Options or Equity

The Details Behind Our $105,000 Investment

Gen Y Finance Guy Financial Analysis 38 Comments

One of the perks of joining the executive team at the company I work for is either being granted options or the opportunity to get equity (i.e stock) in the company. Not everyone gets a choice, but I am fortunate to be in a position where I get to choose. There are pros and cons to each, which I plan to walk through in this post. My hope is that by the end of this post I will have made a decision. As you can imagine there is a risk/reward trade off between the two options.

For those not familiar with options, an option is a derivative of stock, meaning the option derives it’s value from the underlying asset (i.e the companies stock price). Options have a strike price, and as an option holder you make money when the price of the companies stock is greater than the strike price. For example, if the strike price of your options were $50 and the company’s stock price was worth $75, then you would have a $25 profit for one option (or a 50% gain).

Unlike options that trade on public exchanges, with each option representing 100 shares of stock, these types of stock option grants represent one for one. This means if you have 1,000 options, then you essentially have control of 1,000 shares.

Equity on the other hand is no different than equity in the public markets (except it is illiquid until a liquidity event happens). Equity is just fancy way to refer to company stock.

The Lay of The Land – Options or Equity?

I am currently being presented with the choice of either 6,000 options or 6,000 shares of stock. From a gross return perspective (before taxes and risk considerations) they have the same potential. Unlike other companies, the one I work for grants options with a strike price equal to the current stock price. Many other companies will grant options with a strike price that is higher than the current stock price.

This is a great feature of the option grants at my company. You get to participate in any future gains from day 1!

The expected holding period before a liquidity event is 4-5 years. We are partnered with a new private equity group, and the normal investment horizon for private equity is 3-5 years. The last private equity group that partnered with us, was in for 10 years, but that was only because they invested in 2006 right before the great financial crisis. They had to extend their duration in order to achieve the returns they were after. It may have taken a little longer, but they still ended up with compounded returns of 15% over 10 years (before considering leverage).

All of that to say that this will be illiquid until our next liquidity event.

Choosing the Options

If I choose to take the options, there is no financial risk, because unlike taking the equity option there is no financial investment required by me. And like I mentioned above, the gross earning potential is the same. Meaning if the stock is up $200/share in 5 years, the gross gain on 6,000 shares would be $1,200,000 (regardless of my choice). This is pretty much a free lunch, where I get something for nothing. Well it’s not really nothing, I am basically committed for at least another 5 years, and the options vest over 5 years (20% a year).

Then again, 5 years is something I had already committed too internally, before I knew this.

Pros

  1. No out of pocket investment, therefore no financial risk.
  2. Same gross return profile as equity.
  3. Gives me a stake in the outcome.
  4. Strike price is set at parity to company stock price based on date issued.

Cons

  1. Gains on options are taxed are ordinary income tax rates.

The only con I can think of is the fact that the taxes are significantly higher going the options route. Especially when you consider the fact that I live in California. Let’s assume that these shares in 5 years are worth $200 more than the strike price and that we are looking at a gain of $1,200,000 as described above. We would be looking at a tax rate of about 55.25% (see this post and the comments). Oh, and by the way this gain would be on top of our earned income, so it will for sure be taxed at our marginal tax rate.

If you decide not to click over to the post linked above, let me quickly breakdown the marginal tax rate:

  • Federal Top Tax Bracket = 39.6% (on income >$457,601 if married filing jointly)
  • CA State Top Tax Bracket = 12.3% (on income >$508,501)
  • CA State Millionaire Tax = 1% (a surcharge on taxable income exceeding $1M – which this gain will trigger)
  • Medicare Tax = 2.35% (It’s 1.45% for the first $200K in income, then jumps to 2.35% over $200K)

EQUALS 55.25%

Note: it should be noted that I am estimating that our income will be in excess of $600K by 2021, which would be when we would be looking to cash out through a liquidity event. Therefore our marginal tax rate would be as stated above (assuming tax rates don’t change between now and then). I should also point out that I think that a $200 rise in stock price over the next 5 years is a high probability event, so these are my actual expectations.

