Merriman Advisor Rebecca Conner recently co-wrote an article with Joe Wallin from Seattle law firm Carney Badley Spellman for Puget Sound Business Journal, about the questions employees should ask to better understand their stock options. Read the entire article here.
At a recent technology event I attended on the Internet of Things, it amazed me how people’s lives will be touched in the future by ‘smart’ systems at home, in the car and on the go. As technology continues to gravitate toward the cloud and social networking, it’s important to look at how your digital property is distributed at the time of your death.
What is digital property?
Digital property includes:
- Computing devices (smartphones, eBook readers, computers, etc.)
- Data storage devices
- Electronically stored information
- User accounts (including email, social networking sites, web blogs, online gaming, etc.)
- Domain names
- Intellectual property rights in digital property
Why does digital property matter?
Digital property is extremely personal and sentimental – this is where many now store pictures, videos and their most prized projects and conversations. Digital property can also be financially valuable – creating worlds or real estate in online games, web presence through blogs and social media, etc.
When privacy laws conflict with helping your family gather pictures and prized possessions from your best and last moments, it can cause enormous stress on your family. (more…)
In the start-up world, founders create a company and hire a business attorney to compile incorporation documents. Once the company is formed, if the founders elect to vest into their ownership over time, the attorney will send the founders a reminder email saying, “Don’t forget to file your 83(b) election! You have 30 days to make this happen.” Then a week later, the founders receive another reminder email, and maybe a few more down the road, but they let the chance to file the election pass on by.
So what is all the fuss about?
The 83(b) election is often forgotten or ignored at the critical moment when a startup begins to gain traction. Or, an employee who obtains a stock vesting agreement for the first time can easily miss it. When used wisely and in the right situation, the 83(b) election can be invaluable.
What is it?
The 83(b) election is available in stock compensation agreements with a substantial risk of forfeiture (a.k.a., restrictions). This is usually seen with stock vesting agreements for founders and executives of newly created companies and does not apply to phantom stock (RSUs, phantom units, etc.). Rather than paying tax each year upon vesting, this election allows you to pay all taxes up front based on the value of the stock at the time of award/grant. Then, when you dispose of your stock years later, you will be subject to capital gains tax rates. (more…)
Every time I meet with a tech executive or founder holding restricted stock, I ask them if they made their 83(b) election. By this point, many have heard the phrase but few can point to an example that is easy to follow. There are both potential risks and rewards in making this choice.
Example of 83(b) Election in an Optimal Situation
You receive a grant of 90,000 restricted shares vesting over three years. The price per share at grant is $0.01. Assume you hold the vested stock and sell at the beginning of Year 5, your marginal income tax rate is 39.6%, your long-term capital gains tax rate is 20%, and net investment income tax rate is 3.8%.
- End of Year 1, the company received angel investment and the value per share is $1.
- End of Year 2, the company picks up steam and the value per share raises to $5.
- End of Year 3, the value per share is $10 and the company prepares to go the venture capital route.
- Beginning of Year 5, the price per share jumps to $20 due to funding valuation.
Without an 83(b) election, you will recognize taxable income each year on the vested portion. The taxable income will be equal to the fair market value less the grant price. Over time, if the value of the stock increases, you will pay more tax at each vesting event.
Restricted Stock Vesting - No 83(b) Election
|Share Price||Taxable Income||Tax Liability
|Total Tax Paid||$504,098
|Grant Date - 12/31/Year 0||$0.01||-||-
|Vesting - 12/31/Year 1||$1||$29,700||$11,761
|Vesting - 12/31/Year 2||$5||$149,700||$59,281
|Vesting - 12/31/Year 3||$10||$299,700||$118,681
|Sale Date - 2/1/Year 5||$20||$1,320,900||$314,374
If you make an 83(b) election, you will accelerate your vesting for tax purposes to the current year and realize income on the current value now.
