Market volatility has put a spotlight on the risks of having a significant portion of your net worth concentrated in just one company. A concentrated stock position can easily arise, for example, when you acquire company shares through restricted stock unit (RSU) vesting, stock option exercises, or founders’ stock in a fast-growing startup. While a concentrated position can create tremendous wealth if the stock skyrockets, it can also erase your wealth in just one bad day for the stock.
Everyone knows the old investment adage: don’t keep all your eggs in one basket. But diversification, the obvious answer to overconcentration, isn’t always so simple. Many executives have ownership requirements for the stock of their companies and therefore cannot sell large portions of their holdings. Corporate insiders often possess material nonpublic information, which puts them at risk for insider trading when they sell shares.
Moreover, under company rules you may have only very brief open trading windows when you are able to sell your stock. Sometimes sheer loyalty to the company and confidence in its future may make it personally hard for executives and employees to diversify wealth out of the stock.
Strategies exist to mitigate the risk of a concentrated stock position. These techniques were the focus of a recent webinar held by myStockOptions.com, an online educational resource on equity compensation and company stock. The panel of financial and tax experts who presented during the webinar outlined several key approaches, from simple to complex and from short-term to long-term.
Concentration Risk Applies To All Stocks
While experts do not agree on exactly what constitutes a dangerously concentrated stock position, they do agree that the risk applies to the stocks of all companies. Recent volatility has provided fresh examples, as pointed out by webinar panelist Valerie Gospodarek (CFA), the owner of VG Financial Consulting in Lafayette, California. She noted that, at the time of the webinar (May 4, 2022), Netflix was down 70% from its peak, Wayfair 75%, Zoom 80%, and Zillow over 80%. Even stalwarts such as Amazon (then down 25% from its peak), Google (down 21%), and Home Depot (down 28%) have shown alarming volatility and declines, she continued.
Sudden stock losses often do not involve internal and foreseeable business reasons within a company’s operations. “There were no specific company issues causing these declines,” Valerie pointed out. “A lot of stock declines happen due to macroeconomic factors, such as the pandemic, supply-chain shortages, high inflation, and the war in Ukraine. These can affect every stock out there.”
A commonly cited threshold for dangerous concentration is 10% or more of net worth in a single stock. “Many of my clients who receive equity compensation have far more than 10% of their wealth in their employer,” said Valerie. “Usually somewhere around 20% to 30%, I start to get very concerned for my clients.”
Core Strategies: Selling, Gifting, Or Donating
The simplest recourse for a dangerously concentrated stock position is to sell the shares and diversify. An executive should set up a Rule 10b5-1 trading plan for selling shares, as this can provide an affirmative defense against any insider-trading charges that arise. However, said Valerie, her clients may be reluctant to sell their shares because of combined federal and state tax rates on capital gains that can approach 40%.
An alternative strategy Valerie cited is gifting the stock. A gift of stock, no matter how large, is not taxable income, and the recipient does not have to report it. Depending on the size of your estate at death, a strategy of making lifetime gifts can reduce your estate taxes, and you may want to consider using GRATs and other techniques involving trusts. Another approach is stock donations, including the use of a charitable remainder trust.
Short-Term Strategies: Hedging
More complex strategies for concentrated stock positions were discussed by webinar presenter Marcel Quiroga (RMA®), the founder and CEO of TQM Wealth Partners in Marblehead, Massachusetts. These strategies involve “hedging” the stock: techniques for protecting gains against the risks of concentration without the full tax consequences of selling the shares.
Alert: Hedging transactions are sophisticated devices. They involve legal and tax rules that require professional advice and may attract IRS attention. Some companies prohibit them altogether.
Marcel discussed four short-term hedging strategies during the webinar:
1. A put option gives you the right to sell a specified amount of an underlying security at a specified strike price when or before the option expires. “With a put option, you have the potential to control downside risk,” Marcel observed. “This is a shorter-term strategy,” she emphasized, “because the premiums are high.” However, she noted, there are ways to reduce the out-of-pocket expenditure, such as lowering the strike price.
2. A covered call consists of selling a call option that is covered by a long position in the asset. “This strategy provides income for the stockholder,” continued Marcel, “but it doesn’t offer downside protection. You would use a covered call when you are neutral about the stock, meaning you don’t think it will either increase or decrease in price.”
3. A zero-cost collar does offer some downside protection, said Marcel. “Here you are protecting your losses by purchasing a put and selling a call. The cost of the put is canceled out by what you create in income with the call. You forgo some upside potential, but the put option protects you on the downside. This becomes really interesting not only for that downside protection but also for the possibility of eliminating the cost.” While forfeiting some upside potential may be considered a disadvantage, “with a concentrated position what you’re doing is hedging your bets, so it can be worth giving up that upside potential to protect on the downside.”
