New Passive Income Stream: Employee Stock Options

One of my plans coming into the new year was to de-risk my dependency on an income source that comes via direct employment - something that many of us pursing financial independence and early retirement can easily relate to.


This is something I've already been doing by putting a healthy portion of my money into passive investments that are likely to grow at a steady pace over time. These returns in addition to the dividends (that I reinvest) give me a level of wealth growth that require almost no further input from myself.


I log in once a month to buy a little bit more and that's about all I do.


But in the past 6 months or so I've been thinking about additional things I could do with my money which could potentially give me attractive yields for the risk involved. Naturally, it's tough to find such opportunities considering the market index is so difficult to beat so I needed to do a little bit of thinking while reminding myself not to let my ideas get too out of hand.


That meant stock picking or jumping onto meme stock bets were out of the picture and the thought of pumping thousands of pounds into Bitcoin all at once was too risky. Besides, cost averaging a small amount into my cryptocurrency holdings is already something I'm doing - so no need to overexpose myself.


Real estate was an option but the thought of locking up my equity, getting a mortgage, and deal with all of the management and administrative work made it somewhat unattractive for the time being - it's something that I would perhaps consider later on instead.


With this out of the picture I really needed to think through a couple of different possibilities that included the likes of drop shipping, print on demand, or affiliate marketing. You know, the usual stuff you see some internet guru talk about whenever you're just trying to watch a YouTube video.


But then I realised I was already sort of working on one of these - in the form of this blog.


While the underlying purpose of this blog is a creative outlet for me to share some of my personal finance experiences and knowledge to try and help others, I wouldn't mind getting it to a point where I could truly convert it into a sustainable income source so that I could turn my writing into more of a full time job for myself.


Right now I have a couple of adverts that get served to the reader (which I try to keep at a minimum) but I think building my reputation so that I can start getting some affiliate opportunities is probably a sensible short-medium term goal.


So anyways, what this meant was that I shouldn't really try to take on too much since I haven't even gotten this blog well-established yet - leading me to continue my search for something that requires relatively low effort yet gives a decent amount in return.


It sounds impossible for such a thing to exist and typically it shouldn't exist... until I remembered that I work at a small company that gives its employees incentives via stock options.



Employee Stock Options could have hidden value that you never realised - just like this fish doesn't realise it is in a phonebooth.
Employee Stock Options could have hidden value that you never realised - just like this fish doesn't realise it is in a phonebooth.


What are Stock options?


Stock options are an interesting thing - I've received them at the various companies I've worked at as did my other colleagues, but to my knowledge nobody really seemed to understand them that well. At least none of the more "junior" employees - the group I was a part of - looked into them that deeply.


The only real thought process I think we all had was "If someone buys this company then we get to cash in!"


And that was as far as the thinking went.


The conclusion isn't entirely wrong but the true opportunity was never realised until I personally decided to dig deeper.


From what I've gathered I believe there are a number of types of stock options schemes or incentives that can be offered by a company to its employees. Listed on the government website are the following:


  1. Share Incentive Plans (SIPs)

  2. Save As You Earn (SAYE)

  3. Company Share Option Plan

  4. Enterprise Management Incentives (EMIs)


For my particular case, I have an Enterprise Management Incentive as I work at a small company with less than £30 million in assets.


This plan allows me to acquire up to £250,000's worth of shares via options within a 3-year period. Unfortunately what I've been granted in options so far pales in comparison to that amount but still, it's not a bad amount either.


Author's Note: For the purposes of privacy I won't actually reveal any information on how much in stock options I am entitled to. The aim of this article is to simply pass on my experience with such a scheme to potentially help someone decide if they would like to exercise their own options in their workplace.


From the company's perspective, granting employee stock options is advantageous as it can help align an employee's personal motivations and aims with the company. Usually there is a period of time that needs to elapse - for example, 2 years - before the granted options can be exercised by the employee.


Not only does this mean the employee will need to stick around to potentially capitalise, meaning there is less turnover and retraining costs for the company, it means they have an actual incentive to help the company grow and become more valuable.


The advantage from my (the employee's) perspective is that I have the right to purchase shares at a predetermined "strike price" which could be lower than the current market value, if the company has been successful and grown over time, leading to an (almost) instant profit.


