When I published my 200th post on MrFireStation.com, someone asked me to write about some of the FINANCIAL FAILURES that we encountered on our way to achieving financial independence and retiring early (FIRE). I will write about these over the next few weeks and cross-reference the posts in case someone wants to read about all of our mistakes at once!
Today’s mistake has to do with exercising stock options and grants. If you work for a MegaCorp and achieve at least a managerial level of responsibility, your company is probably starting to give you stock as a part of your ‘long term’ compensation. These programs are designed to keep your head in the game for longer than one year and, over time, become substantial ’golden handcuffs’ that keep you loyalty to your company.
I won’t get into a lot of detail or terminology about what the programs are. I’m guessing most readers understand the basics of them. I will talk about how I screwed up the exercise of stock options when I first started getting them and show you how I learned the concept of leverage.
It was about 20 years ago and as a Marketing Manager at a well-known food company, I was first granted stock. As part of a promotion, I received a mix of both stock GRANTS (1K shares) and OPTIONS (3K shares). Both had a 4 year vesting period – the time that you had to work for the company to ‘earn’ the stock – and the options had an additional 6 year ‘exercise window’. The stock was trading at about $20 a share when the stock was originally given, so that was the ‘strike price’. Those were the basics. I didn’t spend a lot of time thinking about them when I got the award since I wouldn’t be able to exercise them for a while.
I was less than 2 years into the vesting period when suddenly our company was acquired by another well-known food company and because of the change in ownership ALL of the grants and options immediately vested. Awesome, I thought! Since the stock price was at about $24 at that point, I the sudden value of my grants was $24K (1K shares x $24) and another $11K for my options ($24 share – $20 strike price = $4 x 3K shares, with some rounding). Combined, that was ~$35K coming to me from the MegaCorp stock program.
To get an unexpected windfall like that handed to us was great. My wife and I were thinking about finishing the lower level of our house and the estimate was just about $35K. I promptly sold all of the stock (grants & options) and we were able to add 1000 finished square footage to our house and buy a spiffy new Brunswick pool table too!
Here’s a picture of the lower level we finished off (have since moved):
All of the managers in our company were in the same situation with respect to our stock program suddenly vesting and after sharing our new lower level pictures with my finance manager he was shocked that I had sold all of my stock grants AND the stock options. Didn’t I know that the stock options were LEVERAGED he asked? Didn’t In know I didn’t need to exercise them for another eight years? At first, I didn’t understand his concern – after all, the options weren’t worth much – only ~$11K. He then created for me a simple line chart that I have shared with dozens of new managers over the years that show the power of leverage:
As you can see from the example chart – the value of the stock OPTIONS grows exponentially relative to the stock GRANTS. Both lines assume 9% annual stock growth in the same company. The OPTIONS (red line) aren’t worth much early on, but grow at a much faster rate than the GRANTS because you earned ALL of the annual appreciation in the stock (+9%), but only pay a FRACTION of the current price to get them ($20 vs $24).
My financial failure was that I sold my options in Year 2 – a point at which they weren’t very valuable ($11K). If I had held onto them until year 9 or 10, they would have been worth 7-8 times as much as they were earlier (~$75K). Wouldn’t you love to have an investment in your portfolio that returns that much in less than a decade? The stock’s annual +9% appreciation gets leveraged into an incredible annual +35% appreciation in your portfolio.
It was quite a lesson into the power of stock options and the investment returns that come from their leverage. Had I kept the options in my portfolio, I would have been ~$35K richer at the end of the 10 years (the difference between the red & blue lines). This would mean I could have finished off our lower level twice-over (and had two spiffy Brunswick pool tables!).
Every stock option award I received since I made this early mistake, have been kept until the last 1 or 2 years of the 10 year window that I can exercise them in. I typically sell 1/8th of each award for the 8 consecutive quarters at the end of the option window. It is kind of a reverse dollar cost averaging approach. I don’t want to leave them all until the very last day of the exercise window out of concern that a short term market issue could force me to sell them at an inopportune time.
Speaking recently with our financial advisor about what were the key elements of our ‘plan’ that got us to FIRE and we both pointed to the value of the stock options. I was fortunate that the MegaCorps I worked for did progressively well (declining stock values make the options worthless) and also that I held onto most of them for as long as I did. He said many of his clients sell their options much too early. Many people exercise them as soon as the vest – just as I once had – and never realize what they are giving up in terms of opportunity. I still have unexercised stock options in our portfolio that are racking up huge gains, even though the overall market has been pretty flat.
I hope sharing this financial failure is helpful to some of you that are just starting to be awarded stock grants and options. Any additional lessons you’ve learned?