The IPO was announced. You took action and did the 5 things everyone must do. Now, you are in the lock out period.
The lock out period is the time when you are restricted from selling your shares. It usually lasts six months.
Now is the time to plan. You can use the next six months to prepare for ten years of wealth in one moment.
There are five ways to sell your shares after the lock out expires.
1. Sell ASAP
The lock out expires. You exercise and sell all vested shares on the first day. This is the simplest approach.
Selling as soon as possible protects you from possible future losses. The IPO may be your first opportunity to cash in on your stock options. Don’t get greedy.
The greatest gains are usually from the time you receive a grant of options until the IPO. The IPO exposes your company to public scrutiny. Do not expect the post IPO rate of return to match your experience before the IPO.
You experienced great gains. Protect yourself by selling.
Don’t Get Stuck
Not selling is dangerous. You don’t want to be stuck in a life boat without an oar.
For every Facebook and Google, there are many more Twitter and LinkedIn. Too many times we see tech employees who are stuck.
They ask again and again, “When should I sell?” There is no good answer after a fifty percent plus decline in stock price.
Plan now. Don’t get stuck later.
Possible Tax Outcomes
Selling as soon as possible will produce many tax outcomes. Stock option type, date of exercise, and the alternative minimum tax (AMT) determine your tax outcome.
Incentive Stock Options
- Exercised more than one year ago; no AMT paid on exercise. – One Hundred percent of your gain will be taxed at long-term capital gains rate.
- Exercised more than one year ago; AMT paid on exercise – You have two different cost basis. One for regular income tax. One for the alternative minimum tax. It’s complicated. You need help!
- Exercised less than a year ago; no AMT paid on exercise – All your gain will be taxed at ordinary income tax rates.
- Exercised less than a year ago; AMT paid on exercise – It’s complicated. See above. Get help!
- Exercised more than one year ago – One Hundred percent of your gain will be taxed at long-term capital gains rate.
- Exercised less than a year ago – All your gain will be taxed at ordinary income tax rates.
Three Real Life Reasons to Sell
You have made your money. The IPO is an opportunity for transformational wealth. Here are three real life reasons to sell.
- Free up cash for a home down payment. You may need as much as $260,000 to buy a median priced house in San Francisco.
- Pay off student loans. Get rid of that anchor from grad school that’s dragging you down. Check the interest costs versus your expected investment return. Determine if paying off student loans early is right for you.
- Diversify your investments. Divorce your future from the uncertain destiny of your company.
Write down your goals. Plan a strategy in advance that supports your goals.
2. Sell a Little at a Time
Sell in installments. Your trading windows usually occur after quarterly earnings reports.
This gives you four opportunities a year to sell. Divide your existing shares and options by eight. Sell in equal installments over the next two years.
- 15,000 shares vested
- 10,000 vesting over the next two years
- 25,000 divided by 8 = 3,125
- Sell 3,125 shares at each trading window
This is the reverse of dollar cost averaging. Instead of buying equal amounts of a stock, you sell equal installments.
Your average sales price becomes the average of the stock’s price over the next two years.
No one can predict future share prices. Do not confuse your knowledge of the company with a crystal ball.
You may be an insider, but you do not know the future. General stock market conditions can impact the value of even great companies.
We see many people fail with this strategy. Few pull it off.
The stock price goes down one trading window. The plan to sell gets put “on hold.”
“We will wait for a rebound,” you say. The rebound never comes. You get stuck. Tied to an old stock price.
Don’t get stuck.
3. Hold a Percentage
Decide on a percentage of your investment portfolio to keep invested in the stock. You could do 5%, 10%, or 20%.
Remember to count your unvested shares as part of the percentage. You may be at 10% now but new shares vesting will put you over the limit.
How long will you stay with your employer?
Lots of employees move on after an IPO. Your shares vest. You get new grants but not like before.
Leaving for a new job can change your desire to own the stock. Keep this in mind when deciding on a percentage.
Keep In Mind
Consider this strategy in reverse. You have a $1 million dollar portfolio. Ten percent is $100,000.
Would you invest $100,000 in one stock?
Not your employer’s stock. Just one stock. You are doing this by holding a percentage.
What is your assumption? That your stock will earn a return greater than the return of the global stock market.
This is a huge assumption!
You are betting that your company is the next Google. It probably is not.
We would not advise you to do the reverse of this strategy by buying a single stock. Yet, many of our clients insist.