Author's Note #2: "Almost" because I would need to be able to sell the shares on the market, which may not always be the case i.e. the company is still private.


In addition to this, I would not owe any Income Tax or National Insurance on the shares I bought as long as the strike price was not set at a discount to the market value at the time I received the options. If a discount was given then I would owe tax on the difference.


This tax advantage cannot be overstated because it could potentially lead to savings in the tens of thousands of pounds, possibly even more, depending on the value of the shares when sold.


For a pretty good example of the difference in taxes paid between shares acquired via the EMI scheme and shares that aren't - shares simply given to an employee outside of any scheme for example - you can read this article by Accountancy Cloud.


As a final point, even when exercising my options through the EMI scheme I will eventually need to pay capital gains tax upon the eventual sale of my shares. This tax cannot be avoided but I do get to enjoy the advantages of Business Asset Disposal Relief which means the tax rate will be capped at 10%, under most circumstances.


This could mean further savings in terms of tax as if I was a higher tax rate payer at the time of sale I would be paying 10% less than I normally would (higher rate CGT is 20%), since I could treat the disposal of those shares as a disposal of part of my business.



What questions did I ask before exercising?


The company I work at is privately held so not only would it be difficult for me to sell my shares on the market if I exercised my options, it is difficult to evaluate their true value in the first place. The sort of information that would allow me to make a somewhat accurate evaluation is typically only available to the founders or directors - which I am not.


However, since I'm a long term employee at the company I do have the advantage of knowing certain things about the business in terms of the number of clients, what type of work is going on, and potential future developments of the product that could increase market share and value.


I asked myself a very simple question based on what I knew about the company:


"Do I think this company has a future?"


The purpose of asking myself this was to gauge if I would feel comfortable about holding stocks in this company for the long term, potentially without the chance to sell them to someone else.


The easiest and most apparent way to measure this was based on how the company has performed since the start of the Covid-19 pandemic. While many other businesses have shut down, laid staff off or put them on furlough my own company seems to have weathered the worst of the storm without needing to do any of this.


Sure, business is more difficult while the pandemic goes on but I have seen a number of positive signs that point to a better future for both the economy and the company itself.


So based on this I was happy to answer my above question with a "yes".


Now, keep in mind that if I don't exercise my stock options I can still enjoy their advantages if and when the company gets sold or goes public - so my "yes" answer doesn't automatically mean I should exercise the stock options. In fact, so far it is more advantageous for me not to do so since I can hold on to the stock options and keep the money I would need to spend on exercising them.


So the next question I asked myself was:


"What would make exercising those options worth it?"


Short of simply receiving the stocks for free I figured that I needed to calculate if I could get my money back within a reasonable timeframe, even if I couldn't sell my stocks.


Here's one big advantage as an employee - I was fairly certain the company pays a dividend based on casual conversations with directors (usually down the pub).


So the investigation turned into one of finding out how high the dividend yield was in comparison to my strike price. In effect, could I make my money back via dividends within a short enough period of time for me to feel confident that the investment would be worth it.


It turns out it wasn't that difficult to find out - since I report directly to the Managing Director I simply brought the topic up in one of my reviews and asked them point-blank, as I wanted my intentions to be clear.


Obviously, many people out there might not be able to do this and I recognise I'm very fortunate to have that kind of access to "the top" but I do think that being clear about your intentions can go a long way in this type of discussion. The way I see it is you're simply tying your own success to the company even further, so there's no real reason for them to not be open about the details.


My own discussion was very transparent and after learning how much was being paid in dividends I quickly calculated that not only was I likely to make my money back, I would actually be making quite an attractive amount in additional income sooner than I originally estimated.


As mentioned before, I'm purposely not going to mention any specific numbers or percentages to keep things private - your own numbers would vary anyway, so you need to do your own calculations - but I will say that the "payback time", meaning the time it takes for me to recoup what I spent on exercising the stock options, was in single digit years.


Figuring that I could own the actual stock and recoup my money relatively quickly, plus have the additional dividend income which would be passively earned in effect, I was almost ready to conclude that exercising my stock options would be worth the risk.



