In this lesson, you will learn some basic investment and option terms and concepts.
Your employee stock option plan or other equity compensation plan may be the first time you have had to deal with the stock market and investing terms. Don't worry, it's not as bad as it sounds. However, let me urge you to take a few minutes to refresh your memory. You may be familiar with stocks and mutual funds, but options are a different kind of investment. A short course will help you understand how they fit into your portfolio.
Plain English
Portfolio is an investing term that simply means all of your investments, including stocks, bonds, options, mutual funds, and so on.
Even if you plan to cash in your options as quickly as you can, take a minute to read through this chapter. It may open your eyes to some other possibilities.
The basic concepts and terms of investing and options in particular are not hard to grasp, but are very important to understand. Much of what follows in this book builds on this chapter.
Most of the terms and concepts in this chapter apply to publicly traded companies. If you work for a privately held company, you have a different set of circumstances to consider. I discuss privately held companies in greater detail in Lesson 10, "Taxes and Your Options."
Plain English
A publicly traded company is one that has made its shares of stock available to the public for purchase. These are the companies whose stock trades on the major stock exchanges like the New York Stock Exchange.
Shares of stock represent an ownership interest in a corporation. For example, if you own 100 shares of stock in XYZ Corp. and the company has 1,000 shares issued, you are a 10 percent owner of the company.
Most publicly traded companies have millions of shares of stock issued; however, that does not change the fact that you are an owner or shareholder.
As an owner, you can vote for directors to sit on the board of directors and other matters of importance, such as dividends and stock splits. The company will invite you to its annual meeting where the important business of the corporation is decided.
A company may issue different classes of stock with different rights. Be sure you understand whether the stock connected to your employee stock option plan is restricted in any way. One of the restrictions you may encounter is stock without voting rights. Different classes of stock may be identified with the letters A, B, and so on.
Understanding basic investing concepts will help you decide what to do with your options. It is important to understand what you can do with your options and how they fit into your financial picture.
Tip
The basic idea of investing is to make your money work for you. You do this by investing it in a financial instrument that pays interest or grows.
The simplest investment is a savings account at the bank. You deposit money in the account and the bank pays you a small amount of interest.
Another form of investing is to put your money in something such as stocks, which it is hoped will appreciate over time. Either way, your money is working for you.
A complete course in investing is beyond the scope of this book, but the important steps are fairly easy to cover.
The most powerful investing tool you have is compounding, but this requires time to work. The sooner you start investing, the sooner you will accumulate your nest egg. Starting early gives you time to overcome any bad investment decisions you might make along the way.
Plain English
Compound interest is where your interest earns interest. For example, if you invested $100 at 10 percent annual compound interest, at the end of the first year you would have $110. The second year you would earn 10 percent interest on $110, or $11 in interest.
Here is a simple example that shows the power of compounding and starting early. Two investors, Joan and Bill, invest $100 per month until retirement. Joan starts at age 25 and Bill enjoys the good life until age 35, then he starts the same investment program, but at a higher interest rate.
As you can see, Joan comes out almost as well off as Bill even though she didn't pick the best investment. If Joan had earned an annual interest rate of 12 percent, she would do much better:
These tables illustrate two important points:
In the last table, Joan only invests a total of $12,000 more than Bill (10 years × $100 per month = $12,000), yet her total is over $835,000 more. This is the magic of compounding.
Tip
Start the investing habit when you are young and plan on increasing the amount you invest each year as your income rises.
Employee stock options can increase the magic of compounding by letting you buy stock at a discount. For example, say you hold nonstatutory options to buy XYZ stock for $10 per share and the market value is $20 per share. As soon as you exercise your options and buy the stock for $10 per share, you have doubled your money. (Of course, you will have to give some of it back in ordinary income taxes, but whatever is left is tax-free until you sell the stock.)
Diversification is the process of spreading your investment out over several companies in different industry groups.
Why is this important? If you had most of your portfolio in high-tech stocks in spring 2000, you probably lost your shirt. During this period, many of the high-flying Internet stocks dropped 60 percent or more of their value.
Investors that put some of their money in other sectors probably didn't do as well in 1999, but sure came out ahead by mid-2000.
How you split up your portfolio is called asset allocation asset allocation. The process looks at your current and future financial prospects and devises a way to split your assets to accomplish your goals and protect your current position.
Plain English
Asset allocation is the process of spreading out your investments over several different industry segments so that a downturn in one area will have a minimum negative effect on your portfolio.
