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Speaker 1: Bloomberg Audio Studios, podcasts, radio news.

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Speaker 2: How would you like to become part of the ownership society.

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Speaker 2: It's complicated with lots of moving parts, rules, regulations, and taxes,

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Speaker 2: but if you do it right and get a little lucky,

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Speaker 2: there are potentially big gains to be had. To help

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Speaker 2: us unpack all of this and what it means for

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Speaker 2: your compensation, Let's bring in Joey Fishman. He's an expert

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Speaker 2: in equity based compensation and Ben's Oregon his clients from

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Speaker 2: Seattle and Redmond down to San Francisco and Silicon Valley

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Speaker 2: and full disclosure. Joey is the equity compensation expert at

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Speaker 2: Redults Wealth Management and is also one of my partners.

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Speaker 2: So let's start Joey from the employer perspective. What does

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Speaker 2: a firm like RWM get out of equity compensation for

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Speaker 2: its senior employees and partners.

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Speaker 3: It sets the tone from the beginning and incentives as

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Speaker 3: long as their property aligned. It puts everybody in the

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Speaker 3: right position to help push the firm forward and help succeed.

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Speaker 2: So let's drill down to some of the most important

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Speaker 2: aspects of this. Obviously, if you're either offering stock options

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Speaker 2: or any form of equity compensation that's going to be

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Speaker 2: less expensive than using cash. That's obvious. But what about

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Speaker 2: attracting talent, retaining talent, and then getting all the horses

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Speaker 2: pulling in the right direction.

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Speaker 3: That's a really good question, and I think a lot

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Speaker 3: of it depends on the individual industry with what you're

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Speaker 3: working in. So you know, for years, over the last

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Speaker 3: you know, run up to the bull market of the

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Speaker 3: less fifteen years, there was a huge demand for coders

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Speaker 3: and people in the tech world, and so if you

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Speaker 3: could fog a mer, you were offered, you know, one

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Speaker 3: hundreds of thousands of incentive stock options to come join

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Speaker 3: this or that tech company to help build them out.

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Speaker 3: In the banking world, you know, RSAs or restricted stock awards,

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Speaker 3: was a different form of equity that suited better that

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Speaker 3: industry just because of the way which cash flows came in,

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Speaker 3: and RSUs seem to be the better approach for the

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Speaker 3: oil and gas industry. There is a lot of volatility

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Speaker 3: in that market, but there's also a lot of stability,

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Speaker 3: and so rfcus tend to work really well in that environment.

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Speaker 2: So you mentioned banking. In the space we work in

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Speaker 2: wealth management, it seems like it's very much bifurcated. Some

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Speaker 2: companies very much embrace it. Other firms don't really pay

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Speaker 2: much attention to it. What do you see in this

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Speaker 2: space for equity based compensation?

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Speaker 3: I mean, if you want to keep your employees around,

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Speaker 3: you're going to incentivize them accordingly, They got to get paid.

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Speaker 2: Is is that why we seem to have sort of

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Speaker 2: a prisoner exchange at the big wirehouses. They go from

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Speaker 2: MERYLLL and Morgan to Ubs to Goldman and back. They

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Speaker 2: take a big cash check in front as opposed to

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Speaker 2: a long term back end equity version of this. I'm

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Speaker 2: just I never really thought about it that way, but

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Speaker 2: that seems to be what happens in parts of the industry.

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Speaker 3: You hit the nail on the head exactly so by

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Speaker 3: giving or by allowing us to be share share owners

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Speaker 3: of the firm, there's no incentive us for us to

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Speaker 3: be lured away by someone else offering us a huge

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Speaker 3: check just to move for the next couple of years.

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Speaker 2: What about different employees at different levels of the companies?

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Speaker 2: We have founders, partners, employees, and for lack of a

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Speaker 2: better word, probationary employees. What does this look like in

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Speaker 2: all fields, not just wealth management.

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Speaker 3: Once you get to the executive letter a level excuse me,

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Speaker 3: the pay package changes, and so it may not just

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Speaker 3: be NSOs or ISOs. They're going to add in what's

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Speaker 3: called psuser performance stock units. So after you meet a

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Speaker 3: predetermined threshold that's part of your agreement or part of

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Speaker 3: your contract, you'll be granted X number of additional shares.

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Speaker 3: They too have their own tax treatment. But we're seeing

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Speaker 3: now that it used to be more reckless to banning.

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Speaker 3: We're just going to sign and grant you shares each

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Speaker 3: year as part of your equity refresh. Now it's a

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Speaker 3: little bit more of performance stock unit compensation where it's

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Speaker 3: put up a shut up, show us that you're worth

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Speaker 3: the compensation before we're actually going to be granted to you.