4. A variable prepaid forward, like a zero-cost collar, includes buying a put and selling a call, but it has an extra twist. “A variable prepaid forward is packaged with a loan for 75% to 90% of the value of the securities that will be sold in the future, typically in two to five years,” explained Marcel. “Based on the market price at the time the contract expires, the number of shares delivered to the counterparty is variable.” Taxes on capital gains are not due until the transaction is finalized.
“This technique can be useful for executives who are granted stock options but have ownership requirements that prohibit them from selling the acquired shares for a certain time.” However, Marcel warned, this approach can draw IRS scrutiny and is less popular for that reason.
Long-Term Strategies: Exchange Funds And Protection Funds
Two approaches for managing concentrated stock positions over a longer term were discussed by webinar panelist Brian Yolles, the founder and CEO of StockShield in Pasadena, California. These involve what are called exchange funds and protection funds. Both are ways to “pool” concentration risk and thus soften its potential impacts.
An exchange fund, Brian explained, is a partnership or similar entity. Each participant contributes low-tax-cost-basis shares in exchange for a pro rata interest in the fund. As each investor provides stock from different public companies, the fund holds a diversified portfolio of stocks in a variety of industries.
After seven years, if you don’t want to stay in the fund, you can exit by receiving a basket of stocks equal to your fund interest. Contribution of shares to an exchange fund does not trigger a taxable event. The tax basis of your fund interest equals the basis of shares you contributed (i.e. a carryover basis).
“Economically it’s as if each investor sold his or her shares without triggering a taxable event and immediately reinvested the proceeds into the fund,” said Brian. “This is useful for investors with highly appreciated stock positions who wish to diversify out of some or all of their position in a tax-deferred manner.”
However, the stocks you get when you exit the fund seven or more years later “are not really your call,” he cautioned. “That’s down to the portfolio manager of the fund company. The concern there is that when you redeem your exchange-fund interest, you’re going to get stocks that the portfolio manager does not want. You may end up with a bunch of stocks you don’t really like and then have to sell them and pay taxes.”
A protection fund is an alternative risk-pooling strategy. It’s for investors who, unlike with an exchange fund, want to continue owning some or all of their stock position as a core long-term holding. “Each investor contributes a modest amount of cash (not their shares, which they can keep) into a cash pool that’s used to protect the participants from a large decrease in the value of their stock after a period of years,” said Brian, who holds patents for this strategy and whose firm specializes in protection funds. “It’s a way to mitigate the risk but let you keep the stock.”
The pool of cash, he went on to detail, is provided by several investors, “each with a different stock in a different industry and each looking to protect the same amount of stock.” The particular terms of a Stock Protection Trust (SPT) can vary depending on the risk of the underlying stocks. In the example Brian presented, every investor contributes cash (paid up front) equal to 2% of the value of stock being protected per year for five years. The pool of cash is invested to maturity in US government bonds with a five-year duration. The stock being protected is not pledged or subjected to any lockup provision.
At maturity, investors whose stock has appreciated retain their stock’s full upside gain; for investors whose stock lost value, the cash pool is distributed on a “total return” basis. If the cash pool exceeds total stock losses, all losses are eliminated and the excess cash is returned to the investors. If total stock losses exceed the cash pool, large losses are substantially reduced.
Incentive Stock Options (ISOs) And Special Tax Issues
If your concentrated position arose from exercises of incentive stock options (ISOs), you need to know the special ISO tax rules. For ISO shares held more than two years from grant and one year from exercise, you get long-term capital gains tax treatment at sale for the full gain over your exercise price. According to webinar panelist Mark Leeds, an attorney at Mayer Brown in Manhattan, New York, the ISO rules do not automatically prohibit hedging transactions; they consider whether a disqualifying disposition (i.e. sale, gift, etc.) has occurred during the required holding period for ISO shares.
Certain strategies or ways of structuring a strategy can be considered a constructive sale, triggering a disqualifying disposition of the ISO shares and the loss of tax benefits, Mark warned. He also cautioned that any strategy must avoid being labeled as a tax straddle.
The webinar in which these experts spoke, which included case studies and tax analyses, is available on demand at the myStockOptions Webinar Channel. The website myStockOptions.com itself also has extensive content on financial planning for concentrated stock positions, diversification, and other high-net-worth situations involving stock options, restricted stock and RSUs, ESPPs, and substantial holdings of stock in public and private companies.