We all like hearing that we are good at our jobs. It is 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 income. A bigger slice might offer a bigger—maybe even life-changing—financial windfall. Or not. Luck plays an important role. But it is 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. In addition, 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.
“…it is also important to manage your equity compensation by balancing its potential risks and rewards.”
Equity compensation basics
Equity compensation can come in many 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 are 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. 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 have worked so hard for.
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 does not reward you in the same way. Yes, there is 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 you are unemployed at the same time.
Finally, holding concentrated positions in stocks is speculative by nature, a de facto form of stock picking. “But” you may counter, “I know my own company, and I am confident its future is bright.” This is a common reaction—and may be a sign you are falling into a 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.
“…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, you should consult a qualified advisor and 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 the risks of your equity position.
Whatever your equity compensation package looks like, you do not have to navigate its complexities alone. Familiarize yourself with the internal resources that your employer provides, and ask your accountant and financial advisor to help you create a customized plan of action.