He Has Stock Options but Mustn’t Count on Them to Reach His Goals
San Francisco “dot-com” account representative Alan Yin left his heart in Los Angeles.
And his friends. And his family. And his girlfriend. All for several thousand shares in Model E Corp., an e-commerce start-up in Fremont.
“I came up here for the better pay and the chance to make it big,” said Yin, 27. “But I consider Southern California my permanent home and I see myself living there the rest of my life.”
For now, however, Yin’s homecoming hinges on the success of a planned initial public offering for Model E, an automotive site that leases vehicles and offers “e-concierge” services such as pickup and drop-off for maintenance, loaner included.
Considering the recent record of dot-com shares, Yin could use a contingency plan.
“In this industry, things change fast,” said Kurt Brouwer, co-founder of Brouwer & Janachowski, an investment advisory firm in Tiburon, Calif. “Change requires flexibility, and the way to have flexibility is to save money.”
That means taking the first real money Yin has ever made--$70,000 a year in salary--and putting some of it into the high-growth investments appropriate for his young age.
There’s little to stop him from amassing a nest egg. Yin is debt-free and has already begun putting money into retirement accounts.
In fact, his only obstacle is psychological. Yin has an aversion to risk that he learned from his parents. The $5,000 in his 401(k) from a previous job at Nissan is in bonds and conservative mutual funds. And the $2,000 he put into a Roth IRA this year is stuck in a low-earning certificate of deposit.
“My parents came to this country in the 1950s, and in some ways they’re still traditionally Chinese,” Yin said. “In earlier generations, that might have meant converting savings to gold and stashing it someplace. For my parents, it was a savings account. So to take some of my disposable income and put it into high-risk investments would shock me a little bit.”
Brouwer decided to work with Yin’s risk intolerance rather than against it, finding ways to prevent Yin from having to rely too much on the success of Model E.
The first order of business was to calculate his monthly expenses and put aside three to four months’ worth in a money market account.
“Even though the company is well-positioned and funded, dot-com companies with problems tend to lay off people abruptly,” Brouwer said. Yin should pay close attention to whether his company is hitting its performance targets and be prepared to act quickly if it doesn’t.
In the meantime, Yin should work to improve his chances of getting another high-paying technology job if Model E doesn’t fly. One way to boost those chances is to learn more about the technology he sells.
Brouwer recommended that Yin talk to engineers and programmers as much as possible and become involved in product development, offering to give the company’s developers feedback from an account rep’s point of view. He might even take a course to increase his technical knowledge.
“Whatever time and money you can spend on your technology education will enhance your career in the long run,” Brouwer said.
Brouwer started designing Yin’s portfolio by evaluating his current investments. He thought Yin was wise to choose a Roth IRA, but putting the money into a CD was the wrong move--Yin is too young to be this conservative with his investments. Bailing out now would cost him an interest penalty, but he ought to shift into a growth fund as soon as it is practical.
Brouwer suggested putting the money into White Oak Growth, a no-load fund with a $2,000 IRA minimum that invests in market leaders in the technology, pharmaceuticals and financial services industries. Its five-year average annual return is an impressive 38.59%.
Yin’s 401(k) is still with Nissan, spread among six mutual funds that are either bond funds, “value” stock funds or simply poor performers--none the right choice for a 27-year-old who no longer works for the company.
Brouwer advised Yin to do an IRA rollover and split the $5,000 between two more aggressive stock funds: Harbor Capital Appreciation and Firsthand Technology Value. Harbor is a classic large-cap growth fund with a five-year average annual return of 27.67%, and Firsthand is a volatile technology fund with a stunning five-year average annual return of 52.34%.
These funds can offer “pedal-to-the-metal” performance, while providing some diversification of Yin’s retirement portfolio, said Brouwer.
Yin recently spent $2,000 buying three stocks on his own, including Extreme Networks and AT&T; Wireless. But Brouwer thought Yin ought to build an emergency fund before dabbling in individual stocks.
“After you have your rainy-day slush fund, you can do more of this if it interests you,” Brouwer said.
Still, the main thing is that Yin continue to save. At his age, even modest savings can add up thanks to the wonders of compound interest.
“If you put even $2,000 away each year for 20 years and then stopped and let it grow until retirement, you’d have a huge amount of money just from that small investment,” he said.
With an emergency fund and retirement money in place, the next priority is making the most of Yin’s incentive stock options. Yin’s vesting agreement is fairly typical for dot-com companies: He receives 25% of his options after one year of employment, and gets another chunk each month until the entire grant is his at the end of four years.
His exercise price: 5 cents a share.
If Model E makes a public offering, Yin’s stock would be valued at whatever price the market puts on the shares.
If Yin exercises his options before there’s a public offering, the company would have to provide an estimated fair value for the shares.
“Assuming you’re still at the company after a year, I’d exercise the first tranche of options and start the clock running,” Brouwer told Yin.
That clock is on the wall at the Internal Revenue Service: Because Yin has incentive stock options, he normally would not have to pay tax at exercise. But any paper profit he might have is subject to something called the alternative minimum tax.
If he exercises early, however, the risk of AMT becoming a big issue is slight.
Meanwhile, if Yin holds the stock for at least a year after exercise (and at least two years after grant), any profit would be taxed at the long-term capital gains rate, meaning a maximum of 20%. (By contrast, income or gains that don’t qualify for that long-term rate are taxed at federal rates up to 39.6%; Yin’s rate would probably be about 31% on such income.)
As the months pass and Yin qualifies for more shares, he should pay to exercise them while they’re still worth a fraction of what they’re likely to be worth if the company can eventually go public, Brouwer said.
“Five cents a share is not very much money to buy the shares,” Brouwer said, especially considering that the upside can be great.
Doug Gramm, a certified public accountant with Tiret & Co. in San Bruno, Calif., was consulted by The Times on Yin’s tax issues, and concurred with Brouwer’s recommendations.
Brouwer suggested that dot-com workers who want to decide whether to spend the money to exercise their options early should log on to https://www.mystockoptions.com, a site that helps people work out the pros and cons.
Finally, on the issue of Yin’s desire to return to Southern California, Brouwer offered a last bit of advice.
“If you really want to go back, the sooner you do that the better,” Brouwer said. “Have a date in mind for going back, because if you do well here, you’ll build up acquaintances and have more reasons to stay. That’s fine if you want to be here. But if you don’t, the time could drift away.”
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Stephanie Losee is a regular contributor to The Times.
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This Week’s Make-Over
* Investor: Alan Yin, 27
* Gross annual income: $70,000
* Goals: Prepare for retirement, maximize stock options to finance a move back to Southern California
Current Portfolio
* $3,000 in checking account
* $5,000 in six funds from a former employer’s 401(k)
* $2,000 in common stock of Extreme Networks, AT&T; Wireless and Excite@Home.com
* $2,000 Roth IRA invested in a one-year 6% certificate of deposit
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Recommendations
* Save three to four months’ living expenses in a money market account.
* Roll over 401(k) into an IRA and reinvest the money in Harbor Capital Appreciation and Firsthand Technology Value mutual funds.
* Shift Roth IRA money out of CD and into White Oak Growth mutual fund.
* Exercise incentive stock options as they become available. If Yin holds the stock for more than a year after exercise and at least two years after grant, he’ll pay preferential capital gains rates on any appreciation realized.
* Make a plan to move back to Southern California before becoming too established in the San Francisco Bay Area.
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Meet the Planner
Kurt Brouwer is co-founder of Brouwer & Janachowski, an investment advisory firm in Tiburon, Calif. He is also co-author of “Mutual Fund Mastery” (Times Books, 1997).