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Speaker 2: Let's talk about profit interest, which has been something that

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Speaker 2: I've noticed a lot more of over the past five years. Hey,

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Speaker 2: you're joining a company with a billion dollar valuation. If

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Speaker 2: the company is sold for anything over that, and you

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Speaker 2: have a profit interest, you participate, but you don't have

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Speaker 2: to pay in and there's no initial tax penalty for this.

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Speaker 2: Tell us about profit interests back.

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Speaker 3: Appreciation rights is maybe in line with what you're discussing.

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Speaker 3: There's something also called phantom stock to if phantom stock

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Speaker 3: is not used that much anymore because the tax liability

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Speaker 3: associated with it is so severe if you get caught

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Speaker 3: on the wrong side. But stock appreciation rights is more

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Speaker 3: aligned with what you're discussing here, which is we're not

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Speaker 3: granting you or giving you shares per se. But what

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Speaker 3: we're doing is we're going to give you whatever appreciation

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Speaker 3: takes place between now and the next date. And let's

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Speaker 3: say we're going to give you one thousand shares. We're

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Speaker 3: going to assume that you have one thousand shares now

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Speaker 3: if it's trained to ten bucks a share, and if

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Speaker 3: it increases to fifteen dollars a share, well, the net

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Speaker 3: to you is the equivalent of five thousand dollars because

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Speaker 3: you know we've given you that stock appreciation.

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Speaker 2: Right, Let's talk about winners versus losers. You mentioned the

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Speaker 2: banking industry. We were talking about technology previously. You and

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Speaker 2: I have talked about oil and gas. How common or

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Speaker 2: rare are the modest winners and how rare are the

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Speaker 2: you know, lottery tickets like in Netflix or an Nvidia.

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Speaker 3: A really really good thing to wrap your head around

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Speaker 3: so at the end of the day, it's about four

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Speaker 3: percent of stocks are responsible for the vast majority of

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Speaker 3: market returns. So four percent of stocks. Of that, roughly

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Speaker 3: eighty percent of employees sell their shares immediately after they best.

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Speaker 2: Really, so that is shocking to me.

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Speaker 3: Yeah, So think about, like, think about what has to

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Speaker 3: happen in order for you to you know, hit it

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Speaker 3: out of the park. You have to join early enough

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Speaker 3: to get a meaningful amount of equity. You got to

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Speaker 3: stay long enough at least four years to vest all

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Speaker 3: of your equity, and like God willing knock on wood,

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Speaker 3: you're getting equity refreshes each year as part of your bonus.

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Speaker 3: You need to exercise at the right time to avoid

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Speaker 3: you know, tax traps. If it's ISOs, it's a MT

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Speaker 3: tax that you have to navigate around. If it's NSOs,

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Speaker 3: it's ordinary income that has to be navigated with. Over time,

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Speaker 3: is more liquidity events or funding rounds happen, your ownership

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Speaker 3: stake is going to be deluded, but hopefully the firm

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Speaker 3: is getting more valuable. And then finally you have to

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Speaker 3: wait until there's an actual liquidity event. And if it's

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Speaker 3: a publicly traded firm or a firm that went iPod,

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Speaker 3: it's six months after that IPO. Even if it's fully vested,

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Speaker 3: do you then have access to it? So it's kind

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Speaker 3: of like winning the lottery, but you don't. Yeah, there's

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Speaker 3: ambiguity in terms of when you can sell in it,

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Speaker 3: what price you can sell it, So there's always going

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Speaker 3: to be that fluctuation and price. The rarity amongst the

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Speaker 3: winners is much much lower, I think than most people realize.

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Speaker 3: And you know, going back to Michael Musson's book of

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Speaker 3: Skill and Luck and Business and Investing, like this is

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Speaker 3: a great example of what it takes to find yourself

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Speaker 3: in the right place, to have the skill to be there,

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Speaker 3: and then to also be lucky enough to thread all

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Speaker 3: of the needles that need to be navigated for you

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Speaker 3: to win.

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Speaker 2: I'm genuinely shocked to hear that eighty percent of employees

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Speaker 2: sell their stock immediately after vesting. Why wouldn't they want to?

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Speaker 2: Is it just that I'm risk embracing and I want

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Speaker 2: to go on the ride, and other people have mortgages,

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Speaker 2: kids and bills and they just want to take the cash.

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Speaker 3: I think it goes back to four percent of stocks

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Speaker 3: responsible for the vast majority of returns. The other way

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Speaker 3: to say this, or another way to look at the

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Speaker 3: markets is that sixty three percent of stocks are losers

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Speaker 3: throughout the course of their lifetime. So the vast majority

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Speaker 3: of stocks at IPO or the vast majority of equity

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Speaker 3: grants that are given, turns out to really be buckus

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Speaker 3: in the end.

