Managing Your Equity Compensation in a Down Market

Navigating a market downturn is often challenging, but equity compensation can sometimes offer a silver lining. Depending on your individual situation and goals, a down market could be an opportunity to consider exercising your options or buying some company stock.

If you're worried about market volatility, here are some points to keep in mind when it comes to managing your equity compensation:

• Stock options
• Restricted stock awards (RSAs)
• Employee stock purchase plans (ESPPs)
• Stock appreciation rights (SARs)
• Performance stock units (PSUs) and performance stock awards (PSAs)

Stock options usually come with a 10-year lifespan. As you might imagine, there's lots of room in there for market fluctuations—and this form of employee compensation may not need any capital investment (i.e. no up-front money needed from you) until you exercise your options. If your shares are underwater (meaning the stock's current market value is lower than the exercise price), you can wait for the stock to potentially recover, as long as it recovers before the expiration date.

If your options were granted during a downturn, congratulations. Typically, your grants come with a lower exercise price, based on the fair market value (FMV) at the time. Assuming the stock recovers, these grants can quickly add value to your company stock portfolio.

For Incentive Stock Options (ISOs), a lower stock price means the potential to exercise and hold more ISOs during the downturn (if vested options are available) and minimize the impact to the alternative minimum tax (AMT). This is a complex topic that is best discussed with a knowledgeable financial or tax advisor before attempting to exercise ISOs.

Restricted stock awards also come with a certain amount of flexibility when it comes to choosing your time to meet a tax obligation, which you might be able to use to your advantage during a down market.

With restricted stock awards, you can make what's called a Section 83(b) election with the IRS within 30 days after your grant date. With this election, you pay taxes on the value of the stock at the time it's granted, rather than its value at vesting.

Your tax advisor can help you determine if a Section 83(b) election is appropriate for your situation. And there are risks. For example, if you quit your job before the vesting date and forfeit the stock grant, you can't recover the taxes you've already paid.

Restricted stock awards are often granted at a small cost—if at all—to participants. Since you pay nothing or a very small price for the award, you could realize a substantial gain, even after a stock downturn. Make sure you go through all the tax implications before moving forward.

Rather than offering a chance to exercise option grants or get restricted stock awards and take advantage of tax strategies, the ESPP is all about managing price volatility. In general, employees can invest in company stock with their own money.

One feature offered by some ESPPs is what's called a lookback. A lookback is a designated purchase period in certain tax-qualified ESPPs where stock can be purchased at the lower of two prices: either as of the initial date of the offering period or the final date of the period, whichever is lower.

This can help you buy low even if the price skyrockets by the end of the period, which is especially valuable price protection during a volatile market.

For example, let's say you regularly buy shares of company stock with a portion of your paycheck and your company offers a lookback. At the beginning of the lookback period, the stock is flying high. But before the end of the lookback period, the price has dropped significantly along with the rest of the market. You don't miss out on the discount because your purchase price will be the lower of the two price points.

Let's imagine a different scenario where the stock price is in the dumps. Later on, the market recovers and the stock value increases. In this scenario, you still get the lower price from the beginning of the purchase period. This look-back feature is only available with certain ESPPs, so make sure to check with your employer.

While certain equity types have advantages in a down market, others do not. Let's explore two types of equity that don't have a clear advantage in a declining market.

There is no advantage in a down market for SARS because SARs compensation is subject to market fluctuations and carry risk if there is a market price decline. With SARS, if the stock value goes below the exercise/grant price, you can't exercise the stock. In this case, the SARs are considered underwater, and your SARs have no value.

Performance stocks, which focus on the performance of your company as measured by specific business goals during a set period, don't have a clear advantage in a down market. Because PSUs and PSAs are dependent on your company meeting (or exceeding) the goals established at the outset of the performance period, you'll only receive the shares if performance goals are met, which is difficult to achieve in a down market. If the company isn't meeting its performance goals, you could receive fewer shares than the target amount—or even no shares at all.