Based on a tax rate of 55.25%, our net proceeds from cashing in the options would be $537,000 or 44.75% ($1.2M x 44.75%).

That means we would be giving up $663,000 to the state and federal government in the form of taxes. The sad part is the government will get to keep more of the gain then we will. That is a lot of money to give up.

Let’s take a look at the Equity route.

Choosing Equity

There are a few additional factors that need to be considered when going the equity route. If I choose to take the 6,000 shares in the form of equity, I am required to come up with at least 35% of the value. Based on a $50 share price, the 6,000 shares are worth $300,000, which means I will need to bring $105,000 to the table. That is a lot of money and it would represent our single largest investment to date. And as I have previously discussed, I already have a lot of concentration risk with respect to where our income is generated.

Pros

  1. Gains on equity will be taxed at capital gains rates, so we would keep more of the gains.
  2. Gives me a stake in the outcome.
  3. The company will provide up to a 65% non-recourse loan for the remaining purchase of the shares. The interest rate is 1% and it doesn’t require any payments, the accumulated interest will be deducted from the proceeds in a liquidity event.

Cons

  1. I have to put up risk capital of $105,000. The company has just completed a leveraged recapitalization, which means there is a debt to service.

Option #2 requires a significant amount of skin in the game. I wouldn’t have to contribute this until Q1 of 2017, which by that time I estimate we will have about $165,000 in the bank, so that won’t be a problem. It will be tied up for a minimum of 5 years and maybe longer depending on how the economy is by then. It also would put yet another delay in our plan to acquire property #3 in our real estate portfolio.

On the flipside it comes with a much lower tax bill. The gains would be taxed at long term capital gains rates. Sticking with the scenario in which the gain is $1,200,00, the tax rate would be 33.3%, let met break this down below:

  • Federal Capital gains Rate 20% (based on income)
  • CA State Tax Rate 12.30%
  • CA State Millionaire Tax = 1% (a surcharge on taxable income exceeding $1M – which this gain will trigger)

EQUALS 33.3%

Based on a tax rate of 33.3%, our net proceeds from cashing in the stock would be $800,400 or 66.7% ($1.2M x 66.7%). This is an additional $263,400 in our pocket. Well, that is before paying the 1% interest rate on the $195,000 loan from the company. Over 5 years the accumulated interest will be approximately $10,000. So, it is still an additional $253,400 in our pocket.

The government would only get $399,600 in this scenario. Still a lot of money, but much easier to stomach (especially since in this scenario we get to keep more than the government gets in taxes).

The Decision to Be Made

The decision we have to decide is if the potential for an additional $253,400 is worth putting up $105,000 in risk capital. The compounded return, should this scenario play out, would be about 28% per year. In a dooms day scenario the company could go bankrupt due to unforeseen risks on the horizon. It was leveraged up similarly going into the great recession, but it weathered that storm and emerged stronger than ever. But as we all know, history is not and indication of future performance.

The company has a long record (like 20 years) of robust double digit growth. In order to achieve the stock price target (appreciation of $200/share) used in this post, we will need to continue that growth profile over the next 5 years. I honestly don’t think the company is at risk of going bankrupt. To me the biggest risk is another event like the Great Recession happens and the money is tied up for longer than 5 years.

I also feel really confident about the management team and the prospects going forward.

The hardest thing I am having trouble coming to grips with is the concentration of risk…putting too many eggs in one basket. I was hoping that by the end of this post I would have come to a final decision. However, this is not the case, my wife and I are going to have to discuss this further before we make our decision. Luckily we have some time.

Update 11-6-16: I originally wrote this back in September of 2016 when I first was presented with this decision. My wife and talked it over and after thoughtful consideration we decided that going the equity route was the right decision for us. Although it is a lot of concentration risk, I feel very confident about this decision. I really think the risk is assymetrical, meaning that the reward is much greater than the potential risk (10:1 risk/reward or better). It reminds me of a quote from Warren Buffett:

Keep all your eggs in one basket, but watch that basket closely.