We help them evaluate risk at different percentage levels.
4. Sell Specific Lots to Cut Taxes
A lot is a group of shares that are exercised or purchased on the same day. Each lot has its own cost basis.
An example, you were granted 20,000 incentive stock options with a strike price of $1.00.
- Lot 1 – Exercised three years ago when the fair market value (FMV) was $2.00
- Lot 2 – Exercised two years ago at a FMV of $5.00
- Lot 3 – Exercised last year, FMV $18.00
Choose your lots carefully when you sell.
Your best option is to sell shares that were exercised more than a year ago. You pay long term capital gains by doing so.
Long-term capital gains rates vary from 0% to 23.8%. They are always lower than ordinary income tax rates. Shares from incentive stock options must be held for two years after grant to qualify.
How do I choose lots to sell?
Get an unrealized gain/loss report from your stock option brokerage account. This account may be with eTrade, Schwab, or another provider. Check with your employer.
The cost basis reported by your account for each lot may not be accurate. Get help from advisors who are experts at stock options.
Choose based on the type of stock option
You need to understand how different options are taxed.
- Incentive Stock Options (ISO) – Most favorable for holding long-term. You pay nothing for regular income tax at exercise. Paying alternative minimum tax generates an alternative minimum tax credit. Get tax help!
- Nonqualified Stock Options (NQ) – Bargain element taxed as ordinary income on date of exercise. Common strategy is to exercise and same day sale.
- Restricted Stock Units (RSU) – Full value taxed as ordinary income on vest date. Common strategy is to sell at vest.
“Who thinks of this stuff?”
Is what a new client recently asked.
I was explaining stock option taxation. Get help! Don’t waste your wealth on unnecessary tax mistakes.
5. Consider a 10b5-1 Plan
A 10b5-1 Plan allows you to automate the sale of your shares. Check with your employer to see if it’s available to you.
It is the easiest option short of selling ASAP. The plan automates the sale of your shares in monthly installments. Check with your employer to see if a 10b5-1 plan is available to you.
The plan is administered by an outside provider. There is a fee to use the plan. We have seen fees range from 1% to $4.95 per trade.
There is usually a window of opportunity to sign up for the plan. Kind of like open enrollment for health insurance.
How to Combine the 5 Ways
Based on an actual client case. Here are the facts:
- Employment Start Date – 3 years before IPO
- Year 1, Grant #1 – 20,202 incentive stock options, 4,798 nonqualified stock options, $4.95 strike price, 25% vest at one year anniversary, 1/48 vest monthly after one year
- Year 2, Grant #2 – 4,060 incentive stock options, $9.85 strike price, 1/12 vest monthly after one year
- Year 3, Grant #3 – 5,000 restricted stock units, 1/4 vest quarterly after one year
- 2,983 incentive stock options exercised from grant #1 before IPO at a FMV of $14.12.
- IPO occured in May but lock out does not expire till following February
- Stock is currently trading at $43.45
We have three grants, three types of stock option, and one lot of existing shares.
After some discussion, the client describes two goals:
- To avoid babysitting the stock. No watching the stock price and worrying about what to do.
- Hold ten percent of their $1 million portfolio in the stock.
Our initial strategy is to:
- Exercise all vested stock options after the lock out expires. Sell enough shares to cover the cost of exercise and the estimated tax bill. Sell nonqualified stock options first. Hold the remaining incentive stock options for one year.
- Sell existing lot of shares from ISO exercise after one year.
- Sell RSU shares as soon as possible.
- Watch stock price at each trading window. Sell shares if price drops below the price at exercise to lock in lower gain for taxes.
- Update tax projection at each trading window to avoid a “gotcha” tax bill.
Choose the Strategy(ies) that Work for You
Decide in advance. Then carry out your plan.
Compare your life to the story of your company. Most tech companies start as an idea. Then a few people get together and turn the idea into a company.
It is a lot like your career. Just a college degree and an idea.
At first, employees of the company have pretty simple job descriptions. You do whatever is necessary to help the company succeed. Why? Because there’s no money for new hires.
There was a time where you to had to do everything. File your taxes, set up your 401(k), exercise your stock options.
It’s time to grow up.
The IPO is an opportunity for life changing wealth. Don’t get stuck in start up mode. Scale your career and wealth by working with experts.
You will save money on taxes and unlock hidden potential.