Restricted Stock Vesting - 83(b) Election
|Share Price||Taxable Income||Tax Liability
|Total Tax Paid||$428,542
|Grant Date - 12/31/Year 0||$0.01||$900||$356
|Vesting - 12/31/Year 1||$1||-||-
|Vesting - 12/31/Year 2||$5||-||-
|Vesting - 12/31/Year 3||$10||-||-
|Sale Date - 2/1/Year 5||$20||$1,799,100||$428,186
This example displays the benefits in an optimal situation. It assumes one income tax rate across multiple years with the sale of stock occurs more than one year after full vesting. Depending on your particular situation, the impact of an 83(b) election may change substantially. Discuss the implications with your tax accountant and/or financial advisor to find out if this option is right for you.
Before I came to Seattle, I had the pleasure of working for an asset management firm with close ties to lead researchers, Nobel Prize winners and economic powerhouses. One day, a dear friend to many in the company passed away and I was amazed at the outpouring of respect and love. Gordon Murray left a legacy with his co-authored book, The Investment Answer, written during his battle with terminal brain cancer.
Instead of traveling the world or living out the remainder of his time on a beach or mountain, Gordon gave the world the gift of what he learned over 25 years working on Wall Street and consulting with financial firms. The book is a light read (around 68 pages) and can be very powerful for those beginning their investment journey. It simply outlines key decisions every investor needs to make on their path to investing.
If you view the market as your ally rather than an adversary that you must time and compete against, give the book a quick read. Gordon and his co-author, Dan Goldie, outline five considerations:
- Decide whether you’ll do it yourself or hire a professional investment advisor.
- Determine what asset allocation between stocks, bonds and cash is best for you.
- Evaluate what specific asset classes you’ll include in your portfolio, and in what ratio.
- Consider whether you believe you can strategically and consistently outperform the market or whether you believe obtaining the market return is most in your favor.
- Create an execution strategy around when you will buy and sell funds from your portfolio. (For example, will you rotate asset classes? Sell based on trend following dynamics? Periodically rebalance on a definite time frame?)
For a little more history on Gordon and why this book was created, check out this NY Times article.
I’m never surprised when I meet a tech person who is well informed on particular aspects of the market. As voracious readers, I would expect nothing less. However, that knowledge is often limited to the top-selling finance books focusing on one story or perspective of the stock market, or news articles about why certain technology stocks will rise or fall in the next year.
This is natural – we tend to gravitate toward what is in the news or what we are currently focused on from a business perspective.
What’s amazing to me is when I meet a tech entrepreneur or executive who understands exactly what makes them comfortable or uncomfortable in investing. One individual I talked with had figured out what made her comfortable without fully understanding the technical jargon and the possible ways of investing in the market.
Before I asked a question, she told me she believed in diversification across the entire stock market. She didn’t want to waste time and emotion on trying to time particular industries or company stocks – it felt too much like betting. She told me how much money in dollar terms she was not willing to lose from her portfolio, and that she knew this might affect the likelihood of reaching her goals. She wanted to maximize her investment return while following consistent, scientifically proven methods that made sense to her. She felt this way of investing kept her from needing to look at her portfolio daily and feel concerned when particular areas of the stock market had “bad days.”
Needless to say, I was blown away. Determining your investment philosophy is usually the hardest part. It requires understanding behavioral biases, asking uncomfortable questions and playing to your strengths in what you can tolerate. From this foundation, you can build an approach to your financial future.
Overcoming Behavioral Bias
We all want the upside without the downside. I have seen the internal struggle time and time again – how do you balance investing methodically without reacting to stock market news and the emotional rollercoaster that investing entails?
Investing is about knowing what drives your decisions, and then acting on it. You know what the right thing to do is, but struggle to implement it due to our inherent psychology.
So let’s play a game. First, you are given $10,000.
Now you must make a choice… which of the following would you prefer?
- A sure gain of $1,000
- A 50% chance of gaining $2,000, but also 50% chance of gaining nothing
Then, another choice… which of these would you prefer?
- A sure loss of $1,000
- A 50% chance of losing $2,000, but also 50% change of losing nothing
Were your answers different? If so, this is loss aversion – the fear of losing money more than obtaining increased value in your investment portfolio.
This belief drives investors to hold on to losing investments and sell winning investments too quickly. Loss aversion is a classic problem of chasing returns. This thinking leads investors to sell stocks near the bottom of a stock market cycle and then not buy the stock back until a substantial increase in price has already occurred.
