Elliot Pepper, CPA, CFP®, MST
On Saturday November 6th, 2021, Tesla CEO Elon Musk released a Twitter poll asking if he should sell 10% of his Tesla holdings. Out of 3.5 million responses, 58% of them supported selling the shares. Since then, Musk has sold over $10 billion worth of stock, but still has more than 50% to go in order to reach 10%.
More information has come to light since the now-famous tweet regarding Musk’s expiring stock option compensation package. The world of executive equity compensation is complex. Let’s explore the importance of appreciating context when navigating stock market investing, which will be clarified below.
An important skill for any investor is the ability to realize that while we all might be in the same stock market, we are not all playing the same game. The game of a long-term investor dollar cost averaging their way into a ROTH IRA is probably different from a RobinHood day trader. Talking heads on TV driven by ad revenue and commission based financial “advisors” will not necessarily be offering advice that is appropriate for a retiree or pension fund manager. It’s not that one is right or wrong, it’s just important to realize that we aren’t all playing the same game, even if we are all in the same playground. The cool thing about your time horizon, your risk tolerance, and your goals? They are yours!
Let’s dive a bit deeper into the stock option package of Elon Musk and perhaps shed some light on how his “game” might not be our “game” and why it’s important to be aware of that. By any measurement, the dollar figures in the Elon Musk stock option story are significant, but what exactly is a stock option? Why is it part of the CEO’s compensation, and how can a tax liability on exercised stock options create such volatility in a company’s share price?
As a way to incentivize executives to stick around and increase the value of the company they work for, many organizations will create compensation structures that include both a cash salary and equity compensation, sometimes in the form of non-qualified stock options (NSO). NSOs are issued to employees that allow them to purchase shares of their company at a certain price (strike price) at a certain point in time. The strike price is the company’s share price at the time of issuance, and there will be some sort of vesting schedule or hurdle requirement that must be met before the employee can exercise their options. In order to exercise a stock option, the employee simply pays the strike price to the company and receives shares in return. Stock options have expiration dates, meaning that if the employee does not exercise them by a certain date, the option expires and the employee misses out on being able to purchase shares. When the share price increases from the strike price, the options are “in the money” and would be a good deal to exercise. If the share price is lower than the strike price, then the options are “out of the money” and there is no reason for the employee to exercise. “In the money” options allow an employee to pay a below market price and receive shares of the company at the current market value.
This form of compensation creates an incentive for a company’s senior executives to both stick around (due to the vesting schedule) and work hard to increase the value of the company (so options will be “in the money”, prompting employees to exercise).
Here is where it gets tricky…in the eyes of the IRS, when an employee exercises “in the money” options, there is taxable income generated on the difference between the strike price and the actual value of the shares exercised. The employee then has a basis in the shares equal to the current value and will only pay capital gains taxes on future sales to the extent of further price appreciation. Therefore, people exercising options need to pay taxes on that spread when they exercise. In the case of Elon Musk, that tax bill is estimated to be around $15 billion! Musk actually does not take a cash salary from Tesla, but the taxes he will owe are certainly a current liability. What makes the tax bill so high? It is due to the astronomical increase in the price of Tesla shares coupled with the fact that Musk delayed exercises of already vested and “in the money” options until now. In order to cover this very real tax liability, it is common to see employees sell back shares of their own company to cover the taxes. Many companies offer “cashless exercises” which is a way to exercise stock options without incurring a liquidity crunch on the exercise and associated taxes. In either case, shares get sold back at the time of exercise.
Musk would face a smaller tax bill if the price of Tesla fell at the time of exercise, since the spread between strike price and value would have been lower. Additionally, there would have been more value that will be taxed at lower long term capital gains rates upon subsequent price increases. Much speculation exists about why Musk posted his tweet and the timing for when he posted it. Investors and speculators alike have shared narratives on what this means for Tesla’s stock. Is Elon cashing out because he senses a correction is coming? Is the option exercise yet another proof of Musk’s commitment to growing Tesla? Is he simply trying to lower his tax bill? Equity compensation is nothing new to public companies and the Tesla story is interesting. Fundamentally, a CEO exercising options is both nothing new and the details and timing of stock option plans is readily available – shouldn’t we have been expecting this? Obviously, Musk’s options are “in the money”, obviously they are coming up on expiration, so wasn’t this bound to happen?
The market bulls and bears will do their thing to keep our 24/7 new cycle going, so remember we aren’t all playing the same game. Stated simply, Elon Musk has a lot of taxes to pay due to the value of his NSOs. Those NSOs are valuable because they mean that the company has grown profits. I’ll stay invested in good businesses that generate profits – that’s my game.
The decision to start saving and investing is yours, but the “how” can be hard. We suggest speaking with a “fee only” financial planner operating as a fiduciary – having a CPA or tax background is a huge plus. Email firstname.lastname@example.org to schedule a free financial planning consultation with our team.
Elliot Pepper, CPA, CFP®, MST is Co-Founder of Northbrook Financial, a Financial Planning, Tax, and Investment Management Firm. He has developed and continues to teach a popular Financial Literacy course for high school students.