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Speaker 2: Buck gus in the end. So let's talk about some

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Speaker 2: of the rules that govern this. They're kind of fascinating. First,

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Speaker 2: there was a big rule change in the nineteen nineties

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Speaker 2: under the Clinton administration for executives where they were capped

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Speaker 2: at a relatively low amount of compensation in cash, and hey,

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Speaker 2: they had to participate by being equity owners. That worked

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Speaker 2: out really well for senior management, didn't it.

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Speaker 3: It did. What took place then is the original goal

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Speaker 3: was to put a ceiling on executive compensation and the

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Speaker 3: output that actually occurred. So they allowed incentive stock options

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Speaker 3: to flourish at that time and as long as it

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Speaker 3: fell under as long as that option contractor that grant

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Speaker 3: fell under the auspices of being incentive, So you needed

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Speaker 3: to work or prove yourself to be incentivized to be

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Speaker 3: gifted that option, then you would be eligible for a

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Speaker 3: much more favorable tax treatment and avoid those laws that

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Speaker 3: went into place.

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Speaker 2: And then there were some rule changes following the dot

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Speaker 2: com implosion. What took place in the two thousands that

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Speaker 2: affected employee equity compensation.

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Speaker 3: Among the main challenges is the requirement that each year

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Speaker 3: an independent valuation take place through the process of what's

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Speaker 3: called a four to nine to A. So what that

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Speaker 3: means is that the company itself can't just pull out

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Speaker 3: of its tush whatever valuation they expected to be. Instead,

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Speaker 3: it has to be verified by a third, independent, third party.

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Speaker 3: The other thing is that equity now vests upon a schedule,

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Speaker 3: so there are a number of backdating scandals that took

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Speaker 3: place in the late nineties early two thousands. Apple Steve

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Speaker 3: Jobs was even famously and started one of them. And

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Speaker 3: so there's a much more stringent set of rules as

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Speaker 3: it governs equity compensation. The main ones to take away

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Speaker 3: from obviously the four nine A and that going forward,

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Speaker 3: no forms of equity compensation can be given below market value.

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Speaker 3: It has to be at least in one hundred percent

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Speaker 3: of market value, or if you're an insider or an executive,

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Speaker 3: it has to be a one hundred and ten percent

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Speaker 3: of current market value.

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Speaker 2: Huh really interesting. What about some of the crazier tax stories.

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Speaker 2: I know you've regaled me with all sorts of wild

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Speaker 2: scenarios that take place. What are some of the wacky

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Speaker 2: attempts to circumvent taxes that have led to bad outcomes?

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Speaker 3: Everyone knows the term like who you hang out with

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Speaker 3: is who you become. It depends on the socioeconomic demographic

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Speaker 3: with what you're hanging out with, you know. But right now,

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Speaker 3: like making the rounds as conservation easements, these are a

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Speaker 3: tax scheme to help absolutely gut your tax liability on

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Speaker 3: the ordinary side. The IRS has put a stop to it.

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Speaker 3: And basically I think how they work these days is

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Speaker 3: that for every dollar that you would put into a

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Speaker 3: conservation easement, I believe twenty cents goes towards litigation over

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Speaker 3: the next eleven years on your behalf. So it's not

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Speaker 3: for the fainthearted. They don't materialize in the way that

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Speaker 3: they promise. So that's among the main things where people

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Speaker 3: really get themselves in trouble. And I will say, like,

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Speaker 3: if you find yourself on the wrong side of a

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Speaker 3: conservation easement, the tax bill that's going to be jammed

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Speaker 3: down your throat is going to be so insane you'll

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Speaker 3: regret having done it in the first place.

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Speaker 2: So you sound very conservative when it comes to tax

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Speaker 2: schema that aren't approved by the IRS. Let's talk about

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Speaker 2: one that the IRS has already blessed. The QSBS. Tell

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Speaker 2: us about what that is and how does that work.

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Speaker 3: That is the gold standard so qsbs or qualified small

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Speaker 3: business stock essentially is the new rules actually just change

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Speaker 3: with the big beautiful bill. But what it does is

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Speaker 3: that if the company or the industry with which you

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Speaker 3: work in, if you are issued shares and as long

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Speaker 3: as you hold it for a certain time period, then

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Speaker 3: all of the games are entirely tax free. So there

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Speaker 3: are situations where folks come to us and they they've

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Speaker 3: been at the company for ten years, they've had this

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Speaker 3: stock for ten years, their cost basis is fifteen cents,

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Speaker 3: and now it's trading at thirty five or forty dollars,

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Speaker 3: and so the first ten million is entirely tax free

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Speaker 3: at the federal and the state side. So like in

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Speaker 3: the California example, you know, is opposed to walking away

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Speaker 3: with you know, fifty forty eight cents on the dollar,

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Speaker 3: when all of a sudden and done. You know, you're

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Speaker 3: walking with one hundred cents on the dollar on the

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Speaker 3: first ten million dollars worth of gains.

