volatile markets

Stock Options & RSU Strategies During Volatile Markets

Investors are certain to experience volatile markets throughout any normal economic cycle. As unpleasant as they may be, they also offer potential opportunities to long-term investors with the patience and financial wherewithal to withstand a downturn. This particularly rings true for equity compensation in both private and public companies. Stock options and RSUs in valuable companies present potential benefits during volatile markets, which we’ll break down below. Remember that all equity compensation plans are different, and the strategies discussed below may or may not ring true for your specific company or situation.

RSUs in Public Companies


It’s very common for public tech companies to offer restricted stock units (RSUs) to employees as a large part of their overall compensation. For well-performing stock, RSUs can be extremely valuable. Yet, even the best-performing companies and their stock experience the effects of a broad economic downturn and volatile market. First, lets break down how RSUs work and determine potential strategies during volatile markets.

RSUs are typically granted to employees with a set vesting schedule. In this example, we’ll use a vesting schedule of four years, with 25% vesting after one year and the remainder vesting every month after. In regards to RSUs, the vesting date is technically the only date that matters in terms of realizing the compensation. The IRS views the vesting date as the date the compensation is received.  It’s taxed at ordinary income tax rates and will appear on a paystub along with federal (and state tax withholding if applicable) tax withholding. Let’s assume that an employee was granted 10,000 shares of XYZ stock, and it’s been one year since the grant, so 2500 shares are set to vest today. The current stock price of XYZ stock is $50 per share, meaning the total value at vest is $112,500 (2250 shares x $50). Typically, the company will withhold 22% of the $112,500 by selling enough of the stock to cover the taxes (though employees can sometimes elect to pay taxes out of pocket but this is rarely a good idea), leaving $87,750 in either XYZ stock remaining or cash (employees can also elect to keep the shares or have them paid in cash).

Obviously, it’s better that XYZ stock go up to realize more value from the RSUs over time. However, that doesn’t mean there aren’t potential opportunities during down markets to consider. If you believe XYZ is more valuable in the long-term than the down market currently reflects, you can always elect to maintain the RSUs when they vest rather than selling them immediately and taking the cash. Secondly, you’ll also pay less in ordinary income taxes due to the RSUs vesting at a relatively lower share price. Of course, it’s important to respect diversification and your overall financial plan in regards to maintaining an individual stock, even if you believe it to be severely undervalued due to volatile markets.


RSUs in Private Companies


RSUs in private companies typically are given to employees as the company is gearing up to IPO or complete a liquidity event. They’re not often part of the equity compensation plan in the early stages of a startup. They also have a few nuances regarding vesting, taxes, and overall treatment that differ from their public company counterparts.

Private company RSUs will have a vesting schedule similar to the one discussed above. However, rather than paying taxes as they vest, most RSUs for private companies will have a second “trigger” that isn’t time-oriented but rather a liquidity event such as an IPO or acquisition. When both triggers are met (time and liquidity event), the RSUs are delivered and treated as fully vested and taxed.

This is probably the least actionable of the four different types of strategies we’re discussing here. Seeing that most late-stage companies gearing up for an IPO or acquisition likely won’t during a downturn in the economic cycle, it means that employees with private company RSUs will not receive their compensation during economic downturns. What is important, however, is to be aware of how the RSUs that are time vesting will impact your tax situation when the company eventually IPOs or is acquired and meets the second trigger. At this time, ALL the time vested RSUs will suddenly become fully vested, meaning they’ll all be taxed at the same time and, therefore in the same tax year. This massive windfall catches some people off guard. At first, positively when they see the amount of cash deposited into their account as part of the RSU vesting/sale, and then negatively when they go to file taxes for that year.

In our example above, using XYZ company, let’s assume the 10,000 shares were fully time vested, and the company just when through an IPO. The share price is $50, meaning the total compensation is $500,000! This dramatically pushes the individual to the highest federal income tax bracket, and the 22% the company withholds on the initial RSU sale, likely is not enough to cover all the taxes. Utilizing a financial planner or CPA to conduct tax planning and help determine how much extra tax will be owed is key.


Stock Options in Public Companies


Stock options are definitely more complicated than RSUs. Let’s review another example on the basics of stock options. First, we’ll cover Non-qualified stock options or NSO’s (also sometimes referred to as NQSO’s). NSOs provide an employee the right to purchase stock at a set price anytime in the future after the stock option has vested. The vesting schedules are again very similar to RSUs and set at the company’s discretion. Let’s assume XYZ has granted 10,000 shares of NSOs and 25% are currently vested, with an exercise price (the fixed price the employee can purchase the shares for) of $10 per share. The current market value is $50 per share and the employee elects to exercise 25% or 2500 shares.

