Are you putting all your eggs in one basket when you invest in company stock? We’ll tell you about the benefits and drawbacks, and whether or not you should buy stock or options in your company.
It’s pretty common for employees to buy stock or options in their company. After all, since you know your company well, investing in it becomes a logical step. Some companies even provide various incentives for you to do just that.
But is it always a good strategy to buy stock or options in your company? Sometimes yes, sometimes not. Unfortunately, it’s usually not known with any certainty until well after the fact. Only then do you find out if it was a good investment or a bad one.
What are Stock Options?
Stocks are self-explanatory, so let’s focus on stock options. What are they?
Stock options are granted to an employee by an employer, granting the employee the right (but not the obligation) to purchase a certain number of shares at a specific price and by a specific date in the future.
Options have expiration dates, and if the options aren’t exercised by those dates, they expire and become worthless. And much like employer matching contributions in a 401(k) plan, options are subject to vesting. A certain amount of time will have to pass before the options are fully owned by the employee. That can take up to five years.
The value of the options is based on the market value of the stock at the time the options become vested. That means the value of the options can never be known at the time they’re granted.
Examples of How Employee Stock Options Work
Your employer might grant you the option to purchase 1,000 shares of company stock at $25 per share. This is referred to as the strike price, or exercise price. There’s a five-year vesting period on the options, in which you become vested in 200 shares in each of five years. There’s also an expiration date on the options after seven years.
After the first year, the value of the stock has risen to $35. You exercise your option to purchase your 200 vested shares at $25 each. You earn a profit of $10 per share, or $2,000.
At the end of the second year, another 200 shares become vested. The stock prices rises to $45 per share, so you once again exercise your option to purchase the stock at $25 per share. This time you have a profit of $20 per share, or $4,000.
This is an example of how options work when they’re successful. Let’s take a look at the opposite result.
You’ve been with the company for seven years, and you are vested in all 1,000 shares after the end of the fifth year. But the value of the stock never exceeded $25 in all that time, and is now trading at $20 per share. Since the options had a seven year expiration date, and you were never able to exercise the options due to the low stock price, the options expire and become worthless.
The Benefits of Buying Shares or Options in Your Company
Let’s get back to both stocks and options. One of the big advantages is that you know the company. And if you like the company, it can make sense to invest in its stock.
- The company stock is a strong performer. If the company is highly profitable and growing, its stock is probably rising steadily, making it an excellent investment. It may be even one of the better stocks in your portfolio.
- Discounted purchase price. Company stock is typically purchased through an Employee Stock Purchase Plan, or ESPP. The stock is purchased through payroll deductions. Larger employers often allow you to purchase the stock at a discount, which can be as high as 15%. (Note: when you sell the stock, the amount of a stock that represents the discount is taxable as compensation from your employer. The gain above the full purchase price is considered a capital gain.)
- Tax break on the gain. If the stock rises in value, and you hold it for at least one year after purchase, it will be subject to reduced long-term capital gains tax rates. That rate varies between 0% and 20%.
- Benefits on options. In a particularly strong company, options can produce tremendous gains, with very little risk. Since an option is an option to purchase, you’ll have no investment until and unless you actually exercise the option. And you’ll only exercise it if it makes sense. So if your employer gives you the option to purchase company stock at $25 per share, and it goes to $50 per share, you could be looking at a $25,000 profit on 1,000 options.
The Drawbacks of Buying Stocks or Options in Your Company
The biggest drawback is if the stock is a poor performer. Despite the fact you work for the company, its stock is no better or worse than any other you might purchase. But if you’re buying a particularly large amount of the stock–because it’s your employer–and the stock doesn’t perform well, you’ll take a loss on your investment, the same way you would on any other stock.
- Diversification is another issue. If you overload in company stock, or if you purchase too much within your retirement plan, you could simply be setting yourself up with too much of the same security. A decline in the stock price could have an exaggerated negative impact on the rest of your portfolio.
- There’s also the issue of investing your money at the same place you work. If the company falls on hard times, you’ll not only be looking at the prospect of losing your job, but also losing money on the company stock. It’s an excellent example of putting too many eggs in one basket.
- Options can become worthless. That’s not a huge risk, since you actually have no investment in the options themselves. But it will be a missed opportunity.
- Options vesting requirement. If the company stock is doing well, and there’s a five-year vesting requirement, it may compel you to stay with the company even though the job isn’t working for you. This is actually one of the major reasons why employers offer stock options with extended vesting periods. The options can induce an employee to stay with the company longer than they would otherwise.
Should You Accept Options in Lieu of Salary?
Many employers offer options as part of the compensation package. They may offer a salary that’s low compared to competing employers, making up the difference with options. This might make sense if it’s a well-established company, and its stock has a strong record of steady growth. But if there’s any doubt about the stock, or if it’s an upstart company, it probably won’t be worth taking the risk.
In that situation, there’s a high likelihood of the options becoming worthless. If they do, you’ll have ultimately accepted a position at a lower salary than you could have earned elsewhere.
That’s also a possibility with a well-established company. For reasons unknown at the time you take a job, the company stock may still fall. This is more than possible in the general market decline. If the options expire before the market recovers, the options will become worthless, and you’ll have worked at a reduced salary to no benefit.
Buying Stocks or Options in Your Company Intelligently
ESPPs that allow you to purchase stock at a discount are almost always worth participating in. You can sell the stock at an instant profit, which removes your risk.
But if you plan to hold the stock in your portfolio, be careful you’re not overexposed. Many experts recommend investing no more than 5% to 10% of your portfolio or retirement plan in company stock.
And when it comes to options, you certainly want to take them if they’re offered as a benefit, and not in lieu of salary. But if they are offered to induce you accept lower pay, tread lightly. You’ll be giving up a guaranteed income for an uncertain (or non-existent) profit on the options.Topics: Investing