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2013, Study Session # 4, Reading # 13

LOW-BASIS STOCK

1. DEFINING THE PROBLEM

Basis price that serves as the basis for the computation of capital gains (might be different from the initial cost).

Low basis holdings in an individual portfolio may arise through: Entrepreneurial success:

Significant shares in a founded company. Cost equals to original investment in the venture.

Executive success: Usually through equity compensation. Value of these holdings may have risen substantially above the cost.

Investment success: Portfolio comprising of several substantially appreciated securities.

Challenges while dealing with low-basis holdings: Psychological attachments. Investment issues (e.g. risk return tradeoff & taxes).

2. UNDERSTANDING STOCK RISK

Specific Risk Market Risk Residual Risk

Affect all securities. Cant diversify away.

Security specific. Can be diversified away.

Counterparty Risk Regulatory Risk

Risk due to

dependence on a

counterparty to

complete a

transaction

Risk that tax

authorities may

reject a tax

treatment chosen.

Stages of Equity Holding Life

Executive Stage

The investor enters the executive stage once the

business is public.

Specific risk is somewhat lower but still high.

Less diversified equity holdings.

Entrepreneurial Stage

Very high specific risk. Single security dealing. Immature company.

Investor Stage

Multi security portfolio. Two stages:

Diversified investor stage. Indexing stage.

EF = Exchange Funds

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Copyright FinQuiz.com. All rights reserved.

2013, Study Session # 4, Reading # 13

3. APPLYING THE MODEL TO INDIVIDUAL CIRCUMSTANCES

The Executive Stage

Diversification desire is linked to the degree of control.

The individuals position in the organization, specific risk

tolerance.

The Entrepreneurial Stage

No diversification desire. Look for ways to minimize

transfer costs.

The Investor Stage

Investor strongly requires diversification.

Advisor should focus on investors psychology.

Financial Strategies

Completion Portfolios

Utilized by investors with other, liquid assets in addition to the large low-basis position.

Investors goal is to reach a desired target portfolio (e.g. index). Tax loss harvesting to shelter the capital gain realized each time

any low-basis stocks is sold.

May be time taking strategy.

Outright Sale

Simple & often most expensive. Capital gains tax. Maximum flexibility. Eliminates all residual risks.

Exchange Funds

4. REDUCING A CONCENTRATED EXPOSURE

Two fundamental strategies. Financial strategies. Charitable strategies.

Public EF

Partnership for a minimum of seven years. 20% illiquid assets. Each partner receives proportional

distribution.

Shortcomings: High management cost. Lack of control. Inflexibility.

Usually involve a single security. Investor or investors with concentrated

low basis stock positions join partnership

with an unrelated party who buys the

same holdings.

Benefits: Create opportunity to borrow. No exposure to illiquid assets. Flexibility.

Private EF

Hedging Strategies

Law often prohibits constructive sale (offsetting position). Illiquid portfolios can be effectively monetized.

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Copyright FinQuiz.com. All rights reserved.

2013, Study Session # 4, Reading # 13

Two Alternatives

Variable Prepaid Forwards

Forward sale of a contingent no. of low cost basis shares in exchange for advance cash today.

No constructive sale requirement.

Pure Hedging Strategy

Protect gains & let profits run. Reduce or eliminate downside

risk

Pure Monetization Strategy

Get the money out of a position (without taxable event).

Reinvesting proceeds in a desired way.

Equity Collars

Buying put selling call option.

Principal requirement no constructive sale. Collar may have +ve, zero or negative cost. Collar sets the minimum value (serve as collateral), so

monetization is easy.

5. SUMMARY AND IMPLICATIONS

Useful for investors & advisors to

think in terms of diversification

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