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Equity Compensation

Selling After the IPO Lockup

Selling After the IPO Lockup

Although an IPO creates a market and an ascertainable value for your company stock, you are still "cash poor" until you actually sell and diversify. This is why the expiration of the IPO lockup creates as much excitement and anxiety as the actual IPO. There have been a number of studies demonstrating that share prices often decline leading up to and on the unlock date. As a result, many stockholders hoping to sell are reluctant to do so and wonder if they should just wait it out. As you explore what the right decision is for you, it is important to examine not only the probabilities of potential outcomes but also the potential consequences of those outcomes.

While many stocks dip during the IPO lockup expiration and later rebound, others simply continue a downward spiral. While you may truly believe in the outlook of the company and be tempted to bet heavily on it, it is important to first understand your own definition and tolerance for risk. In finance, we often define risk as volatility, but when it comes to your life the real risk is not reaching your goals. Even if the stock is trading down what does that potential value mean for you and your life? For some, it might mean paying off student loans or a down payment on a house. For others, it could be enough to provide financial security or attain financial freedom. Regardless of the number of shares you have, you need to evaluate whether you are willing to jeopardize goals that may already be within reach in hopes that the future performance of your company stock will outpace a diversified portfolio.

Another way to look at it is to consider your likelihood of regret. If you choose to sell everything right away and the stock price later jumps upward, you may regret not holding out longer for a higher price. Alternatively, if you choose not to sell anything and prices move permanently downward you will regret not selling when you had the chance. The latter is especially true when you can no longer attain the goals that were once in sight. If you can determine the number of shares that is the fulcrum balancing these two forms of regret in your mind that is a good place to start.

In the end, the reasonable strategy for many is to sell at least some of their shares early and sell the remainder over regular intervals. This allows you to take some proverbial chips off the table, while still capturing what can be thought of as temporal diversification (selling over time to capture different price points—similar to dollar cost averaging). Exactly how much to sell right away, how much to sell over time, and how much to keep indefinitely is a personal decision that will be driven by your unique goals and tolerance for risk.

The Lockup Period

The Lockup Period

An IPO is one of the most exciting days for founders, employees, and early investors of startup companies. What used to be a small company with a strange name and a crazy idea becomes a large company with a household name and an idea that everyone wants a piece of. It is also the day when all that hard-earned sweat equity which had previously been recognized with potentially worthless stock options and RSUs becomes valuable and marketable equity in a publicly traded company…well almost marketable!

While not required by the SEC, almost every company going public subjects employees, former employees, and other insiders to a lockup period (often 180 days) during which they are not allowed to sell their stock. The reason the lockup period exists is that typically only a small portion of outstanding shares are sold during an IPO and insiders continue to own the majority of stock. If all those insiders decided they wanted to sell right after the IPO it could put downward pressure on the stock price of the newly public company. Since the underwriters (investment banks) assume the risk of buying the IPO stock and then resell it to the public they want to ensure the market is not going to be flooded right away and thus require the company to “lockup” the shares of insiders for a certain period of time, known as the lockup period.

Taxation of Incentive Stock Options

Taxation of Incentive Stock Options

Note: You may find it useful to review this introduction to stock options before reading this post.

Incentive stock options (ISOs) have significant tax advantages over their sibling (non-qualified stock options). For regular tax purposes, the bargain element of ISOs is not taxable upon exercise and no tax is due until the shares are sold. If you satisfy the special holding period before selling (i.e. two years from date of grant and one year from date of exercise) the bargain element will be converted to a long-term capital gain, which means it is taxed at lower rates. Although holding exercised shares still exposes you to investment and concentration risk, the tax benefits make holding ISO shares very compelling. As a result, many employees will exercise and hold all of their ISOs thinking they are saving a significant amount of taxes and that whatever taxes are paid won’t be due until the shares are sold.

