Previously, I’ve discussed all the information on employee stock options and how they can be a good investment.
This article will discuss the drawbacks of investing in employee stock options.
Click on the link below to determine whether employee stock options are a good investment.
Are Employee Stock Options a Good Investment?
Keeping that aside, this article would primarily include the details related to the downsides and downsides only.
Without any delay, let us begin our topic for today, i.e., “What are the downsides of employee stock options?”.
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The Downsides of Employee Stock Options
Listed below are the disadvantages of investing in employee stock options.
Connection With the Company’s Performance
The profitability of employee stock options is connected with the company’s performance.
This means that you only see profits if the company performs well and experiences an increase in its share value.
Note that it is not easy to anticipate a company’s future performance, especially as an employee.
It has been made clear that most companies that issue employee stock options are usually start-ups.
This means the company has yet to face a lot of competitors and needs to build some experience.
Therefore, your company may or may not grow in the future, which leads to the question, “Is it worth it?”.
That solely depends on your confidence in your company’s future growth.
However, one may get a general idea of whether or not their company may become successful.
Always be considerate and note all the negative and positive aspects before you analyze the situation.
Especially as an employee, you can get some insider news regarding your company’s success.
Stock Value
Note that the company’s stock value has to increase by a certain amount for you to benefit from the exercised stock options.
As I said in the previous section, there is a chance for the company to experience losses, which may affect your investments.
That’s why I said earlier that you should only invest in the employee stock options if you have confidence.
Always be patient and wait for the right opportunity before you exercise your stock options.
Low Salaries
When offered employee benefits such as ESOs, you must expect a cut in the package provided.
For instance, imagine that the salary offered to you for a particular role is $150,000 per year.
But when you are being offered employee stock options, you may receive something less than that, such as $120,000 or lower.
This depends on the amount for which you are getting the share options.
Vesting Period
Vesting schedules can be a double-edged sword with drawbacks for several reasons.
Let us examine why vesting schedules can disadvantage employees who invest in ESOs.
- Delay in the ownership
The vesting schedule determines when the employees gain ownership rights to the stock options granted.
Even though it incentivizes the employees, they do not immediately get ownership.
For employees needing liquid investments, this can be a bit of an obstacle, primarily when the employees need to access the invested capital in times of emergency.
- Loss in the value
The company’s stock price performance impacts the advantageousness of ESOs.
If the stock price is stable or declines over the vesting period, the potential for profit with the ESOs decreases.
This means you risk losing value on your investment if the company’s stock price does not perform well.
- Uncertainty in the future
As you know, the vesting schedule is designed to encourage employee retention.
However, the employee’s future is uncertain, and an employee’s circumstances might change.
There may be a need to leave the company for personal or professional reasons.
If that’s the case, the employee might not fully benefit from the options they’ve been granted.
This potentially leads to missed investment opportunities; therefore, they cannot benefit from ESOs.
Taxes
Taxes should be taken into consideration while investing in ESOs as an employee.
When an employee exercises their ESOs, the difference between the stock’s market and exercise prices is taxable income.
This specific price difference is known as the bargain element.
This excess income can push the individual into a higher tax bracket, resulting in higher taxes in that particular year.
- AMT
In some countries like the United States, exercising ESOs can trigger the Alternative Minimum Tax (AMT).
This tax can eliminate some specific deductions and credits, resulting in a higher overall tax liability.
Employees might be subject to AMT if the difference between market and exercise prices is significant.
- Unrealized Gains and Taxes
After exercising ESOs, most individuals might choose to hold onto the acquired shares.
An increase in the stock price could lead to unrealized gains, but these gains might also have tax implications when the shares are sold.
The gains could be subject to capital gains taxes depending on the holding timeframe.
This potentially reduces the net gains and defeats the purpose of investing.
- Tax Complications
The process of taxing ESOs can be complex because employees are required to report all the vital information.
If one fails to report their taxes properly, the individual may underpay/overpay their taxes.
Diversification
If you invest in multiple investment assets alongside ESOs, you can effectively diversify your portfolio.
