“Don’t put all your eggs in one basket”: it’s a proverb most of us have heard since childhood. And for good reason: we all know what can happen when too many hopes, plans, or assumptions are built on a single point of support. If something happens to that one underpinning, the whole structure can come tumbling down around our ears.
Too often, however, successful entrepreneurs and professionals in STEM fields incur this risk, sometimes without even realizing it. It’s called concentrated risk, and it happens when most or all of one’s wealth is dependent on the value of a single asset or the success of a single enterprise.
Concentration risk can develop due to several different circumstances. For example, when employees or founders of a closely held company have been compensated with stock or stock options, and the company subsequently conducts an initial public offering (IPO), concentrated stock risk can become an immediate concern. Or, employees of a public company offering some form of equity compensation, such as restricted stock units (RSUs), incentive stock options (ISOs), or an employee stock purchase plan (ESPP), can often find themselves in a concentrated risk position, especially over time, as they accumulate a larger position in the stock or the options.
Understanding Concentrated Stock Risk
Take, for example, an entrepreneur whose company has just achieved a successful IPO. As the company was launched and being built, she (and, likely, her key team members) were compensated largely by the issuance of equity (stock) in what was then a closely held company. Then, with the successful launch as a public corporation, that privately held equity suddenly became worth much more: potentially, millions. But that “sudden wealth” is entirely dependent for its value on the continued success and profitability of the company. If negative conditions develop—patent complications; a weakening economy; an unforeseen lawsuit by a competitor; the illness, death, or even defection of a key researcher; or any of a dozen other calamities that are impossible to predict—the value of that stock could take a hit, and the entrepreneur’s newfound wealth could evaporate.
For STEM professionals and entrepreneurs being compensated with equity in the company, a central part of responsible financial planning is being aware of and taking steps to manage concentrated stock risk.
Risk Mitigation for Concentrated Stock Positions
The core of managing the risk of stock concentration is a diversification strategy: “unwinding” the concentrated equity so that assets can be repositioned in a broadly diversified set of holdings to reduce over-dependence on any single asset or asset type. It’s important to remember, however, that successfully addressing concentrated stock risk is not as simple as selling the stock and reinvesting the proceeds. There are legal, tax, and liquidity considerations that must be built into the strategy in order to preserve the individual’s wealth in a tax-efficient way.
1. Legal considerations. The first thing to consider is the various restrictions imposed on the timing for selling shares. For stock involved in an IPO, company employees are typically restricted from selling their stock for some period (often 180 days) following the IPO (“lockup agreement”). Additionally, owners and other corporate insiders (directors, major shareholders, officers) may be prohibited from selling stock until they have owned it for a similar set period. In other words, the first step toward unwinding a concentrated stock position is gaining a clear understanding of the requirements imposed by your ownership of the stock, especially when you are actually free to sell it.
2. Tax-aware diversification. Depending on whether the plan is based on incentive stock options (ISOs) or an employee stock purchase plan (ESPP), the IRS imposes minimum holding periods from the time the stock is offered and/or purchased if the owner wishes to obtain the more favorable tax treatment afforded to long-term capital gains. Typically, shares must be held for at least 2 years from the offer (ESPP) or grant (ISO) date and one year from the purchase (ESPP) or exercise (ISO) date. The difference is significant: long-term capital gains are taxed at a maximum rate of 20%, while short-term gains are taxed as ordinary income, which can be as high as 37%. This means that the timing of the sale of the stock is important for reducing the amount of taxes owed on any gains. Also, sales should be considered in the context of the seller’s overall tax situation. Those with other holdings may wish to take advantage of tax-loss harvesting: recognizing losses in one part of the portfolio that can be used to offset gains in the company stock being sold.
3. Liquidity planning and mitigation of concentrated stock risk. Another important consideration for unwinding a concentrated position is liquidity planning. Foremost in the minds of many sellers is having the funds on hand to pay the taxes due on the profit from the sale. This may involve selling extra shares to cover the anticipated taxes due. Or, in anticipation of a sale, the holder may elect to build up extra cash reserves. Some may even employ a multi-year, graduated selling strategy, disposing of smaller lots of stock over several years in order to stretch the payment of associated taxes over a longer period. Some may even borrow against the value of the shares by means of a margin loan; however, this strategy can add extra risk, since the terms of the loan require that the collateral shares retain sufficient value until the loan is repaid. Especially if the value of the stock proves volatile, managing the margin risk may be undesirable. Note also that interest on margin loans is not deductible if loan proceeds are used to pay taxes due.
Managing Concentration Risk: Not “One and Done”
Finally, successful business owners and STEM professionals need to understand that avoiding concentrated stock risk is not typically a one-time event. Those who expect to continue accumulating company stock, either via stock options or a stock purchase plan, will need to remain vigilant to avoid having the stock occupy an excessively large portion of the portfolio. Typical recommendations are for a single asset to make up no more than 5–10% of the investable holdings in your portfolio. To avoid that, have an ongoing diversification strategy and execute it systematically.
