Developing An Exit Strategy For Employee Stock Options In A Down Market

Stocks are down this year, pretty much across the board. Unfortunately, there are some companies that won’t survive the downturn. Even for the ones that do, getting back to Covid-era all-time highs is far from assured. For employees with stock options or owned shares, it may be time to reassess your sale strategy and expectations. Particularly for employees of companies that IPO’d last year, valuations have fallen significantly. Even though the stock price has fallen, it may still be a good time to consider diversifying.

Selling stock options in a down market: dangers of anchoring expectations on past performance

When the Federal Reserve effectively set interest rates to zero, it forced investors to look for returns outside of bonds, inflating the value of many risk assets like stocks. As a result, a lot of companies that went public in 2021 did so at highly optimistic prices. In fact, newly public companies are down about 45% since the beginning of 2021 (Renaissance IPO ETF). Many stocks of seasoned companies were trading at record highs too, before sentiment began to turn around the fourth quarter of last year.

For employees with concentrated wealth, it can be difficult to even consider selling now, knowing what once was. Whether or not it makes sense to sell depends on many factors unique to your situation. Consider your concentration relative to other assets, company fundamentals, growth outlook, cash holdings, need to raise more funding, etc.

As you weigh the pros and cons, it’s important to consider, or re-consider, your expectations and if they justify the price you’re targeting. Some stocks will never return to their all-time high, regardless of how much time passes. If the company was trading at an inflated price due to market conditions at the time, then it’s going to be much harder to justify that valuation when exuberance wanes.

Single stocks vs the market

Historically, on average, the S&P 500 has ended the year with gains roughly 75% of the time. But that’s across the largest 500 publicly traded companies – not just one. There’s a significant amount of dispersion within that. Particularly for newer and smaller companies, there’s greater risk and volatility. Of course, greater upside potential is the goal, but emphasis is on the potential.

Here are some sobering statistics about the performance of individual companies:

• How many single stocks stay public and outperform the market?¹ Roughly 35% over rolling five year periods, 29% over 10 years, and 21% over 20 years.
• The stock is down so much, it has to go up from here.² Wrong. Past performance (whether good OR bad) is not indicative of future results! Between 1947 and 2020, of the stocks that either outperformed or underperformed the market over the last 20-year period, only 30% would outperform as a public company over the next 10 years.
• Big losses are common.³ Between 1980 – 2020, nearly 45% of all companies that were ever in the Russell 3000 Index experienced a 70% decline in price from the peak and never recovered. When considering the distribution of excess lifetime returns of individual stocks vs the Russell 3000, the median underperformance was almost -10%.

Deciding when to sell stock even though the price is lower

Especially for early employees or founders, you likely still have large gains despite current valuations. So it’s worth considering when to exercise and sell stock options or long shares even though the stock is down. Turning paper-profits into realized gains is part of building wealth. Diversifying a concentrated stock position is how that’s done.

When you have a large holding and the stock price falls, it’s easy to try and Monday morning quarterback it. Rather than lament the actual events of the past (which you can’t change), apply it to your forward thinking.

Imagine you own a stock and the current market value is $1M

Perhaps the holding was worth $2M last year, maybe even $5M. But now it’s worth $1M. You’re not happy about selling at the current price but wonder if you should. Lay out your base, best, and worst-case outcomes.

Here’s a hypothetical:

• Base: sell today for $1M
• Best: the stock goes up 50% and you sell for $1.5M
• Worst: the stock loses 50% and you sell for $500,000

Is the potential best-case scenario worth the risk of the worst-case? The answer will be different for everyone.

You can even take this one step further.

Consider assigning probabilities to the likelihood of each outcome. You need to make an educated guess, but it can help work through the decision tree. As a simple example, if there’s an equal likelihood that the stock would either go up or down 50%, then the $1M it’s worth today is probably a fair risk-adjusted value.

It sounds drastic, but recall the numerous statistics shared earlier. Newly public companies are down almost 50% on average and bouts of underperformance don’t mean a rebound is inevitable.

Strategies to diversify

Selling any asset is not a decision to be taken lightly. And tax implications, concentration, risk tolerance and other factors should always be considered. Taking some risk off the table doesn’t have to mean selling 100% of the position at once. Diversification strategies may include dollar-cost averaging, limit orders, new price targets, or even using options on your options (such as a cashless collar).

Like the rest of the decision, the alternatives will vary in availability and advisability. And because each situation is different, selling may make sense in some cases and not in others. But if you’re not asking the question, who will?

Past performance is not a guarantee of future results. or informational purposes only and should not be misinterpreted as personalized advice of any kind or a recommendation for any specific investment product, financial or tax strategy. This is a general communication should not be used as the basis for making any type of tax, financial, legal, or investment decision.

¹ Source: Dimensional, using data from CRSP and Compustat. The US market includes all US common stocks without gaps in monthly data for a given rolling period. Delisted stocks with delisting code between 200 and 399 are considered good delists; bad delists are 400 or greater. Outperformance defined relative to the value-weighted market at each cross-section. Statistics reported are averages computed across rolling multiyear periods formed monthly from the cross-section of stocks available at the start of that month. Rolling monthly periods between January 1927 – December 2020. Article

² Source: Dimensional, using data from CRSP and Compustat. Includes all US common stocks. Delisted stocks with delisting code between 200 and 399 are considered good delists; bad delists are 400 or greater. Stocks with complete prior 20-year monthly data classified as past outperformers and underperformers relative to the value-weighted market. 10-year survivorship and outperformance defined relative to the value-weighted market at each cross-section using stocks without gaps in the following 10-year monthly data. Survivorship and outperformance and bad delists are averages computed across rolling 10-year periods formed monthly from the cross-section of stocks available at the start of that month. Rolling 10-year periods between January 1947 – December 2020. Article

³ Source: J.P. Morgan Private Bank. 1980-2020. Article.