In this post I will evaluate the general rules of thumb around how much to hold in company stock (5-10%), evaluate the risks and opportunities, and give my thoughts on the potential situations where it may make sense to hold a more significant position in company stock than the general advice calls for.
Equity Compensation As a Wealth Building Path
The key to earning significant wealth in a lifetime is to accumulate equity that can eventually grow at a faster rate than inflation and your own earnings. While having a high income is important on a path to wealth, it is usually not enough (unless it is very high). Just as important as earning income by being successful in your business or career is turning some of that effort into equity that can grow above and beyond your compensation for labor alone.
A significant path to building wealth that I have observed as a financial advisor for over 20 years is through equity compensation in a growing company. This can take the form of Restricted Stock Units (RSU’s), Non-Qualified Stock Options, Stock Purchase Plans (ESPP), etc. Regardless of the method, the result is that the equity compensated employee will end up with stock (equity) in the company that they work for.
Over time, and assuming that the company stock price increases an investor can end up with a significant portion of her net worth in the stock of the company that also provides her income. The inevitable question that arises from this is: How much of my net worth should I have in my company stock?
The 10% Rule
If you search the internet for how much to keep in your company stock you will see that the general advice from financial advisors and other experts is 5 – 10% of your investable assets. For most people at most companies this is good advice. In fact this is good advice for just about any asset you could own that has the risk of principal loss.
Not only is there a risk of total loss of your investment, but your income is also tied to the company. If most of your net worth is invested in your company stock it is entirely possible to lose your assets and income at the same time as a company going into bankruptcy is likely to engage in mass layoffs at the same time the stock is becoming worthless.
One example of this is Lehman Brothers in 2008. Lehman Brothers was founded in 1850 and was considered a solid investment bank in the industry. Many employees of Lehman had a significant portion of their net worth in company stock and it was part of the company culture to hold that stock. When Lehaman went bankrupt in September of 2008 these employees not only lost their jobs but most of their net worth, impacting their retirement plans, college savings, and financial security.
This CNBC article has a summary of several of these employees.
Even if your company does not go bankrupt, it is likely to under-perform the overall stock market. In 2023 72% of stocks under-performed the S&P 500. Over time, some have done so significantly. An example is GE, another company that had a culture of employee stock ownership. While GE stock was excellent for decades, and many employees became millionaires, in the past 10 years GE has returned 4% per year while the S&P 500 has returned 12.25%.
The Downside of Keeping a Low Percentage in Company Stock
The downside of keeping a low percentage in company stock is that if you happen to be at a company that outperforms the overall market you could be missing out on an opportunity to significantly grow your wealth in a relatively short period of time.
Rolling The Dice
While the odds are against you, I do think that equity compensation is a valid path to building wealth. As a financial advisor in the Seattle area I have worked with many people who owe their significant wealth to the company they worked for. All of these wealthy investors made a choice (or series of choices) to hold a significant percentage of their net worth in their company stock.
In other words, holding a high percentage of their net worth in company stock is the reason they are wealthy. Had they made more conservative choices and followed the 5-10% general advice throughout their career they would have been significantly less wealthy.
What Got You Here Might Not Get You There
What about the equity compensated investor who chose to lean into company stock for years and now finds himself wealthy? Is there a point where it makes sense to adjust? Certainly. While I have tended to lean towards accepting a higher percentage of company stock during the wealth building stage, there does come a time where the risks outweigh the benefits.
That time is when you are on track to have enough wealth to achieve your financial goals. These goals may include retirement, funding your children’s education, charitable goals, etc. At this point you are taking unnecessary risk by concentrating your net worth into a single asset. In other words, the downside risk is likely not outweighed by the upside potential of even more wealth creation.
Managing The Risks If You Plan To Hold Significant Company Stock
If you plan to lean into your equity compensation as your path to wealth I advise also doing whatever you can to balance the risks of principal loss from your company stock, and the potential under-performance of that stock. This assumes you have a relatively high cash compensation in addition to the equity compensation and are willing and able to live within your means and save some of the cash compensation towards reducing the risk of having all of your eggs in one basket. Here is one example framework to consider:
- Hold all equity compensation grants as they vest. Do not sell any company stock until you have reached your goals, or you decide to reverse course.
- Wait to exercise your stock options until as close to the expiration date as possible.
- Contribute to any stock purchase plans up to the amount needed to acquire discounted shares.
- Live within your means so that you can save additional discretionary income.
- Build a cash reserve of around 6 months living expenses. This is so you do not have to sell company stock when an emergency or opportunity comes up.
- With every other dollar of discretionary income you earn, actively purchase investments that will diversify away from your company stock.
- Put as much as you can afford into your 401k (Roth or Pre-Tax depending on your tax situation) and invest into a diversified portfolio that doesn’t include your company stock. This may include more lower risk investments such as fixed-income than you would otherwise hold if you were not concentrated.
- Ideally, you will have enough additional income to at least slowly build a taxable account with a portfolio diversified away from your company (and industry) to be available for more medium term goals, or as a fallback should your company collapse or significantly under-perform.
- Carefully monitor your net worth against your financial goals. Assuming this has gone well and you have built your net worth to the point that you have made significant progress towards these goals, consider reversing course and beginning to diversify.
- This diversification should be done with tax efficiency in mind and should balance your longer term target of how much company stock you would like to hold vs. the downside risks to your financial security and goals of holding too much stock.
- A good advisor can help put together an individual plan to preserve your wealth, reduce taxes, and balance the remaining upside potential of continuing to hold some company stock.
For some people it might be an acceptable risk to hold more than the recommended 5 – 10% amount in company stock. As long as you understand that the fortunes of your company will have an outsized influence on your path to wealth. Diversifying is much safer if your goal is financial security, but concentrating could potentially get you down the path to wealth much faster.
A Note On Startups vs. Publicly Traded companies
In writing this post I had in mind an equity compensated employee at a medium or large publicly traded company. I have worked with many people at these types of firms over the years.
It is also possible to earn significant wealth quickly by working for a startup firm with significant equity compensation. In fact, this is the main economic reason to be an employee at a startup firm.
Startups and early stage companies are very likely to fail. The most likely outcome is that your shares or options expire worthless or are so diluted that only a perfect outcome will result in significant wealth gain for you. Look at startup equity compensation like a lottery ticket and focus on building your career and saving your cash flow into the get rich slowly method.