Would my money have been better invested in an index fund?


One more question I needed to ask myself before exercising the stock options was if it would be worth it compared to simply putting that money into an index fund. Because even if the action of exercising my stock options was "profitable" it still wouldn't make sense if my money was going to be performing better within the index.


As an example, let's say it costs me £10,000 to exercise my stock options and I get paid a dividend of £2,000 each year once I own the stock. It would basically take 5 years for me to recoup my money before the dividend became "purely profitable", ignoring the effects of inflation.


So after 5 years I would have £10,000 in cash from the dividends plus ownership of the stock which would be worth something.


We'll come back to this something in a moment.


Now let's say I didn't exercise my stock options and simply invested that £10,000 into the index instead. Assuming an average return of 7% each year that investment would grow to around £14,025. Giving me £4,025 in returns on top of the £10,000.


Now we can compare the two scenarios to decide which is better.


Start by taking £10,000 away - the amount recouped via dividends in the first scenario, and the original investment in the second scenario - and what does that leave us with?


£4,025 in index fund profits and something.


That something is the exercised stock options and the decision that needs to be made is if they are valued at more than £4,025 based on the example numbers. Keeping in mind that they originally cost £10,000 to buy (which has been recouped) and that 5 years have elapsed since that time.


At this point there's never going to be a real clear answer because it is going to be specific to the company that you are working at. You'd need to use your personal judgement based on how you feel the company is going to perform in the future.


Obviously with such example numbers it's quite easy to say "yes" since the continued dividends of £2,000 will easily surpass the returns from the index in the long run even if the value of the stock falls somewhat. But things may not be as clear cut in a real life scenario.


For my own case the eventual decision I made was "yes" based on the same formulas used in this section. I guess time will tell if my choice was right, but so far so good!





Comparing the dividend yield to the index


Another interesting way to look at this is by doing a dividend yield comparison to the index.


Using the Vanguard FTSE Global All Cap Index Fund (Acc) as the "benchmark" - as this is the global index fund that I invest into - I can work with the dividend yield of 1.44% (31 Dec 2020) and determine what the equivalent investment amount would need to be to match the dividend amount I receive from exercising my stock options.


Let's use the same example numbers as in the previous section, where I use £10,000 to exercise my stock options and receive an annual dividend of £2,000.


To get the same dividend of £2,000 from the Vanguard FTSE Global All Cap Index Fund (Acc) I would need to invest about £138,889.


Here's the math:


Target dividend: £2,000


Investment amount: £138,889

Yield: 1.44%

Dividend: £2,000

(£138,889 ÷ 100) × 1.44


I could even give myself a range to account for lower or higher yields in the future from the index fund.


If I assume the yield falls to 1% then I would need to invest £200,000.


And if the yield rises to 2% I would need to invest £100,000.


So effectively, that example £10,000 to exercise my stock options could be considered to be equivalent to an investment between £100,000 and £200,000 into the Vanguard FTSE Global All Cap Index Fund (Acc) when compared on a dividend basis.


Obviously the company needs to keep existing and keep paying dividends for the long run, which is another factor to consider (among others), but this was still a pretty neat calculation to do nonetheless.



Mitigating my risk even further


Originally I thought the stock options contract needed to be exercised in full, but based on my Notice of Exercise form it turns out you can specify how many stocks you want to exercise.


Seeing that there appeared to be a way to partially exercise I decided to speak with my Managing Director about setting up some sort of system to gradually exercise my stock options over a period of time.


I wanted to set up a system where I would "sacrifice" any bonus payments (received quarterly), commissions, and future dividend payments to receive exercised stock instead. Essentially, anything above my base pay was going to go towards exercising my stock options.


Author's Note #3: The term "sacrifice" in this case isn't the same as salary sacrifice, i.e. into a pension, where it would be tax-efficient to do so. The money I use to exercise stock options needs to be post-tax, and setting up this system was purely for convenience. Since the money was going to go back to the company anyways they might as well keep it and simply send me the paperwork.


There were three motivations for this system:


1. I didn't have the money to exercise my stock options in full


I run a pretty efficient budget and don't really have much cash laying around. If it isn't being spent on living then it's either in my emergency fund or already invested - in general.