My book Macmillan Teach Yourself Investing in 24 Hours describes the process in detail. For our purposes, the best way to understand the concept is to look at the needs of a worker nearing retirement and a worker just starting out.
This comparison is not complete, but I believe it illustrates the point.
Notice how the older worker is shifting from stocks to bonds. Bonds are predictable, while stocks can be volatile. If our older investor had most of her money in stocks and the market went south, there may not be time to recover.
Be sure you don't make your company's employee stock option program the only investment you have. Invest in companies that are in different industry groups to avoid the problem of one industry sector (like health care, for example) going bad and taking your portfolio with it.
There are expenses associated with investing, and keeping them as low as possible will improve your performance.
Online brokers typically charge the lowest commissions, but if you are not comfortable with investing over the Internet, pick a discount broker to handle your transactions.
Mutual funds, which are pools of investors' money managed by professionals, also pass on expenses to shareholders. Look for mutual funds with low expense ratios.
Caution
Brokerage fees and taxes that result from too much trading can eat up any profits in a hurry. Avoid excessive buying and selling.
One of the biggest investment expenses can be taxes. How you plan for the tax consequences of your investments may mean the difference between a nice profit and a so-so profit.
Employee stock options have their own set of tax consequences depending on the type of option. As I discuss the different types of options, I mention tax concerns and suggest ways to minimize them.
As we discussed in Lesson 2, "Why Options Are Important," options give you the right to buy a specific number of shares of stock at a specific price within a specific period.
Options granted under employee stock option programs are almost always different from the options traded on major stock exchanges. Companies do not issue those options. Investors can buy and sell those options on the open market. In most cases, employee stock options are granted to employees of the company only and cannot be freely traded outside the company.
One of the key points about options bears repeating: Employee stock options do not obligate you to do anything.
Options have their own terminology. The following are a few of the key phrases that you will see in documents about your employee stock options.
Exercise . Exercise is what you do to an option to convert it into stock. You exercise your options.
Exercise price . The exercise price is the dollar amount per share set by the company you pay when you purchase stock under an employee stock option plan. This is the same as the "grant price" or "strike price."
Grant . The grant is the name for the action taken by the company. For example, the company grants stock options at $25 per share.
In the money . This term refers to an option with an exercise price that is for less than the fair market price of the stock. For example, a stock option granted at $25 per share for a stock priced at $35 per share is "in the money." Like-wise, an option that is higher than the fair market price of the stock is "out of the money."
Tip
Don't give up on an option that is "out of the money." With enough time, the stock may rally and that worthless option will suddenly become valuable.
Intrinsic value . Options have value when the exercise price is lower than the fair market value of the stock. This intrinsic value is only one of two types of values (see time value later in this list).
Option agreement . The option agreement spells out the terms of the grant: how much per share, how many shares, and how long of term. Any other conditions or restrictions should be included in the option agreement.
Spread . The spread is the difference between the exercise price and the fair market value of the stock. For example, an option has a strike price of $20 per share. The underlying stock has a fair market price of $25 per share. The spread is +$5 per share and the option is "in the money."
When the fair market price of the stock is lower than the option's strike price, the spread is negative and the option is "out of the money."
Price Exercise Price Market Spread $20 $25 +$5 $20 $10 -$10 Time value . Options have value in the length of their term. In other words, an option with a term of 10 years has value because the stock may rise during this period, making the option more valuable. Even options that are presently "out of the money" have time value if there is time remaining on their term.
Vesting . Many companies use employee stock options to encourage workers to stay with the company. You may be required to wait a certain period of time before you have access to the options. This is vesting.
I discuss vesting in more detail in Lesson 4, "All About Vesting, Lock-Ups, etc."
You need to understand the tax consequences of your employee stock options. Because it's so important, I will spend considerable time on this subject throughout the rest of the book.
There are three basic taxes that come into play with stock options:
Plain English
The alternative minimum tax is a special tax that comes into play when a taxpayer avoids tax on certain transactions that most taxpayers pay.
It may be possible to shift your tax burden from one to another if it suits your purposes, but this requires a plan. I discuss your alternatives later in the book.
Employee stock options can be an important part of your investment program.
Investing success increases when you begin early.
Compounding is the magic that makes your investments work for you, but requires time to be effective.
Options have a vocabulary of their own that is not hard to master.
The tax consequences of employee stock options have a tremendous impact on their return.