That said, we will be cutting a check for $105,000 in January of 2017. We have already been granted the stock, but were given until January 31, 2017 to come up with the funds.

What would you do if you were in my shoes? Is there anything else I should be thinking about? Anyone else ever have to make this kind of decision?

-Gen Y Finance Guy

Comments 38

  1. I am jn the military so I do not get options or 401k matching. If I was in your shoes I would do the same thing. I feel like it is putting some skin the game, holding you accountable, and finally making your hard work or black thereof matter.

    1. Do you think the stock will continue to grow?
    2. What economic downturns would hurt this investment? Can you cash out in the event of an emergency?
    3. Does the stock pay dividends and if so what happens to them?

    1. Post
      Author

      Nicky – This definitely gives me a stake in the outcome. If forces you to move from the employee mentality to the owner mentality.

      Re: Your Questions

      1 – I absolutely think the stock will continue to grow. If I didn’t have a high degree of confidence that it would, I would had opted to take the options.

      2 – This company has continue growing through most recessions it has experienced, with the exception of the Great Recession. But I think all investments are susceptible to recessions. Depending on the timing of the next recession, it may extend the duration of this investment. Our last private equity partner had to hold for 10 years in order to get their gains, but we also ended up being the funds best investment EVER! The investment is not liquid, so I can’t just cash out whenever I wanted to. However, I do think if things were really tough they would be willing to work something out…but I am not counting on that…I am assuming it is locked up until the next liquidity event.

      3 – The stock does not pay dividends. It is a pure equity appreciation play. I will give updates on the value of the stock starting in January in my monthly financial updates. I will be using the same formula we use internally to value the stock (it will be a ball park estimate).

  2. Hey, interesting post. I’m assuming the company stock does not pay dividends since you didn’t mention it in the post?

    If your company paid dividends or started paying dividends, then, at current tax rates, you could save more money by holding the shares. This assumes the tax code stays the same.

    From the sounds of it, your company is in growth stage, so the company wants to hold on to your cash and use it for reinvestment.

    Just a thought! Cheers!

    1. Post
      Author

      Erik – You are right, the company stock does not pay any dividends, it is a pure equity appreciation play.

      Our company has continued to grow at robust double digit rates for 20 years now (CAGR of 25%). Of course their have been dips, but overall the trend continues to be up and too the right.

  3. Congrats on the opportunity. I think there is more than just the math to consider. Through my experience a 3-5 year hold period for a PE investment seems short. I’ve seen a lot lately that approach 7 years before they divest, so just something to keep in mind that your liquidity event may be further out than you estimate now. Also, I don’t know what industry you’re in but I’m sure you’ve done your due diligence. Having your income AND some of your assets in the same business obviously increases that risk. If something happened to the company not only would you lose your income, but also some of your nest egg. This is why I preach for people not to own too much of their employers’ stock.

    In the grand scheme of things with your end goals, $105k cash outlay today won’t make or break you so I don’t see it being THAT huge of a risk. Best of luck!

    1. Post
      Author

      FF – Thanks for your additional thoughts.

      I agree that it is more than just math to consider. Although the target is 3-5 years, it all depends on the economic environment, and I am well aware and prepared to hold it longer if need be. To your point our last private equity group invested in 2006, just ahead of the Great Recession, and ended up staying invested for 10 years. In the end their returns were a home run, and we have gone down in the history books as their best return ever.

      Putting investment capital into the same place that signs my paycheck certainly increases my concentration risk. That said, as part of my decision making process (and negotiation of the specifics of my promotion), I did this in conjunction with a 40% pay raise. Because of the 40% pay raise, the way I look at it is that most of this capital will come back to me within about 15-months (in the form of additional income), and then I am playing with the houses money.

      In the past I have also had the opportunity to participate in an ESPP when I worked for a public company, and it was a very different situation, and like you I preached not to put to much into the hand that feeds you, I would cash out and make my guaranteed return every 6 month distribution (You can read about it here).