Cost: 2500 shares x $10 = $25,000 total cost to purchase the 2500 shares

Taxes: 2500 shares x $50 = $125,000 gross value of 2500 shares at the $50 current market price

$125,000 – $25,000 = $100,000 in ordinary income

You can then determine whether to maintain the shares or sell them immediately. There are no additional tax consequences to selling the shares immediately, and it often presents a good time to diversify. However, during volatile markets, this again can present an opportunity to pay fewer taxes upon exercising the NSOs (for example, if the current fair market value of the stock was $30 instead of $50, the ordinary income realized is much less) AND essentially purchase the stock at a discounted price. Again, we’re assuming the underlying stock has strong fundamentals and a great long-term outlook and ignoring any potential need for diversification.

The other type of stock option, Incentive stock options (ISOs) aren’t typically granted to public company employees. Rather, they may carry over from when the company was private, and the employee never exercised them. They work similarly to NSOs but DO NOT realize ordinary income taxes upon exercising them. Instead, they use the alternative minimum tax (AMT) to gauge whether it will have tax consequences IF the employee holds the underlying stock through the end of the calendar year and elects not to sell the stock in the year that it was exercised. Obviously, these can be very complicated, and we highly suggest working with a professional when dealing with ISOs or NSO. Generally, the same strategy applies for ISOs in public companies when experiencing a down market, and detailed tax planning is required to realize its full potential. For example, if the fair market value of the underlying stock has fallen to near the exercise price, you can essentially pay zero in taxes as a result of the exercise. A key part of planning is also determining whether to hold the stock through year-end to jump to the AMT tax table or sell before year-end to recognize ordinary income. Of course, it’s always better for the stock to go up, but that’s never ALWAYS the case, and this can present a time to mitigate taxes while also exercising holding the underlying stock.


Stock Options in Private Companies


Most stock options are awarded to employees at private companies, and I’d argue this presents the most opportunity for planning around volatile and down markets. Typically, private companies will be evaluated annually using a 409(a) valuation. This provides stock option holds the current fair market value of their private company shares that they would otherwise have a very hard time figuring out what the value is and in turn would not know the tax consequences of exercising their stock options. Private companies can also provide a new valuation when receiving additional funding from outside investors. During down markets, it’s not uncommon to see the private companies’ stock value also go down (just as public companies do). Which again presents a tax planning opportunity for stock option holders.

Every time the difference between the exercise price (fixed)  and the current fair market value (variable depending on the value of the company and impacted by outside market dynamics) of the private company shrinks, the tax consequences of exercising also shrink. Therefore, it’s almost always best to exercise as soon as possible when the stock options vest to mitigate tax consequences (again, assuming the underlying stock is a good investment that will eventually reap liquidity). Or, during an economic downturn where the valuation fo the company recedes, and therefore also reduces that difference.

Finally, stock options in private companies may have a unique feature called “early exercise” or 83(b) election. This allows stock option holders to essentially exercise ALL their stock immediately without regard to the vesting schedule, and therefore paying all (if any) tax consequences in the year of exercise. This can be beneficial for people who have a very small difference in their exercise price and the current fair market value, and for some new employees, this is essentially zero. Meaning, the tax consequences are zero!


The Bottom Line


Volatile markets and economic downturns are normal and part of being an investor. While we’d much rather have markets continually go up, it doesn’t mean we have to sit by the wayside during volatile markets and being proactive about equity compensation strategies is beneficial. Most strategies assume that the underlying stock will go up and/or is a good investment, so be wary that you’re doing your due diligence with the information available to determine whether you believe the long-term value of the company/stock. Work with a financial planner/tax planner to assist in any complicated tax situations and as always, adhere to diversification benefits first! Schedule a free consultation here if you’re looking for assistance in reviewing your equity compensation!

Levi Sanchez, CFP®, CPWA®, CEPA®, BFA™
Levi Sanchez, CFP®, CPWA®, CEPA®, BFA™
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, CERTIFIED PRIVATE WEALTH ADVISOR®, CERTIFIED EXIT PLANNING ADVISOR®, BEHAVIORAL FINANCIAL ADVISOR™ designee and Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. Levi’s been quoted in the New York Times, Business Insider, Forbes, and is a frequent contributor to Investopedia. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!

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