While this can be true, it often is not the case. ISOs would be beautiful if it were not for the dreaded Alternative Minimum Tax (AMT) which significantly complicates your tax situation and can diminish much of the tax savings you thought ISOs had. AMT is a separate and parallel tax system. Every year you calculate your tax liability under the regular system and the AMT system. You then pay whichever tax liability is higher. Many taxpayers never have to contemplate AMT, but if you have ISOs it becomes critical as there is a good chance you will owe AMT in the year of exercise.

Under AMT, incentive stock options don’t receive special treatment, which means the bargain element is considered taxable income upon exercise. If this is a significant amount or there are other impacting factors in your tax return (e.g. if you have high itemized deductions from owning a home) then you could owe AMT. Since it’s not considered compensation income, your employer will not put it on your W2 and it’s up to you to remember to report it. Further, if you use tax software to self-prepare your returns there is a good chance you will miss this as it’s often not part of the normal prompts.

As a result of the complexity, many financial advisors will recommend selling ISO shares immediately after exercise if the company is already public—which essentially converts them to non-qualified stock options and greatly simplifies your tax situation while minimizing risk. However, this is often bad advice and is a classic example of throwing the baby out with the bathwater. If you have ISOs it’s a good idea to speak with a CPA or better yet a CPA/PFS who has experience with stock option planning. A PFS is a designation awarded only to CPAs who have additional education and experience in financial planning. Based on your unique tax situation and risk tolerance a sensible exercise and sell strategy can be developed that will likely result in you paying lower taxes than if you otherwise chose between a blanket hold or sell policy.

Taxation of Non-qualified Stock Options

Taxation of Non-qualified Stock Options

Non-qualified stock options are not taxable until exercised. Upon exercise, assuming you are vested (or have filed an 83(b) election—a topic for a future post), you must report the bargain element as compensation income. You may recall from a prior post that the bargain element is equal to the current FMV less the strike price. Since the bargain element of NQSOs is considered compensation income, your company will report it on your W2 and withhold income tax, social security, and medicare. When you eventually sell the stock (same-day or years later) you will have a capital gain or loss determined by taking the eventual sale price and subtracting your basis (what you paid for the stock plus the amount reported as compensation income).

For example, if you were granted non-qualified stock options with a strike price of $2 per share and the FMV at time of exercise is $10 per share, your taxable compensation income will be $8 per share. Regardless of whether you immediately sell the stock or hold it, you will pay income tax, social security, and medicare on $8 per share. When you eventually sell the stock you will have a capital gain or loss based on the difference between the sale price and your basis of $10 per share ($2 exercise + $8 compensation income). If the sale occurs within one year from the date of exercise it will be considered short-term and subject to ordinary income rates, and if you wait more than one year it will be taxed at the lower long-term rates.

When it comes to personal record-keeping, non-qualified options should be pretty easy. Your company is responsible for reporting the compensation income at exercise on your W2 and any subsequent capital gains or losses should be reported on a 1099 from the broker or custodian where your shares are held and sold.

An important note about risk: If your company is public at the time you exercise non-qualified stock options and you’re not subject to any restrictions (e.g. lock-up or black-out) you need to consider carefully whether it makes sense to continue holding the stock. From a tax standpoint, holding stock from exercised NQSOs is no different than getting a cash bonus and buying the stock on the open market. In other words there is no tax incentive, but you will bear significant concentration risk by holding a single stock instead of a diversified portfolio.

Know Your [Stock] Options

Know Your [Stock] Options

When you get hired at a startup company you’ll often receive stock options as part of you compensation package. If you’re lucky your grant will include ISOs. Once vested, you can exercise your options and buy shares of stock at the strike price instead of the current fair market value. This bargain element provides an instant economic benefit, but also puts your money at risk and can create AMT implications. When your company IPOs and the lock-up period has expired you’ll be able to sell your stock and hopefully make a small (or large) fortune.

Simple and understandable, right? Probably not.