      Like you mentioned in the big picture, this is a small investment based on where I am ultimately heading. That said, this is a significant investment, as it will represent about 20% of our 2016 ending net worth. By the end of 2017, we should be able to dilute that concentration to about 15%.

  4. Great analysis and very nice problem to have. Wouldn’t it help to have considered additional scenarios? Minimizing taxes in a home-run scenario (combined income >$600K, gain on stock >$1.2MM) is certainly great, but only considering that + a b/k scenario feels incomplete. Can’t you put your mad Monte Carlo simulation skills to work 🙂 ?

    Also, while confidence in combined income >$600K in 2021 is high (and congrats on that!), I suspect there is a frightening amount of correlation between a b/k scenario and combined income <$600K, which makes putting the $105K elsewhere more valuable as a hedge, even if that's a low probability scenario.

    But the die is cast, and I have a sneaking suspicion things are going to work out well. Good luck!

    1. Post
      Author

      Paul – Thanks for the comment.

      Although anything can happen, the b/k (which I assume you mean bankruptcy) is a very low probability. The thing I love most about this company is the visibility we have into future revenue. Our business tends to have very long term contracts, which allows me (as the finance guy) to have very good visibility and thus confidence in this investment. I don’t know very many businesses for example, that know how much revenue they already have in the bag in 2017, 2018, 2019, etc. Some of our contracts are pushing 6-7 years out. On top of this, our business has a large % of variable costs, that are easily cut with any downturn. On top of this, our capital needs are very minimal being a consulting based firm. From a CAPEX perspective we spend less than 1% of revenue.

      And as I mentioned to FF below, part of this decision was made in conjunction with the 40% raise I negotiated going into 2017, which will allow me to recoup the entire investment in about 15 months. Had this not been the case, the decision to invest this much capital would had been a bit harder for me to make.

      I also didn’t spend too much time analyzing the downside, because that is really simple, my total potential loss is $105,000 (Monte Carlo Simulation would be overkill to me).

      Thanks for the thoughtful questions.

  5. Dang, I was hoping this $105k investment was going to be the new rental!

    I agree with your decision, the only trouble I have with it is there isn’t an opportunity to get out. With a public stock, if things aren’t going well, you can cut your losses and move on. Even if you are watching your basket closely, there isn’t much you can do about it.

    Still worth the risk though: $105k earns an extra $250k in 5 years.

    1. Post
      Author

      Brian – I know you were hoping this was going to be another property. This was a bit of a curve ball thrown my way, which as I mentioned is now delaying us yet again on property #3. But I do like the fact that we are adding a private business to the asset allocation, and it does come with the more favorable taxes that I am looking for in investments.

      Your right on the illiquid nature of this investment. Although not official, we have had people sell back some of their stock to the company if absolutely needed, which I don’t see as ever being an option I would need to pursue. I may not be able to do much to cash out, but as far as watching the basket closely, I am in a very influential position to guide the business decisions being made. And I am in the best position to know everything I need to know about the financial performance of the company.

      One of these days we will get another property…I think 🙂

  6. I think it all depends on what you think the likelihood of success is. If you think it’s low, go with the options. If you think it’s high, go with equity.

    Another “pro” of buying equity is that it shows upper management that you’re committed. You’re on “the team.” Senior execs like that sort of stuff. 🙂

    I put $20k into a start up during the dot com boom and lost it all. I knew it was risky and that I could afford to lose it. So it wasn’t a killer loss by any means.

    1. Post
      Author

      ESI – I do think the stock is low, but to your second point this was also about showing my commitment as well. Additionally, as I mentioned below it was part of an overall negotiation that came with a comp increase of 40%, which will help me recoup that $105,000 investment over a 15 month period.

      I should also point out in case it isn’t clear, this is not a start up. This is a company with a 20 year history a 25% CAGR, bottom line profit margins north of 20%, and an extra ordinary amount of visibility to future revenue due to the long term nature of our contracts. Oh, and it has a highly variable expense base that allows us to be nimble during downturns, and requires very little CAPEX (less than 1% of revenue).