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Speaker 2: Really really interesting. One of the things that we talked

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Speaker 2: about with private companies is often a lack of a

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Speaker 2: liquidity event for some time in the future. But a

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Speaker 2: lot of these small startups, especially in technology, they're venture funded.

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Speaker 2: You have the seed round, the A round, the B round.

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Speaker 2: How significant are dilution issues for employees or if this

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Speaker 2: goes public, it doesn't matter. It's just money, money, money.

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Speaker 3: Well, ideally you're not having a down round when you're

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Speaker 3: raising cash. If you are, then the odds of your

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Speaker 3: is hose working out tend to be slim to nil.

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Speaker 3: But typically in the startup spaces you want as many

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Speaker 3: option contracts as you can because if this thing ends

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Speaker 3: up being a runner or ends up being something magnificent,

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Speaker 3: the leverage factor is just so enormous that it's well

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Speaker 3: worth it. You know, the vast majority of these companies

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Speaker 3: end up crumbling. Carter does a really good job of

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Speaker 3: the regulatory work that's required behind the scenes for the

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Speaker 3: startup space, and so I say, over the last probably

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Speaker 3: five or six years, they've been one of the greatest

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Speaker 3: improvements in this space and helping like the broader investor

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Speaker 3: class or employees that have access to this stuff have

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Speaker 3: a much better understanding of what is a very very

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Speaker 3: complicate in seat of personal finance.

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Speaker 2: And for people not familiar with KARTA, they're the ones

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Speaker 2: who track the entire cap table from seed investments to

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Speaker 2: ABCD round. They know everybody that owns every last Yare

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Speaker 2: you get a sense of exactly what the value of

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Speaker 2: your holding is, at least relative to the most recent round.

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Speaker 2: Last two questions, let's talk about common mitigation strategies. What

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Speaker 2: should an employee or an employer be doing to make

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Speaker 2: sure that the compensation structure is fair and that everybody

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Speaker 2: involved pays their legitimate but minimal taxes.

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Speaker 3: So, if you're an employee, I've never seen a plan

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Speaker 3: where this wasn't the case. But if your employee, the

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Speaker 3: company is responsible for withholding taxes on your behalf whenever

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Speaker 3: you exercise, if there's taxes owned that exercise, and whenever

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Speaker 3: you sell the shares or that's a tender offer, So

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Speaker 3: the company itself is responsible for withholding taxes. Where things

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Speaker 3: can go sideways is that the company is only required

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Speaker 3: to withhold the statutory minimum, which is twenty two percent

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Speaker 3: or twenty four percent. Most folks, like if you're having

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Speaker 3: a big payout, are in the thirty five to thirty

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Speaker 3: seven percent federal tax space, so you'll find yourself under withheld.

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Speaker 3: So it's important that you work with the CPA or

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Speaker 3: advisor to figure out exactly what your tax liability is

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Speaker 3: on that distribution.

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Speaker 2: So final question, we've been talking very judiciously about all

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Speaker 2: the risks and all the downsides and how circumspect you

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Speaker 2: need to be about this. But obviously equity compensation has

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Speaker 2: been really attractive going back to the nineteen nineties. How

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Speaker 2: advantageous can these be? Not in an Nvidia, Microsoft, Netflix

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Speaker 2: sort of way, but just in a good, solid company

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Speaker 2: that has fairly reasonable results over the course of your

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Speaker 2: employment there.

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Speaker 3: It is fantastic any additional cash flow that you can

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Speaker 3: capture that you can then add to your financial plan

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Speaker 3: to help reinforce your quality of life as a.

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Speaker 2: Great Thanks Joey. This has been really interesting. So to

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Speaker 2: wrap up, if you have an opportunity to become part

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Speaker 2: of the ownership society, understand what you're getting into. It's complicated.

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Speaker 2: There are a lot of moving parts. There are rules

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Speaker 2: and regulations and taxes, but if you do it right

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Speaker 2: and you get a little bit lucky, there are enormous

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Speaker 2: potential upsides to be had over and above your employment

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Speaker 2: cash compensation. I'm Barry Ridolts. You're listening to Bloomberg's At

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Speaker 2: the Money