In the words of the esteemed Warren Buffet, “Never invest in a business you cannot understand.” While this core component of Buffet’s investment process certainly has merit, all too often the principle is taken to extremes by individuals with robust compensation programs in their own company’s equity. After all, what business could you understand more fully than your own?
As we have discussed, it is not uncommon that high-ranking and key employees of both new and well-established companies are paid in large part through distribution of the company’s equity. These compensation programs take many forms ranging from performance-based, outright units of company equity to stock option grants that vest over several years.
While there are undoubtedly benefits to the company and employee under these programs, without proper management of these lucrative opportunities an employee can be exposed to undue risk to their financial future – chiefly, concentration risk.
Concentration risk is defined as the potential for a loss in value of an investment portfolio when an individual or group of exposures move together in an unfavorable direction. When an ungainly percentage of one’s portfolio is dedicated to a single company’s stock (even their own employer) that is exactly what you get.
Because high-ranking employees often have a great deal of confidence in their own firm and their ability to influence that firm’s success, it is easy to become complacent about properly diversifying their own assets. While they may be able to influence company success in some manner, there will always be factors beyond their control that affect the value of the company. For example, legislative changes could significantly undercut profit centers, another key employee could negatively affect sentiment due to scandal or departure from the firm, outside innovation could render current products and services obsolete.
To manage such risks, it is crucial that you do not have too many of your eggs in the company basket. So, how many is too many? The answer is not cut and dry – and if you do your research, you’ll find quite a few different opinions. However, the majority suggest that the maximum threshold for owning company stock is from none at all up to 10 %. In fact, most investment advisors will suggest that no single-equity investment position compose greater than 10% of your portfolio. Concentration risk exists whether they are your employer or not.
So, what do you do now? First and foremost, consult your investment advisor. As we have discussed in prior installments, the sale of employer stock, through outright sale or option exercise, requires consideration of many factors (tax, timing, price targets, trade restrictions and otherwise). It is also not uncommon that highly compensated executives are required by their firm to hold a minimum amount of company stock – be sure that this does not apply to you before commencing any strategy to reduce your exposure. Discuss with your advisor the exposure that you currently have and also what exposure you are likely to continue receiving through additional stock distribution in the coming years. If you expect with reasonable confidence that you will continue to be granted shares on an annual basis, it is likely in your best interest to establish a disciplined strategy for diversifying those assets on a concurrent basis. Great responsibility at a company typically comes with great compensation, and often individuals focused on improving their firm neglect their own finances. Know what you own, know what you are expected to receive in future years, and establish a healthy strategy for diversifying your stake in the company alongside your work to grow the company for the future. Don’t let your Golden Parachute fail you because you forgot to pack the reserve.