      There are a lot of variables that aided my decision. I acknowledge and accept the $105K of downside risk, but am also very confident and optimistic about our future prospects (based on what I know).

  7. Buy it. You will be surprised how fast five years goes, and your holding period might turn out to be quite a bit longer.

    It is a big chunk right now, but in five years, $105K will be just a pi$$-in-the-pool. Right?

  8. You understand the risk/reward well, so it is an informed investment. Personally, I think you are crazy to put up your own money on your company’s success, when there is a free lunch option from day one.

    Business conditions change, and many factors beyond your control can derail the growth train. It has happened to me in the past where I held options in my company, which underperformed for unforeseen external reasons. I’d argue that the place you work is the last place you can analyze objectively, since you already “believe.” Your return assumptions are quite aggressive (maximizing the tax benefit towards equity), and I notice there is no opportunity cost factored for investing the $105k elsewhere.

    Still, I hope it works out for you.

    1. Post
      Author

      Reepekg,

      I may well be crazy, and not just for investing my own money in the company that feeds me. When I first started with this company, before options or equity were ever even a thought, I was fascinated with the growth and robust profitability. You don’t find many companies with this kind of profile. More often than not you sacrifice high profitability (relative to your industry) for high growth or vice versa. Back then, I thought to myself, I would love to invest in a company like this…that dream became an reality.

      But there are many other variables at play here as well aside from my potential reward analysis above:

      1 – The board of directors and private equity know that I am committed (as I put my money where my mouth is). This goes a long way.

      2 – This offer was part of a bigger negotiation, where I negotiated a 40% bump in compensation, which will help me recoup the investment capital in 15 months or less.

      3 – We are leveraged far less than we could have been, therefore from a solvency perspective, there is very little risk. The business could be cut in half and we would still have plenty of cash to service our debts.

      4 – I am betting with the smart money. The private equity fund that invested in us has a $2B fund, they are a smart group of guys. The due diligence process was grueling, but it spoke a lot to their investment process and criteria.

      5 – Although there is always risk in any investment, the risk in this case is asymmetrical.

      6 – Unlike others, I wanted to lock up money in a illiquid asset, as not to be tempted to touch it or cash out early.

      7 – In the future, I will be offered options and equity as further incentive, in the future I will opt for the options.

      8 – Getting equity in this first tranche was opportunistic and strategic.

      Re: return assumptions being aggressive

      It may be aggresive, but I know my total risk on the downside is $105,000 and $1,200,000 on upside. Even if we land somewhere in the middle, it will be a very good return.

      Re: Opportunity Cost

      Although not explicitly talked about in the post, I have mentioned it several times in the comments. Part of this helped me secure a 40% bump in pay. So you could say I would have missed out on an additional ~$500K in income over the next 5 years if I chose the options over the equity.

      Other than that I don’t tend to dwell on potential returns of other investments I didn’t pursue. There was nothing concrete that I was evaluating at the time.

  9. Thanks for sharing this decision you’ve made here Dom! I’d have to say if I had the same situation and financial resources as you I would have made the same call.. Not saying this to pump up your ego, for me it’s more about as you suggest the taxes and despite the additional risk I’d be willing to take that on

    I get the point people are mentioning about a free lunch however there’s plenty of tax in place and having skin in the game is going to make you work harder to achieve the outcome

    Looking forward to seeing your progress and cheers!

    1. Post
      Author

      Thanks Jef!

      I like to also think that because I am no in the C-Suit I also have a bigger influence on the outcome over the next 5 years (and thus a nice stake in that outcome).

      Cheers

    1. Post
      Author

      Thanks Michael!

      I don’t know if I am up for the CEO roll. I make a much better number #2 🙂

      Hopefully I will just hit my $10M net worth goal by the time we have our next liquidity event and then just work on my own projects, business, and investments…and leave formal employment behind???

