How do I manage my concentrated stock positions?
December, 2011 | Portfolio Management: Creative Investment Strategies
By Kevin Burns
A stunning driver of wealth creation has been the concentrated stock position. Entrepreneurs, corporate executives and investors have enjoyed tremendous appreciation of stock options and company stock due to incentive-based equity compensation plans. These concentrated stock positions present planning challenges because volatility is significantly higher than with diversified portfolios. We have witnessed company executives with single-stock holdings representing 80 percent or more of their net worth. Such individuals should consider the psychological, financial and regulatory factors associated with diversifying their positions.
The emotional attachment to the enterprise that has created significant wealth is undeniable and may present the greatest obstacle to creating a rational plan. Executives and retirees commonly feel distrustful of the general market, yet confident about the future of their stock, as they had a direct role in ensuring the company’s success. This may wane as new management takes the company in different directions or the economic environment changes.
Executives should make rational diversification decisions by developing a family risk allocation plan. Each asset is defined by risk parameters (safety, market, aspirational). Concentrated positions are categorized as aspirational and characterized by a high risk/reward profile. By taking into account future cash-flow needs, taxes and life expectancy, advisors can guide clients to identify an optimal mix of diversification and the concentrated position.
Once an allocation decision is made, determine the best methodology to execute the plan. Some investors want to protect profits but do not wish to pay current tax. Some remain employed at the company and do not want to send a message to the investment community that they are sellers. Strategies such as zero premium collars or variable prepaid forward contracts may make sense. Both provide protective floors under a pre-determined price. In return, the holder gets appreciation over a certain price. The term may be up to seven years and may be extended under certain circumstances, thus pushing the taxable event further. We often recommend exchange funds in which investors exchange shares of a concentrated position for shares in a diversified fund. The exchange of shares does not constitute a taxable event, so the desired results of diversification and of deferring taxes until the investment in the fund is terminated are achieved. There is a minimum holding period of seven years for the fund, although investors may maintain a position indefinitely, thereby delaying the taxable event.
In cases where taxes are not an issue or corporate optics are unimportant, an outright sale due to low current capital gain tax rates is an option. Stock options and restricted shares received as compensation are generally treated as ordinary income, so it may be advisable to exercise and sell shares in relatively low-income years when the tax rates may be lower.
When diversifying concentrated positions, regulatory restrictions that govern corporate insiders may apply. One must clear any anticipated stock sales with company counsel. Insiders are governed by volume and time restrictions when making transactions and must not be in possession of material, nonpublic information when selling or buying. A 10b5-1 selling plan, established during an open selling window, identifies the price, volume and time intervals at which the executive wishes to sell shares (including during blackout periods). It cannot be modified during black-out periods and is widely regarded by securities lawyers as providing an affirmative defense against concerns over insider trading.
In summary, our 25 years of experience in counseling corporate executives confirms that a logical process must be followed to deal with emotional, financial and regulatory issues.
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