upon exercising these options the spread between fair market value and the exercise price is taxed immediately as ordinary income, but any appreciation in the stock after you exercise is treated as a capital gain. If you anticipate growth in the share price, exercising early and holding the shares for at least one year will provide favorable tax treatment upon selling. 

Finding the Right Approach for You

It can certainly be prudent to sell your equity awards quickly, but there can often be a conflict of interest with conventional financial advisors who might recommend selling everything so they can manage your assets. It is important to keep in mind that there is no one-size-fits-all answer and the best approach usually lies somewhere in between. A good financial advisor can develop personalized recommendations tailored to your unique circumstances and that are in your best interest.    Furthermore, investing often has an emotional aspect to it, and coming into sudden wealth via equity awards is likely to exacerbate that. It is a huge financial event in anyone’s life and you will likely have your own thoughts and feelings about the future of the company, which may tie into decisions with your equity awards. It can be helpful to work with an experienced advisor who does not have the same emotional attachment to the shares to help make objective decisions about next steps. 

Filed under: Wealth Management

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