If you work at a startup company you've heard the above narrative before. In fact, it was probably a big reason for accepting the job in the first place. We’ve all heard the stories of stock options making Silicon Valley employees rich, but few truly understand how they work until it’s too late. As a result you could end up paying more in taxes and leaving a lot of money on the table. With a basic understanding and proper planning you can easily put yourself in a better position. In future posts I’ll teach you some of the inner-workings of stock options and most importantly how to maximize your profit while minimizing risk and taxes.

Before we can get to the “fun” stuff, we first must understand the language. You have probably heard most the italicized terms in the opening narrative, but I doubt you fully understand what they all mean. Let’s break it down…

Stock Option: A stock option simply gives you (the option holder) the right to purchase shares of stock in the future at a pre-determined price after certain requirements have been met. The stock option itself does not give you equity in the company—it merely gives you the right to acquire it.

Grant: When your employer “gives” you stock options it is called a grant. The details of your grant are outlined in an option agreement. The option agreement will specify the number of shares you can buy, when you can buy them (vesting), and for how much you can buy them (strike price).

Incentive Stock Option (ISO): An Incentive Stock Option is a type of stock option that meets certain requirements and therefore is eligible for special tax treatment. Anything other than an ISO is called a non-qualified stock option, often shortened to NQSO or “non-qual.”

Vesting: Contained in your option agreement will be a vesting schedule which dictates when you become eligible to purchase shares of stock (i.e. exercise your option). As an example, when hired you might be granted an option to buy 4,800 shares of stock, vesting over the next four years. At the one-year anniversary you will be eligible to purchase 25% of the stock (1,200 shares). Thereafter you will vest at a rate of 100 shares per month for the next three years until you are fully vested.

Strike Price: The strike price (also referred to as the grant price, exercise price, or option price) is the price you may purchase shares of stock for under your option agreement. Usually the strike price is the fair market value per share of stock at the time of grant. Assuming the value of the company increases after the grant, your strike price will be lower than the fair market value at time of exercise, thus allowing you to buy the stock at a “discount.”

Fair Market Value (FMV): The fair market value of a company's stock is critically important to your planning process. It determines both your strike price (FMV at time of grant) and your bargain element (defined below) which in turn affects your risk exposure and tax liability. Determining the FMV of a private company is beyond the scope of this post, however most of the time an appropriate FMV will be given to you by your company. Once the company goes public, determining FMV will be easy as it’ll simply be the price at which it trades on the public market.

Bargain Element: The bargain element is the difference between the current FMV and your strike price. It represent the economic value of your stock option. If the current FMV of your company’s stock is $10 per share and your strike price is $2 per share, the bargain element is $8 per share. The bargain element is also commonly referred to as the spread.

Alternative Minimum Tax (AMT): The AMT is a separate (think parallel) tax system to the “regular” tax system. Every year you pay whichever tax calculates to a higher amount (fun, huh?). Unless you own a home, have lots of itemized deductions, or have previously exercised ISOs there is a good chance you have never had to pay AMT and perhaps that you didn’t even know it existed. However, if you are going to exercise ISOs it is imperative that you consider the implications of AMT or you could get caught underpaying your taxes, which would result in penalties and interest (definitely not fun!). We’ll get into this more in future posts.

Initial Public Offering (IPO): An IPO is one of the most exciting days for employees and investors. It represents the first time company stock is offered to the public and begins trading on the open market. The reason this is important to you is that it gives you the ability to sell your stock (hopefully at an appreciated price) and diversify into a long-term portfolio. Think of it as an opportunity to harvest all the energy and value that you’ve put into the company.

Lock-up Period: Not so fast! Although everyone else gets buy/sell after the IPO, most employees and insiders will probably be “locked-up” and unable to sell for six months after the IPO. This can be a very volatile period for the newly public stock and your emotions will likely follow in lock-step as the stock hits new highs and lows.

Now that we’ve defined and explained the jargon that is so often thrown around with stock options, re-read the narrative at the beginning of this post and see if it makes any more sense. Understanding these elements will be important as we delve deeper into stock option planning and strategies. Stay tuned for future posts!