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Solving the Concentrated Stock Puzzle


Accountant

Concentration risk in single equities is a common puzzle for ultra-affluent families. For this discussion, we define this as a single appreciated position of more than $500,000 that would result in a capital gain of more than 100% on the holder's initial investment and a substantial tax bill if they sold the position. This concentration risk exposes the family to various risks, such as a loss of wealth if the stock were to decline in value or a loss of income if the company were to stop paying a dividend. Employees of these companies face additional risks, such as the loss of both medical benefits and earned income if they were to be let go from the company during a financial hardship for the company. Moreover, if the individual were to sell the position, they could potentially realize a capital gain tax of as high as 23.8% on the gain, creating a substantial barrier to diversifying their risk and realizing the benefits of this investment. Furthermore, if the holder is still employed by the company, they can have requirements to continue to hold or increase their position in the company stock to attain higher executive roles, or the company culture may be one in which ownership of the stock is a point of both pride and commitment to the cause. As a result, holders of a concentrated stock position often feel stuck and unable to sell.


Fortunately, a solution exists. By following a simple framework, a holder of a concentrated position can find a solution that meets their unique circumstances. Professionals use the acronym H.O.P.E.S to describe this framework.

Hold

The first obvious option is to hold the stock. This might make sense if the holder has a requirement to hold the stock as a function of their current or next potential role in the company. This is often the case for leaders in an organization. If holding is the right option then it may be important that the rest of the financial structure be aware of this risk and adjust accordingly. Some considerations in this area may include diversifying their portfolio away from the single stock position and ensuring their current spending level does not depend upon on the stock position.


Options*

Options contracts can give the holder of a concentrated position a number of valuable tools.

Protective Puts - Protective Puts provide downside protection but are akin to buying insurance. This strategy can be effective at mitigating downside risk but will be a drag on performance over time and the investor will need to pay cash for the cost of the Put Option. This can be an effective strategy if the underlying stock declines in value or to ensure against a "margin call" if the stock is pledged to a loan.

Collars - A collar involves simultaneously buying a protective put and selling a covered call. This strategy limits both upside and downside risk. The put provides downside protection, while the call generates income but caps potential gains. This strategy can potentially be structured as a "cashless collar" such that the premium received from the sale of call options is used to buy protective put options.

Put Writing - A client can use the single stock position as collateral for an index options overlay in which put options on a broad index are sold to generate income. This will provide some diversification benefits and if index options are used, can have favorable tax treatment over equity options. The income generated can be used to fund investments elsewhere in the portfolio. It is common to contribute the cash to a direct indexing account that does not own the single stock position and to use this account to harvest tax losses to mitigate taxable gains elsewhere in the portfolio. An additional risk to put writing is that if the stock goes down, so does the value of the put option.

Call Writing - For clients that are either comfortable or desire to exit a position, call writing can be an alternative to put writing. o generate income with limited upside participation.


Philanthropy

If the holder of a concentrated stock position is charitable, then giving long-term appreciated securities maybe a valuable decision. From a tax perspective, it may make the most sense to give highly appreciated positions to charity, in lieu of cash. Instead of making a cash gift, the holder of appreciated stock informs the charity that they wish to make a gift of securities. They then connect their financial advisor and the charity so that the advisor can send securities directly to the brokerage account of charity. By giving stock with a low tax basis, the donor is effectively giving away their future tax bill to the charity, however, the as a non-profit, charity is not subject to capital gains tax and therefore the donor may receive a tax deduction for the fair market value of the gift, meet their philanthropic objective of supporting the charity, and both the donor and the charity avoid a future recognition of capital gain!


Exchange Fund*

For clients that are qualified purchasers and have a highly appreciated concentrated stock position that are seeking tax efficient diversification, an exchange fund may be a creative alternative. An exchange fund and an exchange traded fund are not the same thing. An exchange fund, sometimes called a swap fund, is an illiquid fund in which investors contribute appreciated securities in exchange for a diversified pool of securities. This allows investors to defer capital gains and receive a more diversified portfolio. In this case the investor has the same tax basis as they did when securities were contributed, but now their investment is spread across a larger number of securities. Exchange funds are only available to qualified purchasers and have a 7-year lock up period to satisfy the tax deferral requirements.


Sell

According to Goldman Sachs, in a 20 year period, about 1400 of the 3000 stocks in the Russell 3000 index will experience a 75% loss of value and never regain more than 50% of that loss. Concentrated stock clearly presents a unique set of risks to the wealth of investors. If the above options are not viable solutions, the last resort may be the best alternative. By selling the position down to below 10% of the investor's net worth, this risk can be significantly mitigated. There are a multitude of considerations, depending on the size of the position. For example:

  1. Market Impact: Selling a large position could potentially influence the market price of the stock, especially if the stock is thinly traded. If your position is larger than the average daily trading volume, selling your entire position at once could overwhelm the market and depress the price. A seller would generally not want to sell more than 3-4% of the average daily volume of a stock.

  2. Regulatory Restrictions: If you’re an executive or large shareholder, there may be insider trading rules and regulations that restrict when and how you can sell your shares.

  3. Tax Implications: Selling a large position, especially if it has appreciated significantly, could result in a substantial tax liability. It’s important to understand the tax implications and potentially work with a tax advisor. An investor may consider selling over multiple tax years.

  4. Emotional Considerations: If you have a strong emotional attachment to the stock, such as if you’re the founder of the company or if the stock has significantly increased your net worth over the years, you might find it difficult to sell.

  5. Market Conditions: The overall condition of the market can impact the best strategy for selling a large position. In a volatile market, for example, it might be more difficult to sell without impacting the stock price.


What is right for you? Remember, it’s always a good idea to consult with a financial advisor when making significant decisions about buying or selling stocks. They can provide personalized advice based on your specific situation and goals.



Important notes and disclaimers

*Option contracts are a form of derivative. The scope of this article does not fully address the risks involved in option contracts. This not a recommendation. Contact your financial advisor to learn more.

*Exchange funds are a form of private equity investment and they are complex. It is important to read the offering memorandum and to fully understand the consequences of withdrawing funds early. Investors should consult with the financial and tax advisors before making an investment.


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