Tuesday, November 13, 2007

Employee Stock Option Plans - Time to Sell?

I subscribe to "My Personal Finance Journey", an excellent PF blog. Last week mm posted an update of his net worth, which included a dramatic increase in the value of his employee stock options. I have heard this story before...

Back in the rockin' dot com bubble days, my wife worked for a high flying Internet company. She joined at the right time and received some stock options at a strike price of $3. At their highest, each share of the company was worth over $160, and we were close to being millionaires on paper (before taxes). Talk about a major windfall.

Did we sell at the right time? Not exactly... The stock dropped all the way to low double digits, and while we made some money selling on the way down, we were left with only a fraction of the potential gain. We learned a very, very expensive lesson.

So, how do you know when it's time to sell your employee stock options? Here are few ideas:

It's Not Fake Money - many people are much less concerned about losing money on their stock options, than they are about losing their other assets. I can't quite explain this, but it may have something to do with the notion of "easy come, easy go". Truth is, there is absolutely no difference between stock option gains and money that you receive in your pay check. Treat your stock option gains as you would any other income.

Don't Be Afraid - when I urged my wife to sell more of her stock options, she was concerned that we would feel like dummies if the stock continued to appreciate, while we sold at a lower price. I had the exact opposite fear. I was worried that the stock was going to drop, taking our wealth with it. We were both motivated by fear, and both of us were wrong. Even though my proposed course of action would have generated more money for us, I could not have known it at the time, and my reasoning was not the correct one. One should not make investment decisions based on fear. Investment decisions should be based on goals; risk tolerance and diversification. The same logic applies to employee stock options.

Use the Materiality Rule - If your stock options represent a substantial percentage of your net worth, you should diversify your investment and sell at least some of them. For me, the materiality line crosses at about 10% of my net worth. Any less, and I am not likely to be too stressed by the ups and downs of my company's share prices.

Would You Invest More -if you were given an amount equal to your stock option gains and were told to invest these gains in the most productive manner, would you invest them by purchasing options on your company stock? If your answer is negative, it's probably time to sell.

Mitigate the Stress, Sell Over Time - to make the decision easier on yourself, I propose the automatic selling approach. When my wife and I could not agree on whether to sell or hold the stock options, we compromised. We agreed that we would sell a set quantity of options on the first day of each quarter, regardless of the price at which the stock was trading. The quantity we agreed upon would completely eliminate our position in the stock over approximately two years. This strategy of selling gradually allowed us to diversify away from the stock, while ensuring that we did not sell large quantities of stock into a temporary dip in the stock price.

There is also an important counter-argument here. For many of us, stock options are our best and biggest shot at riches. I mean, just yesterday I read a story about the office masseuse at Google retiring after her stock options made her a millionaire. Of course such stories are exceedingly rare, but if you believe that your company's stock could take off and catapult you into the ranks of the independently wealthy, should you really give up on this shot at riches? That's a question each of us has to answer for his or her self. Personally, I am probably too risk averse to hold onto sizable, unrealized stock option gains. How about you?


Anonymous said...

Thanks. This is an excellent article and thank you for reading PFBlog.

BTW I sold 1/3 of my stock options at $36.60.

MM @ PFBlog.com

Jay Muntz - valueaverager.com said...

I think this the most relevant question: "Would You Invest More?"

As an employee of the company, you have inside information. I'll bet that Google masseuse totally understood how brilliant the people at Google were and that they were destined to be successful.

I'll also bet that your wife could not explain exactly how her company would make money and sustain itself. Most of those bubble internet companies were like that.

You need to understand the business you work for in order to make sensible decisions about its stock options.