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?
MrFireStation 
An expensive lesson for you but I’m sure your experience can help others in a similar situation. I applaud you for not only sharing the good, but the bad and the ugly too. All lessons can be valuable if you learn from them.
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Fortunately, it didn’t preclude all of the other things we did right. I have at least one more “financial failure” I will post in a week or two.
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I know people lost a lot of money (well, they ended up not exercising options) with options for waiting too much. Alcatel Lucent, several banks in Italy… Problem is: you can assume an average X% growth on indexes, not on individual stocks.
Obviously, in your situation, given that strike price was 20 and market price 24… I’d have waited a little bit.
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Yes – options certainly cut both ways and returns are especially challenging with tech companies!
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I’ve been researching this topic as of late as I have a couple friends who are starting to receive stock options/grants and have been asking my advice. Thanks for the story. I’m sure you’re glad you learned your lesson early on!
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It was a huge amount of money to goof on at the time, but at least we did enjoy that lower level!
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Interesting… it’s too bad nobody in the know questioned your cashing in early on those options. I doubt I would have known either. Stock options don’t enter the picture for most of us in medicine.
The best part of making a mistake like that is how you learn and develop a sound strategy to use in the future. You clearly took full advantage of numberous stock options, the value of which surely dwarfed the cost of the initial mistake.
Best,
-PoF
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No – exercising stock options has been an online activity, so their was no one to say “do you really want to do this?” It was also before we started working with a financial planner. In the end, all’s well that ends well. Thanks for the comment, PoF!
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I’m in a similar situation in which I’ve gotten stock options with the underlying value of the stock appreciating. The value of the vested stock options has slowly climbed up and now account up to 30% of my net worth. I’m trying to defer some compensation so that I can exercise them without paying high marginal tax rates. When you exercised your stock options, did you account for taxes on the amount and timing of exercising options?
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I’ve never been in the situation, but a good lesson to share. sorry you learn the hard way.
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All is well that ends well! Thanks, Brian!
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Hindsight is 20/20. For what it’s worth, liquidating the company options was a prudent decision when you don’t know how the business prospects of your employer work out. One already has a large correlated asset (sum of your future paychecks), why pile on and keep even more business risk in your portfolio? Former Enron employees can teach us lessons about the importance diversification.
Ask yourself: if your employer had given you $11k in cash back then, would you have gone to your brokerage account and bought your company’s options? Likely not. So it was a good decision to sell, with the knowledge at that time.
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Good point – many people are overly-dependent on their employer’s stock (and have their job there too).
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I’m not sure that exercising was really a mistake at the time. If the stock had gone down or the company faltered, it would have been the right thing to do. Only at the end of the 8 years do you know how the company stock did relative to anywhere else you could have put your money. For example, you could have exercised and invested the proceeds into Apple.
You got to enjoy your lower level 8 years earlier. Additionally, the company granted you more options every year no?
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It was a food company – so it had a very low historical beta. It did do well over the next 8 years. But yes, it was nice to finish the lower level and we enjoyed it a great deal. Would have been better to take the $$$ out of other investments/savings.
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Just found your website. In my mid forties I set a goal to retire before turning 60. I achieved FI at 55 but held off on retiring until last year on my 59th birthday because I enjoyed what I was doing. While expense management, max contributions to 401k, and regular investing to non deferred accounts were critical success factors to retirement, it was options from 3 different mega corporations that really made the difference. They allowed me to put 3 kids through college without any debt, to pay off my house, and to provide a little cushion to make me feel confident enough to go ahead and retire.
At the first company I received options from, a midsize company, I had the opportunity to speak with the CFO about the options and he told me that every year he exercised 10% of his options and diversified into index funds (good advice at a time when index funds were not as popular as they are now). He told me that he had seen too many people over the years that exercised immediately giving up leverage, or they held on to long and the company hit a down spell and the options expired worthless. I followed his advice and over the years it worked out well for me. I typically would invest ~60% of windfall into index funds and split the remaining ~40% between the kid’s college funds and paying down the mortgage. I didn’t always sell at the top but also never sold at the bottom. Options can be a wonderful thing!
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Yes – options are fantastic when the company is doing well. I worked for a packaged food company that has been especially resilient. I think it has only been down one year in the last 25 years. Not the norm, but it has worked well for us! Glad you found MrFireStation.com!
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