      Then again, I see a scenario play out, where they make me an offer I can’t refuse in the next turn…only time will tell…one day at a time.

  10. Hey!

    Exciting stuff. Personally I would go with the options, but I see your reasoning for going with equity. Quick question though, is this going to be a recurring annual package, or a 1 time thing? In my opinion, that changes the decision making process pretty dramatically.

    Best,
    Sean

    1. Post
      Author

      Sean,

      This will be the only time that I will get to choose the equity option.

      Future incentives will be all options.

      How would this change your mind and what would you do differently?

      Cheers

      1. knowing this is a 1 time thing, it makes the equity option more attractive. It would be hard to come up with an additional $105k/year for a private, illiquid investment. the potential gains for it being a 1 time hit, are worth it in my opinion.

        At any rate you’re absolutely killing it. And while I MAY (big may) beat you to $1MM, the race to 10 will be a lot more challenging for me. I am actually about to go through the opposite at my work, with about $70k of my annual comp disappearing. I have several things in the works though, and while the first half of 17 may be rocky, I hope the second half and beyond should be set up nicely.

        Will give more details as they come in!

        1. Post
          Author

          Excited to hear more details, maybe once you have them it will be time for another guest post???

          Where are you at net worth these days?

          December will be a big push to around $520K in December, and as long as bonuses post in January, we should hit close to $580K

          1. yes, maybe another guest post is in the works!

            We are around 650k at the moment. We don’t have any of the big hits you guys have though. so it will get interesting and I foresee you passing us sometime late 17 early 18 😀

            1. Post
              Author

              I think I might be able to catch up to you in 2017, and 2018 will be the year I turn the rocket boosters on.

              We are projecting to be at around $700K before you consider in changes in the value of our current investments/assets.

              Let the race to $1M continue.

  11. I love your choice and would’ve done the same thing… However, I’m interested to see your income report next month. Will you be changing your contributions to your house to pay off the mortgage faster now that your diversity of investments has shifted back? Or will you take more money and put it into other investments to further diversify?
    Super interested to see how this affects your overall strategy.
    Great article as usual GYFG!

    1. Post
      Author

      Nick,

      We will be resuming our accelerated mortgage payments in 2017 (sometime between Jan-Apr). Because of our last cash-in refinance, we are technically still on schedule to pay it off in 7 years, and don’t need to make another extra payment until April. The plan has us paying down an additional $28,800 in 2017, the question is whether we will spread that out of 12 or 9 months.

      At this point we are not going to try and pay it off any faster, but if we get to the point where we have a large enough cash stash to pay it off in full (like 5 years), then we will consider doing that.

      I think we have to continue putting other money to work, and I don’t want too much concentration in our house, when calculated as a % of total net worth.

      Cheers,

      Dom

      1. Absolutely. That makes total sense. I remember you writing about being careful to have too much concentration in the house.
        I’m interested to see your report in Jan.
        In terms of net worth and % concentration, are you counting this investment separately from your other U.S. investments, since it has a different level of concentration associated with it because of your job?

        Interesting things going on for you Dom!
        Definitely champagne problems and questions we’re all discussing here 🙂

        1. Post
          Author

          Nick – This new investment will be in it’s own category. If you have read my original blue print to $10M that I wrote 2 years ago, you will notice that I had an allocation for “Business” (private business). This will be a new bucket and will make up about 20% of our net worth. Like our house, we will work to dilute that concentration over time.

          Cheers!

    1. Post
      Author
  12. Pingback: Monthly Goal Check-in #12 - 2016 Full Year Review - Gen Y Finance Guy

  13. Pingback: Big Money Moves in 2017 - Putting Over $250,000 To Work - Gen Y Finance Guy

  14. Pingback: PeerStreet - Hard Money Lending - For The Retail Investor - Gen Y Finance Guy

  15. Pingback: February 2017 - Detailed Financial Report #26 - Net Worth $532,590 | Income $23,893 - Gen Y Finance Guy

Leave a Reply

Your email address will not be published. Required fields are marked *