However, if you invest all your money into ESOs without investing in any other asset, your portfolio will lack diversification.
As I have often said, a good portfolio should include investments diversified into various sectors, asset classes, etc.
Unless the portfolio has the necessary diversification, the concentration of risk is increased.
Never invest in a single asset class to maximize your investments.
What Do I Suggest?
Well, ESOs can be a good investment if you plan according to your situation and invest in them.
Just because all your colleagues are investing in ESOs, it doesn’t mean you should also get involved.
Tips for Investing in ESOs
Employee Stock Options (ESOs) require careful thought and planning before you invest.
Here are a few tips to maximize the returns you can obtain from your ESOs:
Understand the Terms
Study the details of your ESOs, including exercise price, vesting schedule, and expiration date.
These details are generally included in your work contract, specifying your salary package.
If you familiarize yourself with these terms, then it helps you make informed choices and avoid mistakes.
Financial Planning
Consider your investment goals, risk tolerance, and cash needs when using ESOs.
Like I said, don’t get into ESOs just because someone suggests them or is also investing.
Ensure you’ll benefit from the ESOs based on your investment profile and goals.
Diversification
Don’t put all your money in your company’s stock, as you might miss out on the benefits of a diversified portfolio.
To spread risk, maintain a well-diversified portfolio with investments like cash, bonds, other stocks, etc.
Long-Term Strategy
Consider ESOs as long-term investment opportunities and hold onto them until they fully vest or if you believe in your company’s growth.
Tax Considerations
Be aware of the taxes linked to exercising ESOs, as you might have to pay AMT or short-term/long-term capital gains tax.
Get help from tax experts to manage your tax liability when you are getting yourself involved with ESOs.
Financial Expert
Try contacting a financial expert with ESO experience to come up with a strategy that fits your investment profile.
Sell-to-Cover
If exercising requires cash, opt for the sell-to-cover strategy and try selling some acquired stock to cover costs.
I have mentioned this strategy in a detailed manner in one of the previous articles written about ESOs.
Click on the link below and navigate to that section to better understand the concept.
Are Employee Stock Options a Good Investment?
Right Time to Exercise
Always be patient and only exercise your stock options at the right time to be successful with your ESO investments.
This can be achieved by assessing your company’s health, market conditions, and finances before exercising.
Avoid Timing the Market
Focus on company fundamentals instead of short-term stock price changes to benefit from your ESOs.
Be Attentive
Always follow up with your company’s performance, industry trends, and market news for better decisions.
Holding Period
The duration you hold ESOs affects tax rates and informs selling decisions, and as I said, long-term strategies are successful.
Tax-Advantaged Accounts
Exercise ESOs with the help of tax-advantaged accounts like IRAs or 401(k)s to reduce taxes if you live in the US potentially.
If you are from another country, try searching for retirement accounts and research how you can benefit from those.
Bottom Line
Remember that ESOs are an excellent investment opportunity but are associated with risks.
Efficiently utilizing them can help you make the most of this employee benefit.
Some other employee benefits act as alternatives for employee stock options. They include:
— Restricted Stock Unit Grants (RSUs)
— Employee Stock Purchase Plans (ESPPs)
— Phantom Stock
Alternatively, you can opt for other traditional investments such as stocks, bonds, mutual funds, etc.
If you have a knack for alternative investments, try going for REITs, ETFs, Gold, etc.
Remember that having a diversified portfolio can always be helpful for you to preserve and grow your wealth.
You should note that investing is a complex process, and it is wise to acquire the help of financial experts who have the skills and expertise.
If you are an expat or a high-net-worth individual looking for an efficient wealth manager to tend to your investment needs, then you are in luck.
I cater to clients worldwide and help them achieve financial freedom with tailored investment solutions.
Feel free to contact me to find out whether you can benefit from the top-notch personalized investment solutions I provide.
I hope you found this article helpful in finding the needed information.
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Adam is an internationally recognised author on financial matters with over 830million answer views on Quora, a widely sold book on Amazon, and a contributor on Forbes.