Here are some other behaviors investors struggle with.
- Procrastination: Some individuals wish to avoid planning their investing approach altogether. Ben Franklin said it well: “If you fail to plan, you are planning to fail!”
- Hindsight 20/20: Attempting to time economic shifts and anticipate changes in stock prices may seem obvious when looking back at the event, but it’s very difficult different to accurately predict. Seeing errors in hindsight can makes us overconfident in predicting it “next time,” ahead of the event occurring.
- Here-and-now reactions: The media has an uncanny ability to focus on particular stories that increase readership and draw the stories out for as long as they can. When looking at economic newscasts, a story is one pin point for an entire outline of what makes the financial markets tick.
Last year’s sound bite? It was all about the S&P 500 rising dramatically. When someone uses the S&P 500 as synonymous with the stock market over the last year or two, this indicates a here-and-now reaction.
How do you feel about the stock market?
This question makes people uncomfortable. I see the shift in their body language and gaze, and suddenly I get the uncomfortable vibes.
“Um, I don’t know,” or “I am in a growth strategy… I think.”
How you are currently invested may not be the best for you. So what are some driving factors in establishing what is best? Here are some things to consider.
What am I willing to lose?
- How comfortable are you investing in the stock market?
- How much money (dollar-wise) are you willing to lose from your investment portfolio?
- The average intra-year S&P 500 stock market drop is 14.7%. How does that make you feel? Surprised, unsettled or unfazed?
- What are your goals and how much time do you have to save for each goal?
- What level and kinds of debt do you currently have?
- How many stock options do you have? What time frame do they vest over?
- What is your professional plan for the future?
- What benefits are available to you in your employment agreement? What risks are apparent?
- What obligations or goals have you set as a family?
What drives your decisions around investing?
- Do you understand the level of risk inherent in different types of investments (i.e. stocks, bonds, mutual funds, ETFs, private equity, angel investments, etc.)? All investments involve a degree of risk.
- Do you know what style of investing you prefer?
- Active investing – managing your investment portfolio by picking particular investments you believe will outperform the financial markets. You will time when to move in and out of each part of your portfolio using different types of analysis to find opportunities.
- Passive investing – systematically buying into a strategy you will hold for a long time period. You’re not worried about daily, monthly, or annual price movements. You’re looking to capture the persistent and pervasive opportunities the financial market provides overall.
- What analysis and strategy will you use in maintaining your investment portfolio?
- Do you believe the financial markets are unpredictable over the short term?
- Do you believe in diversification?
- Do you prefer picking stocks?
- Are you concerned with trading costs and rebalancing your portfolio?
A great book to begin this discussion can be found in my post Where are you on the investment continuum?
Should you do it yourself or hire a financial advisor?
- Will you manage your own investments?
- Do you have the time to manage your investments?
- How will you choose which stock, bonds, mutual funds, etc., to invest in?
- Are you aware of the fees involved in investing?
- How will you track the tax implications of investment choices?
- Will you hire an advisor?
- How will you find the right advisor for you? Do you trust them?
- Do you care if they are a fiduciary required by law to do what is in your best interest?
- Do you understand the difference between hiring a financial advisor at an investment bank or an independent advising firm?
- Does the financial advisor understand who you are and where you are going?
Your investment philosophy is made up of guiding principles that will govern your future investment decisions. These crucial choices and commitments help you filter through the noise that doesn’t matter and focus on the path to wealth creation, accumulation and maintenance.
Be honest with yourself through the process of investing – it’s easy to reach analysis-paralysis quickly and feel overwhelmed. So whether you’re analytical or laid-back in nature, it’s is easier than you think to misstep and begin judging your future moves based on making up for past mistakes.
That’s where a good financial advisor can step in and help you remove the emotion from investing, while helping you maintain discipline in the markets.
 Source: Business Insider, CHART OF THE DAY: Here’s One Chart Every Stock Market Investor Should Pin To The Wall by Steven Perlberg on Dec. 3, 2013. Standard & Poor’s, FactSet, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2012. The 2013 numbers represent returns as of 9/30/13.