Naturally I'm not going to deplete my emergency fund or sell existing investments to exercise my stock options, nor am I going to have money sitting "out of the market" while I try to build the sum up to exercise.


If that were to happen then the case for simply investing into the index would probably become much stronger.


2. I can continue with my standard investments as normal


My budget only covers my base pay, and the default action with any pay I receive in excess, i.e. bonuses and commission, is to simply invest it into the index. But my projections and future return estimates never assume that there will be any bonus or commission.


By only redirecting the excess towards exercising my stock options it means that my standard investments, covered in my budget, can continue as normal.


I felt that I could get the best of both worlds by doing this as I wouldn't be losing any "time in the market" since I only project my future returns using investment amounts coming from my budget - which would still continue as normal - yet at the same time still be getting the benefits of exercising my stock which I already determined to be positive.


3. I could use the dividends I received to exercise more stock options


Since I knew I'd be receiving a dividend I figured that the best thing to do would be to utilise it in acquiring even more stocks, which would lead to more dividends, and ultimately compound in this manner.


In fact, if I really wanted to keep my exposure to a minimum I could simply make the initial purchase for a small amount of stock, just to start receiving a dividend, and then continue exercising my remaining stock options using just dividend payments.


It would take longer to exercise all of my options in full, but risk would be minimal since the dividends would effectively pay for themselves by generating even more dividends.


Ultimately by setting up this system I felt I was able to mitigate my risk - mostly by not disturbing my standard personal finance activities and habits - which led to my decision of exercising my stock options being even easier.



To Conclude


At the end of the day, whether or not you exercise your stock options is going to be a personal decision that involves a number of factors; some of which cannot be generalised to suit everybody perfectly.


For example, stock option agreements can differ between different companies so there could be specific conditions that you need to take into consideration. Or, perhaps it turns out that there aren't any dividends being paid so the time to "recoup" your money is much harder to calculate, and therefore the benefits of exercising your stock options are more uncertain.


A close friend of mine was in this situation where the company didn't pay a dividend, so exercising their stock options didn't really seem to make sense. However, when they found a new job they decided to exercise some of their options just to keep a "piece of the pie" - in case the company ultimately went public for a large valuation.


Despite the variance of factors, my hope is that by talking through my own experience and discoveries it can give you a bit more insight into some of the things that you might want to consider and think about.


Just like any other type of investment, there's no such thing as "completely risk free" and the decision essentially comes down to you balancing the pros against the cons.


Could the company you're working at fold within the next couple of years, meaning that your investment can't fully come to a profitable fruition?


Could the dividends suddenly be cut or stopped?


Could the market index rise much more than average over the next couple of years, making it the "better investment"?


Nobody can ever really know unless it was in retrospect.


But regardless of what the future holds it seems as though company stock options are very much underestimated by normal employees - I suspect most company directors are "in the know" - in terms of the value they could potentially hold.


At the current time of writing this article, my "system" of gradually exercising my own stock options via excess pay (above base) is in progress and I've already received some dividends which I'm reinvesting.


While I actively work at the company to try and contribute towards it's profits and overall value, the dividend payments I receive are truly passive. If I leave the company I'd still be entitled to receive those payments without doing any work.


If we were to take the earlier calculations or comparisons and conclude that the potential dividend yield was equivalent to a six-figure investment into an index fund, then exercising stock options could be among the best "low effort" investments possible out there for some additional passive income.


So make sure to check your own employment contracts and see if you're unknowingly sitting on a dormant passive income stream - sometimes we're so busy looking around that we forget to think about the "options" that are already available to us.



Hey - just one final word before wrapping up - Have you wondered if there was a difference between being a "frugalist" and a "minimalist". There's always going to be an overlap but to me, one involves spending as little as possible while the other is being more deliberate with spending.


I recently read quite a nice article by Off Hour Hustle that describes their own take on minimalism and how to use certain decisions or principles to generate some extra value. Check it out!


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My mission is to help people understand their money by making financial scenarios or concepts easy to understand. Support me by sharing the blog with someone that you want to help.

Thanks for reading!

Kujah

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